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Morning Call about Monetary Policy Statement Economy – Arif Habib Limited

Karachi: 150bps cut in policy rate raises valuations by 7%

According to Arif Habib Limited, The Stat Bank of Pakistan (SBP) decision to cut the policy rate by 150bps, to 12% (real rate +0.53% adjusted for 3MFY12 YoY headline inflation) on 8th oct’11, does not seems like a one off an event, instead signalling a further rate cuts down the road. Hence Arif Habib Limited is revising its discount rate outlook for FY12 to 11.0% from 12.5% previously, with a further 100bps room for easing possible. Indeed Arif Habib Limited thinks the SBP decision to further continue rate easing will primarily be dependent on inflation trending downwards along with banking sector willingness to lend private sector. The SBP decision to slash the policy rate appears to be motivated by following two factors in mind:

Cut in interest rate, re-rating likely with earning yields of 16%

With 1.5% cut in risk free rate, AHL universe stocks target price revises by +7% on average. This monetary easing is likely to bode well for the highly leveraged companies like ENGRO, DGKC, NML and EPCL. Arif Habib Limited re-iterates its positive stance on the market, which offers an earnings yield of 16%. Arif Habib Limited recommends investors to overweight Fertilizer, Cement and Banking sector. Arif Habib’s preferred list of stocks includes POL, APL, PSO, FFC, NBP and LUCK. On a dividend yield basis its top picks are HUBC, KAPCO, NCPL and PTC.

Inflation receding to comfortable levels beats the market expectations

The CPI headline inflation for the fiscal period up to Sept’11 receded to 11.2% YoY on average. This was broadly on the back of high base effect and revised weight-age calculation methodology causing the 12 month inflation expectation to bottom out below 12% YoY target. In the statement the decision to start easing rested pretty much on the stance of further downward trending inflationary expectations over the horizon. However in Arif Habib’s view the inflationary expectation provides less of a comforting view in the medium to long term. While beyond FY12 the SBP remained hesitant on achieving inflation targets for the FY13 and FY14 (10%, 8% YoY respectively), given the upside risks of administrated price adjustments of energy, public sector borrowing requirement remaining high and exchange rate depreciation.

Rates were unfertile for growth dynamic to pick up
Moreover, SBP decision concluded that the rate cut were more in the view on achieving the growth target of 4.2% YoY, which rested on reviving private sector investment. The report also see downside risks to the global economic growth and implicating a potential upside risks to Pakistan own growth dynamics. Hence to spur economic growth the SBP identifies the need for positive developments primarily through the resolution of intra debt of energy sector and keeping government borrowing under the default threshold, in order for the private sector credit to pick up.

Although the rationale for easing the policy rates by SBP seems logical when viewing it from the growth perspective. However there are factors that may cause this easing cycle reversal in long term.

Second round effects are gaining momentum, which have been overlooked
The main source of upward pressure on inflation in the past few months has been rising food prices partially owing to flood-related supply disruptions and rising world food prices. Well that sentiment seems to be receding in general as food inflation dipped to 9.6%, after rallying in double digits for 22 consecutive months. Similarly the WPI non-food went down to average 13.9% YoY 3MFY12. However in Arif Habib’s view monthly inflation rise shall not be overlooked yet, with commodity prices staying at elevated levels. Any spike in oil or food prices will eventually transmit into a first round inflation effects. While Arif Habib Limited suspects the possible risks of second round effects materialising in the medium to long term backed by high commodity prices remaining intact, would further uptick the core inflation, from current levels of 10.6% YoY (Sept’11).

Intra-energy Debt; Primary source of contention seems irresolvable in MT

Although the industrial growth gained some momentum (LSM+0.68% YoY, Jul’11), but it is likely to stay weak in FY12. This is despite the government decision to consolidate the intra energy debt resolution through the issuance of PIB’s worth around PKR 400bn and retirement of subsidies paid (which Arif Habib Limited thinks has taken over optimistically by SBP), rate cuts will only cause a muted impact on overall revival of the growth. Arif Habib Limited continues to think slack resolution of energy debt along with risky appetite of private sector would albeit tilt to a softer growth prospects in FY12, despite domestic demand staying intact. Hence given the aforementioned Arif Habib Limited continues to expect growth to languish at around 4.0% YoY in FY12.

Enough lending appetite shies of borrowers’ credibility

Along with the aforementioned near term risks (high oil and other commodity prices), interbank liquidity may remain tighter for longer. While in Arif Habib’s opinion banks lending behaviour toward private sector is unlikely to change in near-term (albeit with a slower pace), despite a falling weighted average lending rate (WALR +14.22% Aug’11, against 14.65% in Jul’10). Arif Habib’s concerns primarily stems from high public sector borrowing requirements offering a risk free appetite.

Pak rupee likely to readjust, with a slight depreciation in Arif Habib’s view
Finally Arif Habib Limited thinks Pak rupee (PKR) is likely to readjust to the monetary policy cycle, with slight depreciation to Arif Habib’s revised estimates of 3% YoY (PKR/USD 88.73) FY12 average rate. Arif Habib’s concerns mainly stems from the mixed message delivered by recent SBP intervention in the exchange market to stabilize sharp currency devaluation, when PKR touched lows of PKR ~90 (intraday, kerb market) against the greenback. Arif Habib Limited thinks a repayment to IMF starting from 2HFY12, will put an upward pressure on country’s reserves which currently stands just above USD ~18bn, while Arif Habib’s initial view was restricted influence of policy rate easing on imports due to low trade to GDP ratio (~11%). Further given the IMF repayment schedule, low foreign inflows and the need to fill in the fiscal gap, Arif Habib Limited reiterates its call for the Pak rupee to depreciate to 89.7 (~4% YoY) by fiscal year end.

Bottom line
Given the SBP embarking on an easing cycle Arif Habib Limited see a possible 100bps cut further. But it is too early to have a clear view the pace of easing, and how will the SBP responds to the interplay of growth and price stability factors. Hence future monetary policy management should be viewed in the long term prospective rather than short, as it internalizes the reactive bias, which is adverse for the economy, in Arif Habib’s view.

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