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KARACHI: Morgan Stanley Capital International (MSCI) has proposed to reclassify Pakistan into MSCI Frontier Markets (MSCI-FM) from MSCI Emerging Markets (MSCI-EM). The MSCI has been artificially maintaining Pakistan’s stature in Emerging Markets since the country has been no longer meeting EM standards for size and liquidity criteria for last 19 months.

It is now proposed to put Pakistan back to Frontier Markets with a higher weight of 2.3 percent from existing meager country weight of 0.02 percent in Emerging Markets. Moreover, Pakistan’s weight in the widely tracked Frontier Market 100 Index will now be 5.8 percent whereas OGDC has been included in MSCI Pakistan Standard Index.

“Although country classification has been downgraded one notch from Emerging to Frontier markets, this boded well for local stock market as Pakistan will enjoy higher weightage in Frontier Markets compared to negligible weight in Emerging Markets which may result into net inflows in Pakistan market,” Farhan Mahmood, senior analyst at Sherman Securities said.

“We expect lower outflow from funds tracking Emerging markets since already foreigners has been net sellers of $1.3 billion ever since Pakistan included in EM four years back (KSE-100 index down 5 percent since then),” he added.

As per MSCI, discussion on classifying MSCI Pakistan Index from EM to FM will continue till August 2021 while the final announcement will be made by September 07, 2021.

Interestingly, Pakistan market is now available at 35-40 percent discount to fund managers tracking frontier markets as Pakistan market was trading close to 9x on forward PE at the time when Pakistan reclassified from FM to EM.

Currently Pakistan market is trading at 01 year forward PE of 5.3x with Banks and Energy sector.

Syed Atif Zafar, Director Research and Chief Economist at Topline Securities said that the number of companies in the Pakistan equity universe that meet the relevant size and liquidity criterion of the MSCI Market Classification Framework has consistently been below the minimum of 3 index constituents required for EM. “Based on Pakistan’ weight of 0.02 percent and estimated global passive EM AUMs of $400-500 billion, we estimate investment of passive EM funds in Pakistan to the tune of $175-225 million, where around $100-125 million are likely invested in main EM stocks while $75-100 million are potentially parked in small cap EM stocks,” he said.

“We estimate potential investment from passive FM funds to the tune of $150-200 million where $125-150 million is likely in the main constituents.”

Some of the active Frontier Market funds were still investing in Pakistan even though it was classified as an Emerging Market.

“While the potential inflows and outflows remain early estimates and may largely net off, we believe the reclassification to FM from FM may turn out to be beneficial for Pakistan in terms of increasing visibility amongst foreign participants”, Atif Zafar said adding that the foreigners have been key participants at Pakistan Stock Exchange, however they have shied away recently due to Pakistan’s minimal weight in EM. However, Frontier markets have trailed the bigger markets in recent times as liquidity has dried up due to COVID-19 and consistent underperformance.

Three times previously MSCI has downgraded markets from EM to FM and those include MSCI Jordan Index (in November 2008), MSCI Argentina Index (in May 2009) and MSCI Morocco Index (in November 2013). The performance of these stock markets, 1-year before and 1-year after reclassification remained mixed.

In a small survey conducted with foreign investors, 50 percent believe this development is positive, 25 percent believe it is likely to have mixed implications and 25 percent believe it is negative for Pakistan equities.

Tahir Abbas at Arif Habib Limited said that the market classification framework for MSCI FM is full market cap of $1,171 million, free float market cap of $88 million and ATVR at 2.5 percent as compared to MSCI EM criteria of full market cap at $2,343 million, free float market cap at $1,171 million and ATVR of 15 percent.

He said the reason for potential reclassification is the steady decline in market cap of Pakistan constituents since 2017 leading towards ineligibility on meeting the criteria in the market classification framework for EM. Moreover, index continuity rule has been applied for MSCI Pakistan since November'18 to artificially maintain the MSCI Pak index in EM. Since November'19, none of the three companies in MSCI EM have met the EM classification framework.

Due to the above mentioned reason, MSCI has proposed reclassification of MSCI Pak to FM. The simulated index for MSCI Pak FM would have a total 23 companies including 4 standards and 19 small cap as compared to current 16 companies in MSCI Pak EM (3 mid cap and 13 small cap). The MSCI Pak FM standard cap will include LUCK (35.5 percent weight), MCB (23.1 percent), HBL (22.2 percent) and OGDC (19.1 percent).

The MSCI Pak FM would have weight of 2.3 percent in MSCI Frontier Market Index and 5.8 percent in the MSCI Frontier Market 100 Index.

The small cap of simulated MSCI Pak FM will include PPL, MARI, ENGRO, UBL, FFC, POL, PSO, HUBC, INDU, EFERT, TRG, BAHL, ABOT, NBP, SYS, MTL, SEARL, BAFL, PKGS.

To recall, Pakistan’s weight was around 9.2 percent when it exited the FM space in November’17. Pertinently, our weight has come down to 5.8 percent due to a decline in our market cap on the back of a significant depreciation in the Pak Rupee. While the weight of other markets has displayed an improvement as their currencies did not lose as much ground against the US dollar.

Prior to this, Pakistan was downgraded from the EM to the FM Index in May’09 (9.2 percent weight) whereby foreign inflows arrived at $306 million during June’09 to December’09, and $530 million in CY10.

“We also highlight that currently the size of funds tracking the MSCI FM space has compressed to $6.5 billion-7.5 billion, while most of them are active funds”, he said. “Although the Frontier Market has shrunk in size since 2017, amid global redemptions in the wake of COVID-19, we believe our weight will gradually go up as markets rebound and attract pre-corona foreign inflows and the weight of Bangladesh and Nigeria market is currently frozen.”

“We estimate outflows from funds tracking the EM Index to arrive at $111 million, effective from the day of exit.” Expected outflows from LUCK, HBL and MCB are $45 million, $29 million and $25 million respectively, while outflows from small cap. scrips are expected at $12-15 million.

“Most of the FM funds are active funds and we view that inflows from these funds would offset the outflows from EM funds. We estimate a net inflow of $100 million,” he said.

The discretion for allocation of whether to go overweight or underweight for active funds lies with the funds and hence this poses an upside or downside risk.

Moreover, barring Vietnam, the fundamentals of the KSE-100 index are relatively stronger than those of the peer markets (with a higher weight) with valuations at very enticing levels. Overall dynamics of the KSE-100 index are comparatively stronger than the peer markets with a higher weight such as Kazakhstan, Kenya and Bangladesh etc, he added.

Hamza Kamal at AKD Securities said that the announcement has been in line with the expectation as Pakistan has been hanging by a thread in the MSCI EM index since November’18 due to index continuity rules while engrossing a weight of 0.02 percent as per last review versus 0.1 percent when it was initially upgraded to EM.

As such, Pakistan’s classification in FM is unlikely to bring material foreign flows in the market and hence, locals are expected to continue dominating sentiments in the near future, he said. “However, we do find major funds performing due diligence on frontier markets which could unlock fresh allocations going forward,” he added.

Copyright Business Recorder, 2021

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