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Capital Markets

Pakistan turns to Islamic finance market for support

Government seeks to raise up to $1bn to shore up foreign reserves

A man checks an electronic board displaying share prices at the Pakistan Stock Exchange in Karachi.   © Reuters

ISLAMABAD -- Pakistan's first international bond in a year is likely to be well received by investors, despite deepening concerns about the country's macroeconomic stability and deteriorating political risk profile, fund managers and economists said.

The finance ministry plans to raise up to $1 billion by issuing a five-year sukuk, or Islamic bond, in November to help plug a sharply widening current account deficit and shore up falling foreign exchange reserves. Sukuk refers to sharia-compliant securities structured so that buyers receive returns from assets or transactions rather than interest.

The finance ministry has issued a request for proposals to financial institutions with Oct. 14 as the deadline. Analysts said Pakistan's decision to float a sukuk was in part due to a glut of traditional sovereign bond issues between July and September.

"The main issue facing Pakistan is that the market is currently being saturated with new supply and many of the latest bond issues have struggled a bit," said Jan Dehn, head of research at Ashmore Group, a British investment manager focused on emerging markets. "By issuing sukuk, Pakistan may avoid some of the saturation issues."

International investors would take into account Pakistan's encouraging economic growth trajectory against its widening current account deficit. The deficit has increased pressure on the government to reverse its strong rupee policy and raised the prospect of it seeking balance of payments support from the International Monetary Fund.

"Pakistan will probably need to receive another financial support package, devalue its currency, or both, as the IMF will make any support contingent on a devaluation," the Eurasia Group, an American risk consultancy, said in a recent advisory note to investors about the sukuk issue.

Pakistan's gross domestic product grew by 5.3% in the fiscal year ended June, up from 4.8% in the previous year, driven by domestic consumption and improved agricultural and industrial output. In early October, the Asian Development Bank and the World Bank each revised upward their forecasts of Pakistan's economic growth to 5.5% for the current fiscal year.

Pakistan's current account deficit swelled 148.5% to $12.09 billion during the last fiscal year, driven by rising imports of petroleum products and machinery for the $62 billion China-Pakistan Economic Corridor infrastructure program, part of Beijing's Belt and Road Initiative to improve connectivity in the region.

It reached the equivalent of 4% of GDP, up from 1.7% the previous year, according to State Bank of Pakistan, the central bank. The ADB projected the current account deficit will increase to 4.2% of GDP this fiscal year.

The ADB said Pakistan's external debt and liabilities rose by $8.9 billion in the last fiscal year, with the government borrowing $4.8 billion to finance about 30% of the current account deficit. This included $2.3 billion received from Chinese state-owned banks, including $1 billion to pay off a 10-year Eurobond that matured in June.

The trend has continued into the new fiscal year, with the current account deficit for July and August totaling $2.6 billion. But August data suggested imports were slowing and inflows from exports, remittances and foreign direct investment were improving after two years of stagnation.

Widening gap

The yawning deficit has caused a drawdown on foreign exchange reserves held by State Bank of Pakistan, which fell to $13.86 billion on Sept. 29, the lowest level in two years and only enough to pay for 3.7 months of imports, uncomfortably close to the 3-month threshold required for acquiring loans from the World Bank.

The import splurge has forced Pakistan's overall foreign exchange reserves to drop from an all-time high of $24.5 billion in October 2016 to around $20 billion since July.

After a series of cabinet consultations, the government decided against a devaluation of the rupee, fearing the impact it would have on rising foreign debt. Instead, it recently decided to discourage the consumption of imports by allowing petroleum products distributors to increase their commissions and by imposing import duties of between 5% and 50% on up to 250 items.

The IMF, however, has questioned the approach. "Using administrative measures to correct the external imbalances is rarely effective," Tokhir Mirzoev, the IMF resident representative to Pakistan, said in recent local newspaper article. "Such measures tend to have a limited impact and often produce significant distortions."

Genuine reforms are unlikely to be introduced until after Pakistan's forthcoming general election, scheduled for August 2018, analysts said. "We expect the government to undertake reforms once the political situation permits," Dehn said. "Our base case is that the government will not borrow to levels which are unsustainable."

Pakistan's sukuk is expected to attract investors with strong appetite for yield-bearing fixed-rate instruments from emerging markets.

"There is such huge demand for yield amongst investors that the issuance should still proceed smoothly," said Lee Jin-Yang, a fixed income research analyst at Aberdeen Standard Investments, a U.K.-based global asset manager.

Analysts canvassed by the Nikkei Asian Review expected the sukuk to achieve the $1 billion target, or at least come close to it. They expect the yield to be between 5.5% -- the rate achieved for a $1 billion sukuk issued in October 2016 -- and 6.5%.

"Developing countries such as Pakistan generally offer much higher dollar yields to specifically reward the investors for such exogenous risks," said A.A.H. Soomro, senior adviser for Tundra Fonder, a Stockholm-based emerging markets fund manager. "There would always be yield-chasers who would -- despite current domestic and international political risks -- consider participating in the issue."

In choosing an Islamic financial instrument, Pakistan is seeking to mitigate political risk concerns by reaching out to less risk-averse Muslim investors in the oil-rich Gulf Arab states and Southeast Asia, analysts said.

"Political risk considerations, especially in relation to bilateral relations with the U.S., are likely to be very different for investors in sukuk capital markets compared with conventional bond markets," said Rajiv Biswas, Asia Pacific chief economist for British market research firm IHS Markit. "A Pakistani government sukuk bond placed mainly in Islamic financial markets is likely to be more resilient to political risk considerations than if funding had been raised in conventional bond markets in Europe or the U.S."

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