Pakistan: The Economic Barometer Indicates Fair Weather Ahead

Originally published in the Financial Post on Monday 18th February 2002

If one accepts notion that the stock exchange is the barometer of the economy’s state, one would conclude that the pundits expect good tidings ahead. The KSE Index was at around 1250 a day before 11^th September 2001 and is currently ranging between the 1600 and the 1700 levels - an improvement of around thirty percent.

Sceptics would dismiss this by saying that the Pakistan market is manipulated by a handful of speculators and therefore the barometer cannot be relied upon. It is true that the market is influenced by speculators and that the bulk of the volume traded is on account of speculation. However, we must recognise the fact that speculators simply try and forecast the future price levels and then buy shares if they believe that the future levels will be higher than the current levels; and as more and more speculators get involved, the demand causes the prices to rise.

As is true anywhere in the world, as more people notice the price run up, with the typical herd mentality, the public starts jumping into the fray. This causes a further price momentum and prices at times go beyond sustainable levels. This leads to profit taking by the more astute players and the public may be left holding rather expensive shares. This leads to the accusation that the speculators had manipulated the market in the first place.

Irrespective of which side of the story we accept, the fact remains that the initial price run-up is caused because of a belief by some speculators that there are grounds for prices to rise and they try and act in anticipation of that. What we must analyse is whether the run-up this time around is based on a realistic expectation of improvement in the economy or it is merely driven by market manipulators.

The question to answer is, as to why should an anticipated improvement in the economy lead to higher share prices. Share prices are determined by the market participants by first trying to forecast the profitability of companies and thereafter deciding as to what would be a fair value to buy into such profitability.

We know that if conditions are very uncertain, we prefer not get our money stuck in any long-term investments, so even if a company is profitable, we would not want to pay to much for its shares; on the other hand, if we perceive the conditions to be reasonably stable, we are willing to commit our money to longer term investments and we may be willing to pay somewhat higher for the shares of the same company. The market participants call this factor the Price Earning Ratio (PE Ratio). It means the price they are willing to pay for a share expressed as a ratio of the earnings per share. In other words, if a company’s earnings are Rs. 3 per share and the price of the share is Rs. 15, the PE ratio is 5 times (equivalent to five-year pay back period). If the business environment becomes more certain, the market participants may be willing to settle for say an eight-year pay back period or a PE Ratio of 8 times, thus be willing to pay Rs. 24 for the same share.

Secondly, if the earnings forecast of the company were to go up as well, the market participants would take this into account as too. If we assume that the same company’s profit forecast improves due to the better anticipated conditions to say Rs. 4 per share and if we use the improved PE Ratio of 8 times, we would anticipate a price of Rs. 32 per share. Thus the share price of a company could be expected to go up from Rs. 15 per share to Rs. 32 per share, not because the company has become more than twice as good overnight but because the future expectations for the economy and therefore for the company have become better.

The astute investor will not wait for the future to unfold but would try and buy the shares now in anticipation of the future expectations. Based on this example, the investor would be willing to keep buying at anything below the price expectation of Rs. 32. Thus causing a run-up in prices.

Now to answer the question whether the present run-up is a forecast of an improved economy. Our view is that it is.

Some of the factors that prevailed preceding 11^th September 20001and what prevails today needs to be looked at to come to this conclusion:

• The Pakistan Rupee was under constant pressure. Many people were expecting the Rupee-Dollar parity to reach Rs. 70 per Dollar by December 2001. We have actually seen an appreciation of the Rupee.
• Pakistan’s foreign currency reserves were in a precarious position, with a constant threat of default on our foreign obligations. Today’s position is that the reserves have never been better (around $ 5 billion), with further improvements expected by June 2002 ($6 billion). That is a coverage of around six-month’s of imports from what was a coverage of just a few weeks of imports.
• The US Dollar was the preferred investment before, with a definite trend towards Dollarisation of the economy; the trend is totally reversed today.
• Pakistan was isolated in the world community, today it at the centre stage.
• We were under a regime of sanctions by the first world. All economic sanctions have been lifted.
• New markets have been opened out by the European Union for our textiles and other products.
• We were at a stage of political uncertainty but are now reasonably certain of the new political structure that is likely to emerge. It is extremely important for business that there is continuity in policies.
• Privatisation seems to finally be moving ahead.
• There is a greater investment towards on social development and poverty alleviation, which in turn is necessary for sustainable economic growth.
• On the agricultural side - a major contributor to the GDP - we are seeing surpluses in wheat, rice and cotton despite the water shortages.
• Afghanistan finally seems to be settling down after over 20 years of strife. We should benefit both from the re-building and the opening out of the trade route with Central Asia.
• Interest rates have come down substantially. This will translate into more trade and economic activity.
• The results being announced by the corporate sector are better than before with good dividend payouts.

One can only surmise that the barometer is showing an accurate reading this occasion.