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MSCI Pakistan’s downgrade to Frontier Market: -

Sarmaaya Desk
Sarmaaya Content Team
MSCI Introduction:

MSCI is an acronym for Morgan Stanley Capital International. It is an investment research firm that provides stock indexes, portfolio risk and performance analytics, and governance tools to institutional investors and hedge funds. MSCI is perhaps best known for its benchmark indexes—including the MSCI Emerging Market Index and MSCI Frontier Markets Index—which are managed by MSCI Barra. The company continues to launch new indexes each year.

MSCI and Pakistan:

Pakistan has had a rocky history with the MSCI. For starters, normally when the MSCI gives a country a ranking, that country usually only moves up, not down. Pakistan, however, is only one of five countries that have ever been downgraded by the MSCI. Back in 2008, Pakistan was categorised as an emerging market. It was at this point that the stock market crashed in 2008. As a result, the Karachi Stock Exchange was temporarily closed to prevent the flight of foreign investors from the market. Once the market opened again, foreign investors pulled out their investments from the country and the MSCI relegated Pakistan’s status from that of an emerging market to a frontier market, causing the country’s equity market to lose access to trillions of dollars. While this was a major blow, making Pakistan only the third country to ever be downgraded by MSCI, it also helped set a new resolve that would take Pakistan forward. Pakistan has performed consistently and the country’s equity market delivered, with improved regulation standards and market fundamentals. As a result of this, the PSX was declared the “best-performing stock market in Asia in 2016.” This was quickly followed by the MSCI deciding to give it the much-coveted emerging market index status. This was really an underdog story. Not only did Pakistan get redemption by the improvements in the PSX, it went ahead and regained its earlier position by being declared an emerging market in 2017.

KSE 100 Index during the changes:

It can be seen that the market rose in the frontier market and a downward trend can be seen when Pakistan entered the emerging market. This shows that Pakistan performed well in the frontier market.

KSE 100 chart

The market crash in 2008 caused investors to lose confidence and become risk averse. The Pakistani stock market also faced a downfall. The local investors backed out and foreign investors also lost interest. Even when the markets opened afterwards, the index suffered more as no one was willing to invest in the market. It fell from 9187 points to 4929 points when it reopened. This shows the lack of confidence of investors to invest in the Pakistani Stock Exchange.

Frontier Markets:

A frontier market is a term for a type of developing country's market economy which is more developed than a least developed country, but too small, risky, or illiquid to be generally classified as an emerging market economy. The MSCI Frontier Markets Index captures large and mid cap representation across 27 Frontier Markets (FM) countries. The index includes 81 constituents, covering about 85% of the free float-adjusted market capitalization in each country. Frontier Markets countries include: Bahrain, Bangladesh, Burkina Faso, Benin, Croatia, Estonia, Guinea-Bissau, Iceland, Ivory Coast, Jordan, Kenya, Lithuania, Kazakhstan, Mauritius, Mali, Morocco, Niger, Nigeria, Oman, Romania, Serbia, Senegal, Slovenia, Sri Lanka, Togo, Tunisia and Vietnam. The MSCI Frontier Markets Index was launched on Dec 18, 2007. Data prior to the launch date is back-tested data (i.e. calculations of how the index might have performed over that time period had the index existed). There are frequently material differences between back-tested performance and actual results. Past performance -- whether actual or back-tested -- is no indication or guarantee of future performance. Investors in the frontier market are risk takers as higher returns are offered at high risk.

An emerging market is a market that has some characteristics of a developed market, but does not fully meet its standards. This includes markets that may become developed markets in the future or were in the past. An emerging market economy is the economy of a developing nation that is becoming more engaged with global markets as it grows. Countries classified as emerging market economies are those with some, but not all, of the characteristics of a developed market. As an emerging market economy progresses it typically becomes more integrated with the global economy, as shown by increased liquidity in local debt and equity markets, increased trade volume and foreign direct investment, and the domestic development of modern financial and regulatory institutions. Currently, some notable emerging market economies include India, Mexico, Russia, Pakistan, Saudi Arabia, China, and Brazil. Investors in the emerging markets are risk averse which means they do not feel confident taking risks, so they settle for lower returns with respect to lower risks associated.

Critically, an emerging market economy is transitioning from a low income, less developed, often pre-industrial economy towards a modern, industrial economy with a higher standard of living.

MSCI Pakistan Index (USD):

MSCI Pakistan Index was removed from MSCI Emerging Markets Index at the end of December 2008 following the deteriorated investability conditions prevailing in the Pakistani equity market. The index was classified as stand alone.

Rationale:

The Pakistani equity market underwent a number of positive developments over the course of the past 12 to 18 months. The Pakistani equity market has grown significantly and its liquidity has greatly improved over the past years. As a result, the concerns about the potential for failing to meet size and liquidity criteria should there be a negative market event have receded.

Simulated Constituents Change:

Number of constituents

Large Cap Mid Cap standard Small Cap IMI
Frontier Markets 6 10 16 20 36
Emerging Markets 3 6 9 19 28

Free Float Adjusted market Capitalization (USD billion):

Large Cap Mid Cap standard Small Cap IMI
Frontier Markets 3.4 3.6 7.0 2.2 9.2
Emerging Markets 2.6 3.2 5.9 2.7 8.6

The MSCI Pakistan Index would have 9 constituents under Emerging Markets, compared to 16 under Frontier Markets The free float adjusted market capitalization would be 16% lower under Emerging Markets.

Simulated Constituents Index :
Company Full Mcap * FIF Mcap * FIF ** Size segment
Oil & Gas Development 4.0 0.6 0.15 large Cap
Habib Bank 2.5 1.0 0.4 large Cap
MCB Bank 2.1 1.0 0.5 large Cap
United Bank 1.7 0.5 0.3 Mid Cap
Lucky Cement 1.5 0.7 0.5 Mid Cap
Fauji Fertilizer 1.3 0.6 0.45 Mid Cap
Engro Corporation 1.3 0.6 0.45 Mid Cap
Hub-Power Co 1.1 0.4 0.35 Mid Cap
Pakistan state Oil Co 0.8 0.4 0.5 Mid Cap
Stimulated Emerging Market Weights:
Stimulated Emerging Market Weights

The simulated MSCI Pakistan Index would have a potential weight of 0.20% in Emerging Markets.

Emerging Markets:
Emerging Markets
Top 3 Constituents
Factors
Sector Weights:
Sector Weights
Reclassification :

MSCI has been artificially maintaining Pakistan’s stature in the Emerging Markets since the country has been no longer meeting EM standards for size and liquidity criteria for the last 19 months.

Reclassification proposal :

* MSCI proposes to reclassify the MSCI Pakistan Index from Emerging Markets (EM) to Frontier Markets (FM)
-This would be reflected in all relevant global and regional composite indexes
-the proposal is to implement the potential reclassification in one step coinciding with the November 2021 Semi-Annual Index Review (SAIR)
*MSCI proposes to apply the minimum size requirements for Smaller FMs, and the minimum Liquidity markets(15% Annualized Traded Value Ratio or ATVR)
*MSCI will consult with market participants on this reclassification proposal until August 31, 2021

Thus, it is now proposed to put Pakistan back to the Frontier Markets with a higher weight of 1.9 per cent from the existing meager country weight of 0.02 per cent in the Emerging Markets. Moreover, Pakistan’s weight in the widely tracked Frontier Market 100 Index will now be 5.8 per cent, whereas the Oil and Gas Development Company (OGDC) has been included in the MSCI Pakistan standard Index.

An analyst at JS Global Capital said currently, the weight of the MSCI Pakistan Index in the MSCI Emerging Markets Index stands at 0.02 per cent. “If the reclassification takes place, the weight of MSCI Pakistan Index in the MSCI Frontier Markets Index is expected to be 1.9 per cent, whereas Pakistani securities would have a simulated weight of 5.8 per cent in the MSCI Frontier Markets 100 Index.

Although the country’s classification has been downgraded one notch from the Emerging to Frontier Markets, this boded well for the local stock market, as Pakistan will enjoy higher weightage in the Frontier Markets, compared with the negligible weight in the Emerging Markets, which may result in the net inflows in the Pakistani market.

“We expect lower outflows from [the] funds tracking Emerging Markets since already foreigners had been net sellers of $1.3 billion ever since Pakistan was included in EM four years back (KSE-100 index down 5 per cent since then),” an analyst at Sherman Securities said.

As per the MSCI, the discussion on classifying the MSCI Pakistan Index from the Emerging Markets to Frontier Markets will continue till August 2021, while the final announcement will be made by September 7, 2021. Interestingly, Pakistan market is now available at 35 per cent to 40 per cent discount to the fund managers tracking Frontier Markets, as Pakistan market was trading close to 9x on forward PE at the time when the country was reclassified from the Frontier Markets to Emerging Markets. A downgrade resulting in higher inflows may sound counter-intuitive, but most brokers insist that a higher weight in the FM index will attract increased foreign investment. Pakistan currently has Emerging Market status with the MSCI, but it has recently threatened to downgrade Pakistan to a Frontier Market. If the downgradation happens, it will be the second time Pakistan has been downgraded and it will become the only country to be downgraded twice by the MSCI. This means that foreign investors will now look at Pakistan and not be as excited about investing there. Essentially, the downgrading would mean Pakistan appears a riskier investment than it would if it remained an emerging market. Despite the looming downgrading, some analysts think not only will it not negatively affect foreign investment in Pakistan, it might even help out. You see, an emerging market and a frontier market attract very different kinds of investors. An emerging market attracts cautious investors while those that want to invest in frontier markets are willing to take more risks. In the nine years Pakistan was a frontier market, it did well as one. Emerging markets are countries that are in the process of becoming a developed economy. They are also called less economically developed countries. While they are not as economically advanced as the US or Japan, they are well on the way. Emerging market countries include Russia, Mexico, India, Saudi Arabia, and currently Pakistan. These markets have greater liquidity and are more stable than frontier markets. Frontier economies are less advanced economies in the developing world. It is generally believed that emerging markets earn greater returns with lower risk, whereas frontier markets are considered riskier. These countries usually have equity markets that are less established compared to emerging markets, are smaller, less accessible and are more risky. Political uncertainty, poor liquidity, problems with regulations, substandard financial reporting, and currency fluctuations are some deterrence for investors. So while Pakistan would generally be considered a small fish in a big pond as an emerging market, it would be a better prospect for frontier market investors. However, there is still the fact that if you’ve read the paragraphs above, you can see that no matter how much visibility Pakistan may get by this downgrade, it still very much remains a downgrade.

Outcome Analysis :

MSCI will reclassify the MSCI Pakistan Indexes from EM to FM in one step, coinciding with the Nov-2021 Semi-Annual Index Review (SAIR). The MSCI EM Index has 3 constituents from Pakistan, whereas MSCI FM Index is simulated to have 4 constituents – with OGDC being the additional constituent – as per Jun-2021 simulation provided by MSCI. The MSCI EM Small Cap Index has 13 constituents from Pakistan, whereas MSCI FM Small Cap Index is simulated to have 19 constituents – with INDU, BAHL, ABOT, NBP, SYS and PKGS being the additional constituents – as per Jun-2021 simulation provided by MSCI.

Potential gross outflow of around US$150mn: Based on Pakistan’ weight of ~0.02% and estimated global passive EM AUMs of US$400-500bn, we estimate investment of passive EM funds in Pakistan to the tune of US$125-175mn, where around US$75-100mn are likely invested in main EM stocks while US$50-75mn are potentially parked in small cap EM stocks. Potential gross inflow of around US$100mn-150mn: As per MSCI simulation, Pakistan is likely to have a weight of 1.9% in MSCI FM Index and ~5.5% in the MSCI FM 100 index (at the time of Pakistan’s upgrade to MSCI EM from FM in 2017, Pakistan’s weight in MSCI FM 100 index was around 8.5%). It is difficult to gauge flows with respect to FM due to lack of data availability, however we estimate potential investment from FM funds to the tune of US$100-150mn, where US$75- 100mn may be in the main constituents. It is worth mentioning that some of the active FM funds have been investing in Pakistan even though it was classified as an EM. Impact: The potential inflows and outflows remain early estimates and may largely net off, however we believe the reclassification to FM from EM may turn out to be beneficial for Pakistan in terms of reduction in foreign selling. Foreigners have sold equities worth US$730mn (net) since Dec 31, 2019, and have sold equities worth US$159mn (net) this year already. We expect the selling pressure from foreign funds to persist till at least Nov-2021, and may wade off post the rebalancing.

Potential Gross outflows due to downgrade

Weight Value (US$mn) Shares (mn)
LUCK 0.0079% 35.59 7.40
HBL 0.0054% 24.33 34.23
MCB 0.0050% 22.70 23.32
Net foreign selling in equities Pakistan
Conclusion::

The MSCI Pak FM is expected to hold a weight of 1.9 percent in MSCI FM Index and 5.8 percent in the MSCI FM 100 Index. The MSCI Pak FM standard cap will include LUCK with weight of 35.5 percent, MCB 23.1 percent, HBL 22.2 percent and OGDC 19.1 percent. The weight was 9.2 percent in the FM Index back in 2017. A potential downgrade to MSCI FM will be positive for the market in the long run. Pakistan fits well in the FM space, both in terms of size and stage of economic development.

There are mixed views on the topic. Each perspective weights different aspects of the emerging market and the frontier market. MSCI’s decision may prove to be crucial for Pakistan’s future. Pakistan Stock Exchange’s downgrade from the MSCI’s Emerging Markets Index to the Frontier Markets Index in the short-term may be good for the capital market.

As it can be seen from the aforementioned information, Pakistan performs better in the frontier market than in the emerging market. Pakistan has a weight of 0.02% in the MSCI Emerging Markets Index, according to data compiled by Bloomberg. which means that for every 100 rupees invested, a return of 0.2 rupees whereas the weight of Pakistan in the frontier market is around 1.9%, according to BusinessRecorder, which would mean a return of 1.9 rupees on every 100 rupees invested.The change from emerging to frontier market can be seen at around 1500% increase. This shows that returns increase thus increasing confidence of the investors to compete in the Pakistan Stock Exchange. It favors investment in the market so it would attract investments, increasing local and foreign investments. To put it all in a nutshell, this downgrade may prove to be beneficial for Pakistani Stock Market’s future as an increase in investments is expected.




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