Everything you need to know about Pakistan’s likely fall from emerging to frontier market

In the World Trade Center in Manhattan, New York, there are a bunch of fancy men in fancy suits deciding the future of foreign investment in Pakistan. Morgan Stanley Capital International (MSCI) is the world’s leading market index provider, and their decision about the status of the Pakistan Stock Exchange (PSX) as either a developed, emerging, frontier or standalone market will have a lasting impact on foreign investment in Pakistan. 

The above paragraph is a load of jargon that means nothing to anyone that is not a student of finance or the economy. What is happening, essentially, is that MSCI calculates the worth of different markets around the world and assigns them different rankings. A developed market is the best ranking and a standalone market is the lowest ranking. To calculate these rankings, MSCI provides market indices. A market index is usually a single number that is calculated from different economic factors, like prices or income. These numbers are calculated to be able to compare different economies in different countries. An example for such an index would be the Gross Domestic Product (or GDP).

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. 

Profit explain how the MSCI works, makes its calculations, what its history with Pakistan is, and what a downgrading to frontier market might mean for foreign investment in Pakistan.  

How it all works 

The last time Pakistan was at a bleak edge like this was in 2008. Back then, Pakistan had the status of an emerging market, which was an ideal place to be in. Pakistan was far away from the dreaded stand alone market status, and had stayed in the emerging category since 1994. The names of these categories are not particularly important, nor do they mean much. All you need to know is that a developed market is the highest rank, followed by emerging markets, frontier markets, and then finally standalone markets at the bottom rung. 

For countries that fall under the developed category, the ranking is not particularly important. These are large, stable players in the world economy like the United States, Canada, the United Kingdom, Japan, Germany and Australia. The only Middle Eastern country that has this status is Israel, whil Hong Kong is the only Asian country other than Japan to have this status. These are countries where there is no shortage of investors trying to get an in. 

The real competition is between countries that are either in the emerging markets list or in the frontier market list. These are the countries that are very much trying to look for foreign investors and make themselves attractive opportunities. Naturally, frontier markets are considered riskier investments so less prolific investors usually end up investing there. Emerging markets status is coveted. Currently that is where Pakistan is at. The question at this point might be how the MSCI determines which country falls under which category. 

The MSCI has been classifying Emerging and Developed markets since the introduction of the MSCI Emerging Markets Index in 1988. An index, as explained earlier, is calculated from different factors in an economy, like the prices of products or the income of the people operating in the economy.The MSCI uses three such factors which are: 1) economic development, 2) size and liquidity of equity markets, 3) market accessibility for foreign investors.

The first indicator the MSCI uses to calculate its index is self-explanatory. It looks at the quality of life of the people operating in the economy and sees whether it is improving or worsening. The second one is a little more complicated. Essentially, liquidity of equity markets means how readily a person can turn their assets into cash. This is an important factor, particularly in Pakistan’s case. Market accessibility is simply about any barriers that foreign investors have in entering an economy – basically how hospitable an economy is to foreign entrants. Using these three factors, the MSCI calculates the market index of a country and through that index it categorizes countries as either developed, emerging, frontier, or stand alone.

Pakistan and the MSCI 

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. But this is also when the country was facing the height of terror attacks, and building the economy was difficult when bombs were exploding in major cities with alarming regularity. It was also 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. As the first civilian government in almost a decade took the reins and Pakistan took a hold of its internal security, things began to improve. Since those dark days of the 2008 crash, 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. Hounded by terrorism at home and downgraded to just a step above rock bottom (stand alone status), Pakistan fought back and its stock market became the best performing one in Asia in 2016. 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. 

Within four years, however, Pakistan is in hot water again and at risk of being downgraded to the status of frontier market. The decision is to be finalized by September 2021, with November 2021 set for reclassification. Now, remember that the three factors MSCI uses in its calculations are economic growth, liquidity in equity markets, and market accessibility. Currently, the factor on which the MSCI is nailing Pakistan is the second one: liquidity. 

“Although the Pakistani equity market meets the requirements for Market Accessibility under the classification framework for Emerging Markets, it no longer meets the standards for Size and Liquidity,” said the MSCI in a notification. “The index continuity rules have been applied since the November 2018 Semi-Annual Index Review to artificially maintain the required three constituents in the MSCI Pakistan Index. Since the November 2019 Semi-Annual Index Review, there have been no securities in the MSCI Pakistan equity universe that meet Emerging Markets Size and Liquidity criteria within the MSCI Market Classification Framework.”

Essentially, what all of this means is that Pakistan has been trying very hard to keep its status but its market has not responded favourably to it. Now, Pakistan can still make it out of this without taking the hit. Pakistan can still retain its emerging market status if it matches the quantitative criteria by September and that is possible when “the banks in particular would have to nearly double their market capitalisation, which seems improbable… unless there is a significant rally in the 3 main MSCI EM stocks (LUCK, HBL and MCB),” said an equity analyst. Essentially, LUCK, HBL, and MCB are the most important indicators in Pakistan’s index calculations, and if they can rally, then Pakistan will retain its status. However, the question many analysts are raising is whether we really want to retain this status, or whether being a frontier market would suit Pakistan better. 

Is downgrading really such a bad thing? 

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.

How you interpret the downgrade depends on how you would like to see it. If you’re a glass half full type of person, you’ll probably be celebrating the fact that Pakistan can be a big fish in a small pond. That means with the downgrade to emerging markets, Pakistan may have greater visibility to foreign investors. However, it is important to note that weightages are important when it comes to such indices.

But before that it is important to know that market reclassification is not something that happens often (even though it has happened quite a lot for Pakistan – both up and down), investors do not always factor the potential effects of it when making investments.

In 2017, when Pakistan exited frontier market status, it had a weightage of approximately 9%. However, with the current proposed reclassification to frontier market, Pakistan would be able to grab 2.3% indicative weightage. A significant slump in comparison to the past. This also largely depends on the state of Argentina’s reclassification and potential upgrade from standalone to frontier market. As per AKD Securities, “While Argentina is downgraded from MSCI EM as a standalone index, potential reclassification to FM could further compress Pakistan’s weight in the index.”

Meanwhile, Topline securities thinks this “may turn out to be beneficial for Pakistan in terms of increasing visibility amongst foreign participants” one cannot forget that not assets under frontier funds have not fared well and have fallen to US$4bn, down from US$15bn in 2014. This is primarily due to the fact that FM markets have not been able to make up for the risks that are attached to them. Based on that, these markets have experienced significant outflows too.”

However, as per AHL Research, “Pakistan’s weight will gradually go up as markets rebound and attract pre-corona foreign inflows”. The report further said that it is likely that the outflows from EM funds would be offset by the inflows from FM funds, which are mostly active, through a net inflow of $100 million.”

AHL believes this is possible keeping in mind the fundamentals of the KSE 100 being stronger than counterparts and decent valuations. “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.”