Construction Potential Hampered By Poor Investment Climate
BMI View: We remain bearish towards the outlook for Pakistan's construction sector despite the change towards a more economically conservative government in 2013. This is because Pakistan continues to present several characteristics that are non-conducive for construction growth. However, should Pakistan be able to resolve the weaknesses in its investment climate, the country's strong fundamentals do present considerable scope for construction activity.
We expect Pakistan's construction sector to continue to slow in 2014. The year-on-year growth rate for 2014 is forecast to be 2.1%, down from 2.8% in 2013 and 5.2% in 2012. Although political risk in the country has been dampened following the strong showing by the more economically conservative Pakistan Muslim League-Nawaz (PML-N) in the May 2013 general elections and the August 2013 by-elections ( see 'By-Elections Further Cement PML-N's Agenda', August 27 2013), Pakistan continues to present several characteristics that are non-conducive for construction growth. These characteristics are non-conducive monetary conditions, poor fiscal position, as well as considerable business environment and security risks.
|Struggling To Fulfil Potential|
|Pakistan - Construction Industry Value Forecasts|
Non-Conducive Monetary Conditions
Monetary conditions in Pakistan are becoming increasingly non-conducive for construction investment. Since the middle of 2013, the State Bank of Pakistan Reserve (SBP) has hiked the benchmark discount rate by 100 basis points (bps) to 10.00%. Although this is still far from the highs seen in recent years, it is at a relatively high level when compared to the region. For example, India's benchmark interest rate is only at 7.75% despite experiencing record-high inflationary pressures. Given the lagged impact of monetary tightening and that we expected the SBP to maintain the benchmark discount rate at 10.00% over the rest of this decade, this elevated level of borrowing cost could deter construction companies from taking on new projects in Pakistan.
|Pakistan - Exchange Rate, PKR/US$ (LHS); And SBP Policy Rate, % (RHS)|
In addition, the Pakistani rupee remains very weak and has been on a depreciatory trend for more than a decade. This depreciatory trend has accelerated in 2013 - since the start of 2013, the rupee has fallen by about 11% against the US dollar to reach around PKR108.00/US$ at the end of November 2013 - and we expect this trend to continue over the rest of this decade. We are forecasting the Pakistani rupee to reach around PKR130.00/US$ by the end of 2020.
This weakness in the Pakistani rupee is also likely to dampen construction activity as it would make it more costly for companies operating in Pakistan to purchase overseas equipment and raw materials as well as repay their overseas debt borrowings. Foreign construction companies may also be dissuaded from taking on projects in Pakistan due to concerns over the final value of repatriated returns from their investments. To be sure, foreign direct investment (FDI) into Pakistan has fallen to levels that are fall below the highs seen during the global boom years of 2004-08. Although investor confidence in Pakistan appears to have been renewed following the strong election of the PML-N (hence the marked pick up in FDI), it remains if the new government can carry out the necessary economic reforms to sustain investor confidence.
|Foreign Interest Depressed|
|Pakistan - Net Foreign Direct Investment, 6mma US$mn|
Poor Fiscal Position
One of these reforms is addressing Pakistan's extreme budgetary imbalance. The previous administration, the Pakistan People's Party (PPP) had allowed the fiscal deficit to nearly double from 5.2% of GDP in FY2008/09 to a 14-year high of 8.0% in FY2012/13. To meet its spiralling expenditure needs, the new PML-N government had accepted loans from the IMF, on the condition that it implements an aggressive fiscal consolidation plan.
|Sustainable Fiscal Consolidation Unlikely|
|Pakistan - Budget Deficit, % of GDP|
The government has so far carried out some of the necessary fiscal adjustment measures (such as rising taxes and cutting down on energy subsidies) - we are projecting the government's fiscal deficit to narrow to 6.8% of GDP in FY2013/14 - but we doubt that the government will be able to sustain them and bring a material change to public finances. This is primarily because Pakistan has a very unstable political environment. Governments in Pakistan perennially face constitutional and unconstitutional challenges, which prompt them to implement myopic, vote-winning policies at the expense of concrete reform and fiscal consolidation.
This not only undermines investor confidence, but also affects the central government's ability to finance its infrastructure plans in two ways. Firstly, the government would have to continue to channel funds into supporting subsidies at the expense of infrastructure development. Secondly, demand for Pakistan bonds could wane on the back of a weaker fiscal picture and higher inflationary costs, pushing up yields across the board.
Considerable Business Environment Risks
Besides a poor political environment, the country's business environment is one of the weakest in the region, presenting numerous risks to investors and to project execution. In its 2014 Doing Business report, the World Bank ranked Pakistan in a lowly 110th place out of 189 globally, with the country faring particularly poorly in several key areas that facilitate project development such as electricity access and contractual rights.
|Bad... And Getting Worse|
|Pakistan - Change In Doing Business Report Categories|
While this in itself is concerning, what is more important is that Pakistan's business environment is heading in the wrong direction. In comparison with the 2010 survey, the country has seen its ranking slide in all like-for-like categories (although we acknowledge that the report covered six less countries back then). We believe that material improvements in the investment climate are unlikely in the short-to-medium term. The power sector remains in a structural malaise ( see 'Fundamental Problems Left Unaddressed In 2013/14 Budget', June 14 2013), which will inhibit growth, while the strength of institutions such as the judiciary will continue to be undermined by the vested interests of the military and the land-owning class, both of which are vying for political dominance.
Lacking In Safety
Lastly, security risk in Pakistan looks set to remain acute over the coming years, which will deter investors, hamper project execution and lead to frequent flare-ups. As the accompanying chart shows, the casualties from Pakistan's internal 'war on terror' have been vast and increasing, with the number of civilian deaths on course to hit a record high in 2013. Large swathes of the country remain unofficially controlled by insurgent and rebel groups, with terrorist attacks not just isolated to the country's periphery, but also in major urban centres such as Karachi.
|On The Rise|
|Pakistan - Civilian Casualties In Terrorist Attacks|
Fundamentals Suggest Upside Potential
Beyond 2014, we believe that construction activity in Pakistan will continue to be dampened by the issues highlighted above. We are forecasting real growth for Pakistan's construction sector to average 3.9% per annum between 2015 and 2023, far below the average annual growth rate seen over the past decade (5.9% per annum between 2004 and 2013). However, should Pakistan be able to resolve the weaknesses in its investment climate, there is considerable potential for upside in our forecasts.
This is because of the country's strong fundamentals for construction activity - favourable demographics, good strategic location and high infrastructure deficit. The country boasts a large and young population, at an estimated 179mn strong in 2012 (with a median age of just 22.2 years). Meanwhile, the country is neatly located in the heartlands of global growth - between China and India and with easy access to the Middle East and Sub-Saharan Africa. To maximise the potential of these structural positives, the country would need to develop the necessary buildings and infrastructure to facilitate trade and generate economic growth. At present, Pakistan has one of the lowest electrification rates in Asia, while the quality of its transport links is below the regional average ( see chart).
|Selected Asia Countries - Logistics Performance Index, Infrastructure Indicator, Scores out of Five (LHS); Electricity Access, 2010, % (RHS)|