LAHORE - Pakistan is currently in MSCI Frontier Markets (FM) Index and there is expectation that it will be upgraded to MSCI Emerging Markets (EM) Index, as the Morgan Stanley Composite Index (MSCI) has stated that it will be announcing results of its annual market classification review on Jun 14, 2016.

Timing of the result announcement is in line with expectations as previously it was understood that the announcement will come in Jun 2016. There is also an MSCI announcement on May 12, 2016 but that is a routine bi-annual review of indices.

In experts view, Pakistan’s induction into the EM index is highly likely and in line with market’s expectation. The latter outcomes, although less likely, will be equally negative for the market as recent rally, led by index heavy weight stocks, has been primarily fueled by expectations of EM reclassification. To recall, Pakistan remained in the MSCI EM Index during 1994-2007, but was removed in Dec 2008 due to price floor. In May 2009, Pakistan was shifted from standalone to FM Index.

Pakistan has met all quantitative criteria for up-gradation to MSCI EM. As per MSCI, Pakistan market has grown significantly with improvement in liquidity. MSCI believes that previous concerns of Pakistan market failing to meet size and liquidity criteria, should the market face negative pressures, have reduced.

MSCI has also acknowledged various reforms that have been recently implemented by Pakistan. These include launch of Pakistan Unified Corporate Action Reporting Systems (PUCARS) at Pakistan Stock Exchange (PSX), restrictions on Negotiated Deal Market (NDM) transactions, foreign institutional investors to be taxed separately and withdrawal of exemption from withholding taxes (WHT), 4) approval of SME regulations, and development of Online Complaint Management System. Pakistan has 8.7% weight in MSCI FM Index and 8.5% in MSCI FM small cap index. In case of reclassification, number of constituents of MSCI Pakistan Index is likely to drop from 16 to 9 with share in MSCI EM to fall to 0.19%.

Although Pakistan’s weight in EM will be much smaller, funds tracking EM ($1.4-1.7tn) are much larger than funds tracking FM (US$17-20bn). Our back of envelope calculations suggests gross inflow of US$600mn by EM passive funds. There will also be an outflow from FM funds, which will lead to lower net inflows.

It is expected reclassification to trigger rebound in Pakistan market from current forward PE of 8.2x. This is based on similar upsurges witnessed by Qatar and United Arab Emirates (UAE) markets, which were up around 40% in 12 months following announcement of reclassification to EM. Consequently, Qatar and UAE Market’s PE improved from 10.8x and 10.2x to 17.1x and 15.2x respectively.

Experts are of the view that even though Pakistan’s share will be significantly lower in EM compared to FM, its improving macros and upside from CPEC will prove to be compelling story in the EM universe. This should attract investors despite its relatively small size. In a recent simulation, MSCI estimates OGDC, HBL, MCB Bank , United Bank, Lucky Cement (LUCK), Fauji Fertilizer (FFC), Engro Corporation (ENGRO), Hub-Power Co (HUBC) and Pakistan State Oil Co (PSO) to be included in the MSCI EM index.