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Pakistan Banks: Interest Rates Assumption Revised up Banks to be beneficiaries

• We revise up our interest rate forecast for calendar year 2018 & 2019 by 50bps each to 8.5% and 9.25% respectively from the current level of 6.5%. In 2018, SBP has so far raised policy rate by 75bps to 6.5%.
• We believe that banks having high current account to total deposits & short term investment maturity profile will be key beneficiaries, which include Bank Al-Falah (BAFL), Bank Al-Habib (BAHL), Allied Bank (ABL), Soneri Bank (SNBL) and Meezan Bank (MEBL). 
• This anticipation of rate hike bodes well for banking sector’s profitability. Interest on earning assets including Advances, Investments and other Lending, rises following rate hike. On the expense side, cost of remunerative deposits (which forms 66% of total deposits) & borrowings goes up. Based on our revised interest rates assumption, following are the revised earnings of banks under our Universe. 
• It is to be noted that banks do not bear any cost on current accounts so higher the current account the better it is for banks in rising interest rate scenario. On the asset side, the shorter the term of investments, the better it is for banks in rising interest rate scenario as they gets reprised more quickly.
• Treasury-Bills are short term in nature with maturity period of up to 1-year whereas Pakistan Investment Bonds (PIBs) are longer duration bonds with maturity over & above 1-year. Below, we have presented list of banks with their respective current account concentration & investment maturity profile.
• We revise up our interest rate forecast for calendar year 2018 & 2019 by 50bps to 8.5% and 9.25% respectively from the current level 6.5%. We are revising up interest rate forecast based on the premise that sharp deterioration in external account (expected Current Account Deficit of US$18bn for FY18) and likely IMF program in 2018 would entail aggressive monetary tightening in upcoming monetary policies.
• Furthermore, CPI inflation is also expected to average around 7% in 2018-20 on the back of currency devaluation and rising oil prices. In Jun 2018, CPI inflation clocked in at 5.2%, taking FY18 inflation averaged 4%. In the last 2-years, SBP has maintained positive real interest rates of 1.8%. It is to be noted further that SBP had also adopted a similar tightening approach in 2008 when interest rates were raised sharply by a cumulative 5% when Current Account Deficit (CAD) climbed to US$10bn (8% of GDP) & inflation peaked at 25%.
• Sharp rise in interest rates are generally associated with pickup in loss ratio (termed as NPL ratio) as cost of borrowings increases. We however, believe that the impact of the same will not be significant enough to nullify the impact of increased Net Interest Income from policy rate rise.
• An analysis of last 18-years of Pakistan’s banking sector suggests that interest rates and loss ratio have a positive correlation of 0.3% which means that on every 1% rise in interest rates, NPL ratio rises by only 0.3%, which we do not expect significant enough to negatively impact profitability. Net Advances of the sector as of Mar 2018 stood at Rs6trn.
• Banking industry was severely affected during 2008-09 economic crisis as NPL ratio of the sector shot up from 8% in 2007 to 9% in 2008 and 12% in 2009. During the said period, not only was their sudden rise in rates (discount rate raised by 5% to 15% in 2008) but overall macroeconomic growth slowed down sharply to 0.9% in FY09 (5% in FY08) amid rising oil prices, impact of global financial crisis & spiraling inflation. Furthermore, Consumer financing contributed around 8% of the total financing in 2009 which has now fallen to 4% of financing as per SBP, minimizing any chances of sharp hike in NPLs.
• In contrast to 2008, NPL ratio is expected to marginally increase from 8% in 2018 to 9.5% in 2020 given 1) GDP growth rate is expected to average ~5% in FY19 & FY20, 2) lower exposure to consumer financing, 3) higher consumer confidence, & 4) improved financial health of banks.
• We however believe that banks with high exposure in consumer financing including Silk Bank (SILK), Bank Islami (BIPL) and Standard Chartered Bank (SCBPL) may be more affected from sharp rise in interest rates in the form of increased NPLs.
• Banking Index (BKTI) in year to date is down 1.7% versus KSE-100 index which is down 0.5%. This underperformance was mainly due to few of the negative developments like pension case, continuation of super tax, tightening of regulation in regards with BASEL-III implementation and bank specific issues relating to UBL & HBL.
• We however believe that the negatives have been priced in as our Topline Banking Universe now trades at an attractive 2019 PE & PBV of 7.0x and 1.1x, respectively with ROE of 16% as compared to average PE of 9x and PBV of 1.3x with ROE of 15% during last 5-years. Banking Universe also offers a dividend yield of 7%. In 2018, sector earnings may remain flat amid maturity of high yielding PIBs & one-off pension cost, however from 2019 onward banks are expected to witness strong earnings growth owing to expected rise in interest rates & strong balance sheet growth. Our top picks in the sector are MCB Bank (MCB), Bank Alfalah (BAFL) and Bank Alhabib (BAHL).