Market Report, "Pakistan Country Risk Report Q2 2016", published

A sharp drop in terrorist activity in 2015 is beginning to have positive effects on the Pakistani economy, following Islamabad's aggressive approach against terrorists based in the North Waziristan border region that were stepped up following the Peshawar military school attacks in December 2014. While significant challenges remain, a promising change in tack by the establishment may be in the offing, with the potential to provide more medium-term stability.

We forecast real GDP growth to come in at 4.3% in Fiscal Year 2015/16 and 4.2% in Fiscal Year 2016/17, helped by cheaper energy prices and an improved security situation. Pakistan's chronically low savings rate is finally beginning to increase, which will provide support for sustainable investment over the coming years.

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The inflation cycle in Pakistan has likely turned and we expect the State Bank of Pakistan to begin hiking rates in mid-to-late 2016. That said, continued low oil prices will prevent the need for the central bank to hike aggressively, and we are forecasting just 50bps of hikes in the benchmark rate this year from the current multi-year low of 6.00%.

The decline in crude oil prices is having a dramatic positive impact on Pakistan's trade account. The trade deficit is narrowing despite a surge in the non-oil trade deficit, providing support to both economic growth and the country's international reserve buffer.

The Pakistani government remains broadly on course in its efforts to narrow the country's longstanding fiscal deficit, with the latest IMF loan disbursement testament to ongoing reform efforts. We continue to see the fiscal deficit narrowing over the coming years to 4.8% of GDP in Fiscal Year 2015/16 and 4.4% of GDP in Fiscal Year 2016/17.

Pakistan is winning international recognition for the development of its Islamic financial sector, and we continue to expect Shariah-compliant banking to grow in prominence over the coming years with the help of the authorities' push to grow the sector.

Major Forecast Changes

We have made a sizable revision to our forecast for Pakistan's current account, with the ongoing drop in oil prices likely to cause a healthy current account surplus of 1.2% of GDP in FY2015/16. This compares with a deficit of 1.0% in FY2014/15, and our previous forecast for a balanced current account position.

Key Risks

The recent improvement in the security situation, as shown by the sharp drop in civilian casualties since the start of 2015 poses an upside risk to the economic outlook. While it is too early to tell whether the reduction in casualties will be sustained, an improved security situation would certainly encourage increased investment inflows.

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