Karachi: Signs that Pakistan, home to one of the world’s top five stock markets last year, is headed for a currency devaluation is giving investors another reason to stay away from the world’s newest emerging market.

Foreign reserves are falling, the current-account deficit has more than doubled in less than a year and the benchmark KSE100 Index has lost its mojo. Now Moody’s Investors Service has joined the International Monetary Fund, which said last year the rupee is as much as 20 per cent overvalued, in urging the central bank to abandon its grip on the currency and allow more flexibility.

The currency pressure comes as Prime Minister Nawaz Sharif and his family are at the centre of an investigation into alleged corruption. An election next year and the make-up of the country’s borrowing — nearly 31 per cent of outstanding government debt was in foreign currency in the 2016 financial year, according to Moody’s — are adding to the stakes.

“The fiscal position will continue to deteriorate, so we are setting up for a big devaluation at some point,” said Nikhil Bhatnagar, director of Asia sales at Auerbach Grayson & Co in New York. “There will be a policy limbo until next year, until the election is done” even if the prime minister is forced to step down before that, he said.

Bhatnagar, who advises clients on stocks in Asia including Pakistan, forecasts the benchmark index will drop 20 per cent in dollar terms from current levels by the end of 2018.

Pakistan’s finance ministry and central bank didn’t respond to requests for comment.

Battered by the corruption probe and a lack of foreign interest as it was restored to MSCI Inc’s emerging-market gauge last month, the index has already dropped 15 per cent from a high in late May. Pakistan bonds have also fallen, with the yield on the dollar notes due 2024 rising 36 basis points to 6.13 per cent over the past month.

The KSE100 measure fell 0.6 per cent as of 9:53am in Karachi.

Stability eroding

The government’s determination to stop the rupee from weakening was highlighted when Finance Minister Ishaq Dar described its 3 per cent plunge on July 5 as “mind-boggling”. A new central bank governor was appointed days later and the currency has since regained almost all of its drop. The government will probably want to avoid abrupt rupee movements before next year’s election, Moody’s said in a July 11 report.

“The devaluation of the currency is always a very unpopular political move in Pakistan,” said Baryalay Arbab, director of equity trading at EFG Hermes in Dubai. “The bigger concern will be when, and if, a devaluation occurs, is it forced by dangerously low foreign reserves or a pre-emptive step by the government. The former will create a lot more havoc.”

Reserves coverage fell to below four months of imports coverage as of April, only slightly above the IMF’s three-month minimum adequacy level, Moody’s said in its report. Exports, while rising last month, are the lowest for the year through June since 2010, and the IMF warned in its July paper that the macroeconomic stability gains made from 2013 to 2016 are starting to erode.

Pakistan needs to devalue the rupee but its high level of external debt will make that “very painful” in terms of pushing up servicing costs, said Saad Bin Ahmad, director of capital markets at Multiline Securities Pvt. in Karachi.

“Rupee management has become a political tool to assuage inflation concerns,” he said. “I believe devaluation will happen in one go. We don’t normally do slow and gradual depreciation.”