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Strategy| Pakistan
22 Apr 2015 Pakistan Strategy

CPEC: A big impetus for growth


Mohammad Fawad Khan and
investment
Strategist
fawad.khan@kasb.com
Chinese
Investment: Sowing the seeds of mutual accord
Sarah Mazher
The signing of unprecedented US$45bn investment deals between Pakistan and China
Economist
Sarah.kamran@kasb.com during a historic visit of Chinese Premier epitomizes rich, mutually beneficial strategic
relationship between the two countries. The agreements signed under the umbrella of
Muhammad Saad Ali China-Pakistan Economic Corridor (CPEC), are the centerpiece of Chinas broader plans
Research Analyst dubbed as One Belt, One Road, and promise big economic and social gains for Pakistan.
saad.ali@kasb.com A total of 51 agreements envisage US$37bn investment in energy and US$8bn in
infrastructure. The projects may yield strategic advantages to both countries once
Farid Aliani
Research Analyst implemented by 2018-20. The progress on CPEC provides yet another reason to upgrade
farid.aliani@kasb.com Pakistans sovereign rating and potential rerating of its equity market valuation.
CPEC: a giant leap towards economic growth
Mohammad Ali Amin
Research Analyst The CPEC earmarks wide-ranging opportunities for lifting economic growth to govt-stated
mohammad.ali1@kasb.com objective of 6-7% over the medium term. CPEC may address two key stumbling blocks to
growth at present: (1) energy deficit (can add up to 2% to GDP growth), and (2) removing
Ameet Daulat financial/fiscal constraints for increasing investment (US$22bn or 7.6% of GDP earmarked
Research Analyst as concessionary loan for various public-private projects). That said, we highlight the
ameet.daulat@kasb.com importance of continued progress on reforms on increasing tax collection in order to create
fiscal room (fiscal deficit targeted at 4.0% in FY16) for fulfilling Pakistans part of
development funding.

Key sector themes to play


Energy: Alleviate power shortages (10GW or 50% of capacity part of early harvest
projects), rationalize power fuel mix (coal contribution may lift to 16% by 2018 from <1% in
Key Investments under CPEC 2014). Engro and Hubco are our top picks (clarity on expansion, capital allocation). PAEL is
Category US$bn leveraged to future demand of electrical equipment.
Energy projects 37.00 Cement: Higher infrastructure investment may translate into an additional demand of 1.3-
Concessionary loans 22.00 2.3mn tons p.a. (2-4% of capacity), supporting sustainability of current robust margin. Key
Suki Kanari hydroelectric power project 1.80 stocks to play are LUCK, DGKC and APL (asphalt demand).
Karot hydroelectric power project 1.50 Banks: Enhanced credit demand from energy and infrastructure projects, opportunities of
Coal-fired power plant at Port Qasim 1.80 non-fund income. MCB, ABL have the largest room to pursue credit growth whereas HBL &
Coalmine in Thar Block II 0.90 UBL are already active in China.
Mine-mouth coal-fired power plant 1.90
Others 7.10 Win-Win proposition for both countries
Non-energy infrastructure 8.00 Key advantages to China include: (1) CPEC is the shortest land-route with promised 2/3rd
Eastern Trade Route 4.00 reduction in travel time from Middle East & Africa to Shanghai; (2) opening up Chinas
Karakoram Highway Expansion 0.93
Multan-Sukkur section of the Karachi-
relatively underdeveloped Western province; (3) alternate route for energy imports boosting
0.26
Gwadar Port East Bay Expressway 0.14 energy security. On its part, Pakistan eyes (1) enhanced economic cooperation with worlds
Gwadar International Airport 0.23 second largest economy; (2) strong pick-up in investment in energy and infrastructure; and
Others 2.44 (3) socio-economic benefit (about 1mn new jobs to be created).
Source: BR/Tribune, KASB Research
Four critical areas
Potential delays in delivery of key legs of road/ infrastructure; political ownership of the
project from opposition parties and military support; security concerns; geopolitical tension
given Chinas increased influence in the region.
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Pakistan Strategy April 2015

CPEC: A big impetus for growth and


investment
Pakistan and China have signed over 51 agreements/MoUs worth around US$45bn during
the Chinese Presidents recent visit to Pakistan, aimed at building a China-Pakistan
Economic Corridor (CPEC), primarily to cater transportation and energy infrastructure in
Pakistan. In turn, China will gain access to Gwadar port to help advance its under-developed
far western regions. Of the total US$45bn commitment (see table 1), China plans to invest up
to US$37 billion on the energy projects along with US$8bn concessional loans for
infrastructure development projects of Pak-China Economic Corridor. In the energy segment,
US$22bn out of the total US$28bn would be commercial loans granted from Chinese banks
to power generation companies in Pakistan. From Chinese point of view, this is one of the
first steps under Beijing's Silk Road Economic Belt and Maritime Silk Road plans. Through
this strategy, China is seeking to build an economic belt, increasing access to Europe, Asia
and Africa through roads and port networks.

Chart 1: CPEC to cut distance to Shanghai from Middle East/Africa by over 70%

Source: KASB Research

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Pakistan Strategy April 2015

Macro implications
Table 1: Pakistan remains net importer of The CPEC earmarks wide-ranging opportunities for improving economic prospects as it
goods from China addresses two key stumbling blocks to growth at present: (1) energy deficit, and (2)
US$bn FY12 FY13 FY14 financial/fiscal constraints. We see potential economic growth prospects in the medium term
Exports to China 2.09 2.70 2.69 as: (1) investment to GDP ratio looks set to increase close to 20% in next 3 years, (2)
as % of total 8% 11% 11% reduced energy supply-demand gap to boost large scale industries (particularly textile), (3)
Imports from China 4.63 4.73 5.98 local industries will likely receive a boost given financing opportunities coming from Chinese
as % of total 11% 12% 14% companies, and (4) improved rail/road network benefits transport and trade sectors.
Balance of Trade (2.54) (2.03) (3.29)
Source: SBP Financing commitments to improve PSDP outlook
Majority of the energy projects are apparently planned to be financed through private
companies, while major infrastructure projects eyed by the PML-N government under Public
Sector Development Program (PSDP) will also see daylight including, Khi-Lhr motorway,
Metro train project, upgrading Karakorum highway and Gwadar port area, which is expected
to be part of next years PSDP budget. Assuming ~90% of the total US$8bn allocation will
Chart 2: Investment/GDP ratio has not likely be financed under PSDP (as per budgeted allocation for CPEC in FY15), required
received any significant boost since FY06 PSDP of ~PRs700bn (incremental ~2% of GDP) though expected to be majorly financed by
20.0% 5.0% foreign aid over a period of 3 years will likely pose a challenge for the govt during the first
year of implementation (FY16) given strict fiscal deficit target (4% of GDP) under the IMF
4.0%
15.0% program (concluding by mid-2016). Recall that growth in PSDP has remained sluggish
3.0% (PSDP/GDP ratio has remained between 2.5%-3.5% in part 5 years) due to low revenue
10.0%
2.0% mobilization and financing constraints.
5.0%
1.0% Increased trade: Export diversification will be key
0.0% 0.0% The project envisages increase in annual trade volume to US$20bn from US$15-16bn
reported at present (including services). However, Pakistans imports from China constitute
FY15E
FY16E
FY09
FY10
FY11
FY12
FY13
FY14

60-70% of trade volume at present. Hence, burden of an unfavorable balance of trade could
Investment/GDP (LHS) PSDP/GDP potentially increase and hurt local industries due to increased competition. Major imports
GDP growth
Source: Pakistan Economic Survey include electronic items and capital goods; we suspect increased import of machinery for
planned new and up-gradation infrastructure projects to contribute to import bill ahead. Major
exports to China remain cotton yarn, fabric, and leather; where, looking ahead, export
diversification will be crucial to reap major benefits.

Table 2: Pakistans trade with China Financial account to receive a boost


Key Exports to China Key Imports from China Investment from China has already increased manifold in past two years, increasing to
Yarn, Fabric Electronic equipment US$696mn in FY14 from US$47mn in FY11. The 51 recently signed pacts provide
Leather Machines, engines unprecedented investment commitment from China, though certain infrastructure projects
Marine products Organic chemicals (about US$8bn) as well as energy projects (about US$22bn) are to be financed through
Minerals Manmade filaments concessional/commercial loans. While increasing liabilities for future years, the projected
Marbles Iron and steel inflows will contribute to sustained increase in FX reserves, making a case for sovereign
Chemical Plastics rating upgrade. Last month, Moodys rating agency commented on CPEC being major credit
Food items Rubber
positive for Pakistan due to potential increase in investment, bilateral trade flows, and easing
Source: TDAP
of energy shortage.

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Pakistan Strategy April 2015

Power
The power sector is likely to be the biggest beneficiary of the CPEC, in our view. Broadly, the
planned projects will serve to alleviate chronic power shortages by helping Pakistan achieve
two long-term solutions: (1) rationalize power fuel mix, and (2) increase generation on
indigenous fuel sources. The sheer magnitude of new projects (about 16,000MW, which is
about 70% of the current installed capacity) to be added to the countrys power supply not
only is sufficient for addressing the existing demand-supply gap but will also support the
elevated economic growth it is likely to spur. CPEC will also direct investment in the weakest
segments of the power chain specifically, new transmission lines to support the surge in
Chart 3: Favorable shift in power mix generation. These attributes will in turn automatically resolve the circular debt issue that has
40% 37% been plaguing the sector, in our view. All in all, the power projects under the CPEC promises
35% 29%
30% to turnaround the power sector of Pakistan.
30% 27%
25% 23% 23% Rationalizing power fuel mix will resolve power outages
20% 16% The CPEC has set out to add 1,590MW of hydropower, about 6,000MW of coal-fired plants,
15% in addition to about 1,000MW of solar plants, and nuclear and wind power plants (refer Table
10% 8%
3). All these projects bear a common theme: cheaper electricity using indigenous/renewable
5% 3% 3%
0.1% 0.4% sources. With these projects online, the country will no longer be largely vulnerable to fuel
0% price shocks (for example, oil prices which culminated in an often insurmountable cash-flow
RFO Gas Hydel Coal Nuclear Wind &
Solar crisis), in our view. The solar and wind power projects, though much smaller compared to the
2014 2021E overall installed capacity of Pakistan, is a step towards diversifying power sources and
Source: KASB Research aligning Pakistan with the global trend towards renewable sources.

Developing indigenous sources of power


Through the alliance, the Chinese will further develop the germinating Thar coalfields and
also set up three power plants on mine mouth. Investment in this area will help Pakistan
reduce dependence on foreign fuel/sources of power. Developing hydropower projects in
KPK province will not only suit its geographic landscape but add to meager generation
capacity in that province, potentially leading to lower transmission and distribution losses.
Hydropower projects will also capitalize on a largely untapped potential.

Adding transmission lines to support generation bonanza


There are also plans to add transmission lines connecting Port Qasim with Faisalabad (a
project of NTDC and National Grid of China). This is another key investment area as the
current transmission system is often cited as inadequate to support higher load, given the
generation capacity is set to nearly double in the next decade. Prospects of investment in
transmission lines for relevant distribution companies (discos) may improve the latters profile
as suitable privatization candidates. On a different note, the Chinese will also collaborate with
Ministry of Power & Natural Resources to develop an LNG terminal and pipeline in Gwadar.

Leveraging Chinese expertise in coal and financial clout


About 90% of Chinas power supply is dependent on coal. Therefore, liaison with Chinese
EPC and O&M contractors will bring in the best of technical expertise in this area. China has
also been making significant advancements in efficiency improvements; we expect these
improvements to ultimately trickle down in Pakistans power sector. Importantly, given the
resistance towards coal-based plants from most international donor agencies, China is filling
the void for foreign investment in future projects, which are predominantly coal fired.

We advocate buying Hubco to play this turnaround


Hub Power (Hubco) has signed an agreement with Chinese Power International Holding
(CPIH) to develop two 660MW plants on Hub site. Progress on this project has been the most
fluid; it may be one of the first projects meeting completion.

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Pakistan Strategy April 2015

Table 3: Details on power projects under CPEC


Project Type Size (MW) Location Parties involved Expected Completion/ Progress
Hub Power Company Coal 1,320 Hub, Balochistan Hubco, CPIH 2019; JV signed
Huaneng Shandong Ruyi Coal 1,320 Sahiwal, Punjab Shandong Ruyi, ICBC LOS issued
Salt Range Coal Power Coal 300 Salt Range, Punjab CMEC, Govt of Punjab LOI issued
Port Qasim Power (2x660) Coal 1,320 Port Qasim EXIM Bank, Port Qasim Electric Power LOS issued
Thar Block I Coal 1,320 Thar, Sindh Sino-Sindh Resources, Shanghai Electric Prequalification of Sponsors under process
Thar Block II (2x330) Coal 660 Thar, Sindh CDBC, Engro Powergen LSI issued
Suki Kinari Hydropower Project Hydro 870 Kunhar River/Mansehra, KPK EXIM Bank, ICBC, SK Hydro September 2021; financial close in process
Karot Hydropower Hydro 720 Jhelum River, Rawalpindi EXIM Bank, CDBC, Karot Power December 2020; LOS Issued.
Zonergy Solar project (9x100MW) Solar 900 Punjab EXIM Bank, CDBC, Zonergy Power End 2016; LOI issued
Quaid-i-Azam Solar Park Solar 100 Bahawalpur, Punjab Govt of Punjab End 2015
Jhimpir Wind Power Wind 100 Jhimpir, Sindh CDBC, UEP Wind Power End 2015
Dawood Wind Power Wind 50 Gharo, Sindh ICBC, PCC of China, HDPPL June 2016
Sachal Wind Power Wind 50 Jhimpir, Sindh Arif Habib Corporation Mid 2016

Source: Business Recorder, PPIB, KASB Research

Table 4: Potential cement demand generation


Cements
through Pak-China infrastructural project Pak-China infrastructure projects to boost cement off-take
spending The agreements signed under the recent CEPC agenda have multi-fold relevance to Pakistan
Scenario Scenario Cement sector, where we highlight proposed investment commitment of about US$8bn (17%
(PRsbn)
1 (5%) 2 (10%) of the total size) for infrastructure and development, which will be outright positive for the
Total investment 800 800 cement sector. While maintaining the importance of several power projects proposed to be
undertaken, we believe that infrastructure lies at the heart of CPEC, with particular focus on
Potential investment on
40 80 construction of highways. Assuming expenditure of US$8bn on infrastructure over the next 3
cement
Potential demand generation years, our calculations suggest total additional cement demand creation of about 4-8mn tons
4 8
(mn tons) (See Table 4 & 5). In the event of demand generation of such magnitude, we believe capacity
Annual demand (mn tons) utilization levels of cement sector, currently at 77% in 9MFY15, may soar to about 88-95% in
1.3 2.3
(FY16-FY18E)
the next two years, compelling cement players to consider expansions. Expected surge in
Source : KASB Estimates
cement off take, in case the projects come through, further increases our comfort on already
robust margins of cement sector (currently ranging between 35-40%). Having said, we
believe governments increased focus on allocation of PSDP budget and its timely
disbursement in the next few years will be pivotal to the success of these projects.

Table 5: Demand-Supply dynamics of Pak Both North and South players to reap benefits
cement sector The agreed infrastructure projects include development of Gwadar port, where Pak-China
(mn tons) FY15E FY16E FY17E FY18E have initiated a feasibility study on Gwadar Hospital, while an MoU has been signed with
Total Demand* 36.4 38.1 39.7 41.6 reference to a provisional governmental concessionary loan for building Gwadar International
Total Demand** 36.4 39.4 41.0 42.9 Airport (US$266mn) as well. With reference to Gwadars location, we believe South cement
Capacity 44.6 44.6 44.6 44.6 players will be key beneficiaries of the aforementioned projects. Moreover, major
Utilization (%)* 82% 85% 89% 91% development/upgrading of highways was also the focus of the agenda between the two
Utilization (%)** 82% 88% 91% 93%
countries, with as many as 4 MoUs signed in this regard. Projects include up-gradation of
Source : KASB Estimates / * Base Case /** Post Pak-China Karakorum Highway (Havelian to Thakot), development of Karachi-Lahore Motorway
Infrastructural Projects (Scenario 1)
(US$360mn) and Gwadar port East Bay Expressway project. Projects in this category will be
beneficial to players in both the North and South region. Commitment on financial
arrangements for several hydropower projects, such as 870MW Suki Kinari Hydropower
Project (US$1.08bn) and 720MW Karot Hydropower Project (Rawalpindi, Punjab), were also
chalked.

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Pakistan Strategy April 2015

Banks
Credit demand and non-fund income potential enhanced
We see medium-term positives in primarily two areas for Pakistan banks: (1) credit demand,
and (2) non-fund income potential. First, Pakistan banks are likely to be heavily involved in
financing the equity portion of power projects developed under these agreements. Second,
industrial demand generated in sectors such as cements, metals, chemicals,
telecommunications and services through ambitious physical infrastructure projects should
also subsequently drive working capital and project financing demand. Finally, in the long
term, assuming reduced energy demand-supply gap, better law and order situation and
improved infrastructure deployed nation-wide, the economy should experience sustained
private credit demand, hitherto severely restricted amid energy and law and order problems.

Rising trade volume targets between China and Pakistan may drive higher trade
commissions. Here, finalization of FTA in banking sector between the two countries enabling
branch operations of banks of one country in another, will also bode well for trade
commission and remittance fee income heads. HBL and NBP will reportedly be the first banks
to open branches in China, whereas ICBC is already active in Pakistan. Few Pakistan banks
including UBL, NBP and HBL currently operate representative offices in China.

Agreements relating to (1) financing cooperation in implementing CPEC between ICBC and
HBL, and (2) promotion of Chinese investments and industrial parks developments in
Pakistan between ICBC and HBL may bode positive for the sector.

We recommend playing this theme in Pakistan Banks via: (1) HBL (PO: PRs213, Buy) as it
has already signed agreements with Chinese counterparties, has sufficient international
banking experience, and maintains active presence in the region already, (2) MCB (PO:
PRs305, Neutral) as the bank has highest capital space available to pursue aggressive
lending, (3) ABL (PO:PRs125, Buy) given its lowest level of ADR and one of the highest
capital room to expand credit risk, and (4) UBL (PO: PRs215, Buy) given the banks existing
presence in China and its valuable experience in international banking.

Four critical areas


Potential delays in delivery of key legs of road/ infrastructure: A U$$28bn investment
over the three years will surely test the delivery capacity of public and private sector. For
transit route to be operational, all the important legs have to be complete. While the two
governments have put in place a framework for coordination and project implementation, risks
of both time and cost overrun remain. We highlight three aspects which, to some extent, may
reduce the risk of delays, (1) many of the projects under the CPEC are under early harvest
initiative where the government has already done the ground-breaking and made
arrangement for financing portion, (2) adoption of innovative structure of public-private
ownership, (3) many of the projects are under private sector control.

Political ownership of the project from opposition parties and military support remain
crucial: A broader buy-in from major political parties is already in place. The CPEC is
envisaged to pass through all four provinces and the focus of investment in infrastructure and
energy projects will benefit all four provinces.

Security concerns: The law & order situation in Gwadar and Gilgit Baltistan, the entry and
exit points of the corridor, is volatile and requires added measures. On its part, Pakistans
army has announced establishment of a separate division of armed forces to provide security
to projects under CPEC.

Geo-political tension: Geopolitical tensions with Iran given an active Gwardar port will be in
direct competition with Iranian port, Chabahar, when it comes Chinas access to Central Asia
and Africa and Europe.

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Pakistan Strategy April 2015

Table 6: Demand-Supply dynamics of Pak cement sector


Type Project name Details
Infrastructure
Gwadar Hospital feasibility study of Gwadar Hospital between China and Pakistan;

Upgradation of Karakorum Provision of Chinese governmental concessional loan for the second phase of upgradation of Karakorum Highway (Havelian
Highway to Thakot) between MoC of China and MoFEA of Pakistan;

Karachi-Lahore motorway Provision of concessional loan between MoC of China and MoFEA of Pakistan for Karachi-Lahore motorway

Gwadar port East Bay Expressway


Provision of Chinese governmental concessional loan for the projectt between MoC of China and MoFEA of Pakistan
Project

Gwadar International Airport Provision of Chinese governmental concessional loan between MoC of China and MoFEA of Pakistan

major communications
framework agreement on co-operation on major communications infrastructure project between China and Pakistan;
infrastructure project

Co-operation between NDRC of China and MoPDR of Pakistan


Pro Bono Projects in the Port of Gwadar Region between MoPDR of Pakistan and the International Department of the Central
Committee of the Communist Party of China;

China-Pakistan Joint Cotton Bio-


the establishment of the laboratory between the MoST of China and the MoST of Pakistan;
Tech Laboratory

Upgradation of ML1 +
A joint feasibility study of the framework agreement between the NRA, China and the MoR, Pakistan
establishment of Havelain Dry port

Gwadar-Nawabshah LNG Terminal


Framework agreement between NEA and MoPNR on the establishment
and Pipeline Project

Lahore Orange Line Metro Train


Commercial contract on Lahore Orange Line Metro Train Project;
Project

Telecom

China-Pakistan Joint Marine


Protocol on establishment of China-Pakistan Joint Marine Research Centre between SOAC and the MoST of Pakistan
Research Centre

co-operation between the State Administration of PPRFTC and MoIBNHP


Agreement between CCT, PTV and PTF on the re-broadcasting of CCTV-NEWS/CCTV -9 Documentary in Pakistan;
Misc
DTMB feasibility study of the demonstration project of the DTMB between China and Pakistan;
Anti-narcotics equipment provision of anti-narcotics equipment between China and Pakistan;
Law enforcement equipment provision of Law Enforcement Equipment between China and Pakistan;
Banking services protocol Agreement on trade in services between Pakistan and China;
Tracking climatic change Provision of Material for Tackling Climate Change between NDRC of China and MoFEAD of Pakistan

Sister cities relationship protocol on establishment of Sister Cities Relationship between Chengdu city Sichuan Province of PRC and Lahore City;

protocol on establishment of Sister Cities Relationship between Zhuhai City, Guangdong province of China and Gwadar city,
Sister cities relationship
Balochistan of Pakistan;
protocol on establishment of Sister Cities Relationship between Karamay City, Xianjian Ugur, autonomous region of China and
Sister cities relationship
Gwadar city
Source: Business Recorder, KASB Research

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Pakistan Strategy April 2015

Analyst Certification
I, Fawad Khan, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and
issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed
in this research report.

KASB Securities and Economics Research


Mohammad Fawad Khan Pakistan Macro, Strategy & Energy +92 21 111 222 000 ext 330 Fawad.khan@kasb.com

Sarah Mazher Pakistan Macro & Autos +92 21 111 222 000 Sarah.kamran@kasb.com

Muhammad Saad Ali Power, OMCs, & Chemicals +92 21 111 222 000 ext 448 Saad.ali@kasb.com

Farid Aliani Banks & Insurance +92 21 111 222 000 ext 332 Farid.aliani@kasb.com

Ameet Daulat Fertilizers & Consumer +92 21 111 222 000 ext 337 Ameet.daulat@kasb.com
Mohammad Ali Amin Cements +92 21 111 222 000 ext 331 Mohammad.ali1@kasb.com

Ahmed Hanif Technical +92 21 111 222 000 ext 383 Ahmed.hanif@kasb.com

Abdul Wadood Manager Database +92 21 111 222 000 ext 334 Abdul.wadood@kasb.com

M. Noman Mughal Library +92 21 111 222 000 ext 339 Noman.mughal@kasb.com

Fundamental equity opinion key


Investment rating Total return expectation (within 12-month period of date of initial rating)
Buy 20%
Neutral 0%
Underperform N/A

Other Important Disclosures


KASB Securities Research personnel (including the analyst(s) responsible for this report) receive compensation based upon, among other factors, the overall profitability
of KASB Securities, including profits derived from investment banking revenues.

From time to time research analysts conduct site visits of covered companies. KASB Securities policies prohibit research analysts from accepting payment or
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Pakistan Strategy April 2015

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