Pakistan’s growing twin fiscal and trade deficits have spurred a decline in the local currency, dented foreign exchange reserves and helped push inflation to new heights. Hounded by such threats to macroeconomic stability, the central bank is widely expected to tighten money supply, in a move that is likely to cause a scramble for Pakistan’s best investment bets.
Negative economic indicators have forced the monetary authority’s hand: the rupee has fallen 5% against the dollar over the last two months, while reserves have nose-dived by over $3.5 billion from a peak of $16.5 billion at the end of October last year.
Alarmingly, consumer price inflation and broad money supply (M2) reached 20% year-on-year in December – driven partly by rising food and energy prices, which in March increased 14% year-on-year.
At a time when US growth is slowing and many central banks are kicking open the liquidity gates, the state bank of Pakistan (SBP) is expected to raise interest rates this year following its 50bp hike in January. “We believe further monetary tightening is warranted and interest rates need to go up by 100–200bp to curb domestic demand and fix the external balance,” says Farid Khan, research analyst at Credit Suisse in Singapore.
Despite the trade-off between high interest rates and economic growth, investors are still bullish about this year’s investment prospects. Indeed, year-on-year domestic loan growth stood at more than 18% in March. With negative real interest rates, the SBP’s move is also an attempt to discourage less productive bank borrowings.
Regardless of these measures, high interest rates will continue to encourage Pakistan’s banking bulls. Floating rates in the country are benchmarked to the Kibor (Karachi Interbank Offered Rate), which will spike this year when the central bank hikes rates as expected – supporting asset yields.
“Investors have large exposures to money-market funds in Pakistan because they thrive in high interest rate environments,” says Nasim Beg, ceo of Arif Habib Investments.
This is because bank profitability is particularly biased towards interest-based income in Pakistan, since lending rates increase when borrowing costs rise quicker than deposit rates (generally six months later). What’s more, lower-yielding current accounts make up over 68% of deposits in the banking system, keeping deposit rates low and allowing banks to earn a yield of 7% over the last two years, according to Credit Suisse.
Liquidity
The financial system has been flush with liquidity over the last year, in part thanks to heavy government borrowing from the central bank. But if the new administration opts to tap domestic debt markets through the National Savings Scheme, this could help the central bank’s aim of curbing money supply and raise bank lending rates.
But taking public deposits to issue short-term debt at high interest rates backed by a government guarantee also risks undermining the growth of Pakistan’s financial services industry, market players say. “I can’t offer as high interest rates for my products, and considering the sheer size of the savings scheme, this will damage the free market environment since it crowds out the financial service industry,” says Beg.
Meanwhile, higher interest rates could hit Pakistan’s equity market investors more than the banking sector. Credit Suisse’s Khan suggests that higher borrowing costs could dent corporate profitability while the market is failing to price in the prospects of any political disruption with the new coalition government.
“We believe it is time to get cautious and defensive on the market. The top 100 companies on the Karachi stock exchange are trading at around 11.5 times their earnings ending this fiscal year, and its strong relative performance to regional peers has opened some space for a correction,” says Khan.—S.V.