TOO MUCH MONEY
What has been happening to money markets lately?
By SHABBIR H, KAZMI
Jun 14 - 20, 1999
Various policy decisions by the government of Pakistan (GoP) and measures taken by State Bank of Pakistan (SBP) have enhanced the cash liquidity in the banking system. All these measures are aimed at boosting process of industrialization, GDP growth rate and exports. The SBP has succeeded in introducing unified exchange rate, controlling dollar volatility and thereby reducing lending rates. Though foreign currency account (FCA) holders still cannot make withdrawal in foreign currency, facility to encash frozen accounts at interbank rate is applaudable. It is apprehended that enhanced liquidity and reduction in lending rates will not help, in any significant manner, in achieving the objectives.
Foreign currency reserves have stabilized and presently stand at around US$ 1.8 billion. This level has been achieved primarily with the assistance of the World Bank and International Monetary Fund (IMF). The ability of SBP to maintain the present level of forex reserves is highly dependent on the restructuring of Pakistan's external debts and successful negotiations with the London and Paris clubs. The issue of Eurobond rescheduling remains unclear. On the domestic front, restructuring of large state-owned power utilities is underway.
During the last few days, a number of regulations regarding forex transactions of banks have been changed by SBP. The objective behind these changes is to try and increase stability in the interbank market.
On May 31, 1999, SBP replaced the net open position (NOP) limit with the aggregate forex exposure limit. This limit, which was earlier fixed according to a particular bank's trade transactions, has now been fixed at 10 per cent of the bank's paid-up capital with a maximum and minimum limit set at Rs 500 million and Rs 50 million respectively. However, banks will not be allowed to net off a position in one currency with an opposing position of an equivalent amount in another currency.
According to analysts, the move is expected to enhance stability in the interbank market for two reasons. Firstly, exposure limits for the banking system as a whole have increased and, thus , banks will not be forced to cover an open position within a short period if they are faced with a large trade transaction on a particular day. Secondly, banks will not be able to net off one speculative position, i.e. dollar, with another speculative position of an equivalent amount in another currency, i.e. DM. Now banks will need to cover this position in the same currency. This will help in increasing the dollar supply in the spot market.
The Nostro limited is now twice the exposure limit with a maximum of Rs 1 billion and a minimum of Rs 150 million limit. Previously the limit was fixed as high as 3-4 times the banks' NOP limit. The revised Nostro limit does not include funds, mobilized under the fresh foreign currency scheme, announced in June 1998 as well as other forex schemes which are not eligible for forward cover. SBP has also decreased the percentage of bank's assets which can be kept abroad to 15 per cent of demand and time liabilities from the previous limit of 20 per cent.
According to banking sector experts the aggregate Nostro limit for all banks would be decreased as a result of this regulation. One of the implications of this change may be that banks whose Nostro limit may have been busted would be forced to drain that account in the interbank market via a sell-buy swap. This should once again increase dollar supply in the spot interbank market. However, it may result in a rise in the forward premium.
NEW FOREX DEPOSITS
The SBP by amending its circular FE-25'' has restricted banks from placing deposits in new FCAs abroad. After June 3, 1999 all the banks will be required to place FCA deposits only to corporate and banks within the country. According to sector experts, if any bank is unable to profitably deploy these deposits, the SBP will be willing to accept these deposits for a margin. These funds will be placed in a special account and the SBP will not use them for balance of payment support. This amendment is expected to increase the supply of foreign currency in the local market and help ease pressure in the interbank market, at least in the short term.
After the introduction of above mentioned amendment banks may not be keen in raising deposits in foreign currency. Spreads on these deposits are expected to reduce considerably due to downward pressure on lending rates with an extremely liquid money market and the high cost of these deposits especially with forex cover on dollar as high as 10 per cent. A number of banks which had started the practice of placing such deposits with foreign branches or head offices (in case of foreign banks) will now be unable to do so. This will further reduce the attraction of forex deposits.
Now exporters are required to convert full export proceed within three days of receipt instead of the earlier one-week facility. From May 26 onward licensed money changers are required to trade foreign currency in a pre-set band fixed by the central bank. Under circular 'FE 11', SBP has stopped banks from issuing travelers cheques, mail transfers, telegraphic transfers and drafts to Pakistani nationals against surrender of an equal amount of foreign exchange in Pakistan. These facilities are now available only to foreign nationals. The maximum amount has been reduced from $ 10,000 to $ 1,000. However, these restrictions will not be applicable to foreign currency accounts opened under FE-25 after June 21, 1998 and those opened under FE 12.
According to bankers, these steps have so far helped in curbing speculations, improving dollar supply in interbank market and reducing pressure on rupee after introduction of unified exchange rate. However, they say that in the longer term it would be difficult for SBP to control value of rupee especially with the current position of forex reserves unless the trade deficit narrows.
As a back up measure and in order to coupe up with any possible rush for encashment of about US$ 4 billion of frozen FCAs, the SBP lowered its overnight lending rate from 14 per cent to 13 per cent. Statutory liquidity ratio (SLR) has been reduced from 15 per cent to 13 per cent. Cash reserve requirement of scheduled banks has been slashed from 5 per cent to 3.5 per cent of their demand and time liabilities. Along with this, the discounting rate was also reduced.
Liquidity continues to remain in high surplus and rates continue to remain low over the last two weeks. An open market operation (OMO) was held on June 3, 1999 and at the outset it appeared that interest would not be enough to turnaround rates. The OMO ended up being scrapped causing rates to fall below one per cent. Money market dealers expect further decline in rates as borrowing interest remains low.
The money market at present is highly liquid. Interest rates are expected to remain low. SBP's low borrowing appetite, coupled with continuing downward pressure on yields, is a cause of concern. Similarly trading volume in the market is likely to remain low. However, banks running a short book may take advantage of prevailing market conditions.
For a long time it has been said that dollarization of economy was not a boon and the bubble could burst any time. Even the SBP wanted to discontinue the trend but GoP policies could not be withdrawn/changed fearing that the change in policy may result in flight of capital from Pakistan. However, after the nuclear tests FCAs were frozen. Though people are still critical of the GoP move, the change in policy has put a restraint, to a large extent, on the dollarization trend. This shift was not only desired but much needed to restore the confidence of people in local currency.
Critics of GoP's policy towards FCAs say that the government has gone back from its commitment. But, the question arises, "Are they justified in saying this?" At the time of freezing of FCAs it was noticed that over 90 per cent of the total amounts belonged to resident Pakistanis. The accumulation of dollars had an adverse impact on the rate on industrialization in the country. Above all the policy has resulted in high volatility of rupee. People had lost faith in local currency and higher rate of return on dollar deposits encouraged/proliferated dollar accumulation practices.
Measures adopted during the last two months are aimed at increasing rate of industrialization through reduction in interest rates and enhanced liquidity in the banking system. All these measures are not expected to render results overnight but have a positive impact in the long run. Abiding by these policies is the crux as major deviation of sudden change even in one parameter can render the system highly vulnerable. So far SBP has been acting autonomously and prudently except a few lapses change in prudential regulations regarding provisioning and over due loans. It must upheld its autonomous operations and should not show any soft corner towards loan defaulters and erring banks.
The fact is that the large scale manufacturing sector which is capable of providing accelerated rate of GDP growth at present is suffering from poor capacity utilization. (The key industries, cotton textiles, sugar, polyester staple fibre, chemical fertilizer, automobile assembly and cement manufacturing suffer from poor capacity utilization.) Therefore, no major investment is expected in these sectors. Similarly, there are hardly any prospects for substantial investment in power generation, oil refining and pharmaceuticals. All these sectors have major foreign investment and foreign investors have significantly low attraction in Pakistan. Their poor interest is due to some bad decisions taken by the government in the recent past. Besides this, foreign investors have also lost interest in the emerging markets including Pakistan.
Looking at the trend of the CPI, one gets a feeling that GoP has been able to control and keep the inflation rate to a single digit. However, for the short-term the inflation rate is likely to move a bit on the upside, mainly due to an increase in electricity tariff and introduction of GST. It is expected that inflation would go up from current level of around five per cent to around 12 per cent.
Pakistan's exports have been under extreme pressure during the current financial year. It was a result of a combination of number of factors. These included substantial decline in unit price realization, somewhat recessionary trend in Pakistan's major markets. The government has declared zero trade deficit in 1998-99 with exports estimated at Rs 10 billion. The current trend of exports and imports and behavior of international markets show that the country may not succeed in achieving total exports above US$ 8 billion. As opposed to this, imports have been persistently increasing despite efforts by commercial banks to discourage opening of letters of credit.
According to SBP sources the foreign investment took a nose dive to US$ 286 million in first 8 months of current financial year. The inflow was more than US$ 600 million during the corresponding period of previous year. While recession in the country may be a reasons the real issue seems to be lack of confidence of investors. Both the components of foreign investment, direct and portfolio, registered significant reduction of 34 per cent and 94 per cent respectively during the eight months. However, some of the analysts attribute the reduction partly to IPPs controversy and economic sanctions.
The relationship between IMF and government of Pakistan have not been adverse despite some of the pending issues. The tranches have been constantly released though too small to mention. However, with the expected rescheduling of debt by London and Paris clubs, Pakistan's debt servicing obligation has been reduced significantly. However, it is only a breathing space and efforts, more rigorous should be made to put the economy of the country at faster track. Otherwise, Pakistan would face a more precarious situation.
The SBP strategy to lower the interest rates has been successful so far. The massage is loud and clear for all the participants. This is the basic requirement for any fiscal and monetary policy. The reason behind lowering interest rates is to reduce the cost of funding for industry. Going to the fiscal route alone essentially means that the government is entrusted with deciding the priorities. It is believed that, as compared to the government, other sectors of the economy are more efficient with the use of monetary tools to try and stimulate the economy if comparing with using fiscal measures alone.
Many analysts question the timing of the decision and response of trade and industry to lower interest rates. It is important to keep a watch on interest rate expectations rather than normal interest rate alone. The market participants are still under the impression that lower interest rates are a temporary phenomenon and not sustainable. This expectation will be corrected in due course of time for which consistent policies are a must.
Pakistan has been witnessing persistent downward trend in exports. This has eventually caused the government to accept the fact that devaluation alone cannot be used to enhance exports. The recent reduction in interest rates seems to be a step in the direction to encourage the industrial sector to utilize the availability of low cost funds to invigorate their units. However, with the noticeable absence of the inflow of remittances, the rupee is likely to come under pressure in next 12 months if the trade balance remains negative.
Since Pakistan went nuclear after which all FCAs were frozen, the commercial banks in the country have been facing depletion in profits and shrinking in their deposit base. Most foreign commercial banks operating in Pakistan had about 70 per cent of their deposit base in foreign currency. This coupled with a slash in interest rates and lending rates to the private sector has led to a sharper fall in profits of commercial banks.
In the short to medium term interest rates are expected to remain low and Treasury Bill cut-off fall below 10 per cent. The Finance Minister has asserted that the discount window is expected to reach 11 per cent by the start of next financial year. The interbank money market is expected to be flushed with liquidity with the reduction in the cash reserve requirement. A reduction in returns on National Savings Schemes will act as a catalyst in changing interest rates in future not likely to go up.
The general perception is that despite overflowing liquidity there are no borrowers. The key industrial sectors, textile, PSF, sugar, cement will not be able to attract fresh financing. All Pakistan Textile Mills Association has indicated a need for about US$ 750 million. However, under the prevailing Prudential Regulations the mills will not be able to avail more than 10 per cent of this requirement.
However, a closer look at the capital market provides some relief. The TFCs issue of Dewan Salman was not only over-subscribed but the TFCs issued by other corporates in the past were also fully subscribed. ICI Pakistan has also announced Right issue of over Rs. 4.7 billion. Therefore, a lot of liquidity may see its way into the capital market.