INTEREST RATES AND INVESTING IN EQUITY MARKETS

It would be sufficient to say that Pakistan's stock market movement has least relationship with the prevailing interest rates.

SHABBIR H. KAZMI, Special Correspondent
Jan 29 - Feb 04, 2007

Anywhere in the world capital market provides medium and long-term funds for the businesses. The inflow of funds to the equities market is dependent on corporate earnings but more importantly on the prevailing interest rates. While talking about interest rates one also has to take into account the rate of return on various products offered by National Saving Centers. Investors are often willing to accept lower return on government securities. However, in Pakistan at times return on government securities has been much higher because the government was forced to pay higher return in order to attract larger sums for meeting budget deficit.

Ironically Pakistan has been a cash-driven market and cash also plays an important role in equities market. Till recently Badla and currently continuous financing system (CFS) have been driving the market. There is empirical evidence that during transition from Badla to CFS market remained highly volatile. Lately, the daily trading volume plunged to historic lows of around six million shares. The KSE-100 index also registered massive erosion. As the situation became clear daily trading volume improved. However, the relationship between higher Badla rate and investors' response has often been confusing.

Historically, brokers have been playing the role of Badla providers. Since they have 'custody' of the shares they are never reluctant in extending credit at any rate. At times Badla rate touched nearly 20% when the real interest rate was nearly half of it. According to an analyst, 'Badla culture has proliferated in Pakistan due to exemption on capital gains. People have been making enormous amounts and reinvesting it in the equities market.

One of the factors fueling inflation in Pakistan has been excessive borrowing by the government, at times beyond the target, casting negative impact on the economy. The government aims at increasing its non-bank borrowings. However, instead of raising the incremental funds through Pakistan Investment Bonds (PIBs) it has re-allowed institutional investment in National Saving Schemes (NSS). While the decision, in theory, allows institutional investors to rollover large NSS maturities, the reversal is likely to have significant negative impact on the development of the domestic debt market. It is also likely to raise interest rate risk for the government. The decision to re-allow institutional investment in NSS is a setback to financial sector reforms. The decision will lead to substantial increase in net NSS receipts.

It is often said that interest rates determine the quantum of borrowing by the private sector as well as the government. The reality is that in contrast to government borrowings, the private sector credit seems to be responding to interest rate signals from the central bank. Lately, the growth in private sector credit has reduced to nearly half compared to the corresponding period last year. Interestingly, the central bank does not consider the slowdown in private sector credit growth - a point of concern at this juncture.

Interest rate also determine the flow of funds to the equities market. The central bank has been using interest rate as a tool to contain inflation. Many analysts are of the view that stringent monetary policy and higher interest rates have not helped in bringing down inflation but adversely affected fresh investment. According to SBP report the headline inflation was 8.9% (YoY) during December 2006 and the food inflation was recorded at 12.7%, which was highest of the last 20 months. On the other hand, non-food inflation declined to 6.2% in December 2006, which was lowest of the last 28 months. However, the downtrend in the inflation over the past 12 months clearly shows a degree of instability and, on the other hand, reducing domestic inflation further is essential to improving the competitiveness of Pakistan's exports, and ensuring a better return to domestic savers.

One of the reasons for the exceptional interest of investors in banking scrips has been exorbitantly high spread, around 7.5%. The higher spread is due to changing maturity and risk profile of banks' assets and liabilities. The central bank encouraged banks to mobilize longer term deposits by reducing cash reserve requirement on their time liabilities in July 2006. There is ample evidence confirming that banks are mobilizing deposits offering higher returns to customers and the share of such deposits has been rising. Since the mobilizations of long-term deposits lower the maturity mismatch for banks and reduce liquidity risks, it was expected that the banking spread would decline.

A factor fueling KSE-100 index movement has been the growing quantum of foreign direct investment (FDI) inflows as well as the portfolio investment. These are much-needed impetuses for a capital deficient country like Pakistan for its healthy economic development. On top of every thing it brings in new technology and management skills, besides funding the current account deficit. During the recent past, telecommunications, financial business services and oil and gas exploration were the largest recipients of the FDI. Another factor worth noting is that with the regular and substantial inflow of FDI exchange rate volatility has also remained low.

To conclude, it may be sufficient to say that Pakistan's stock market movement has least relationship with the prevailing interest rates. Lower rates may prompt the entrepreneurs to indulge in hording commodities but hardly attract investment in equities market. It is mainly because of a very small base of retail investors, particularly small investors. For institutional and high net worth individual investors lower interest rates offer leveraging opportunities, which they hardly miss.