The Curious Relationship between Interest Rates and Currency Markets

 

Over the past year and a half, the Fed’s aggressive interest rate hikes have significantly strengthened the dollar (US Fed rate now stands at 5.25%). A quick peek at the US Dollar Index would reveal just this. But in lands far away from the USA, aggressive interest rate hiking by central banks has not translated into an appreciating or steady domestic currency.

Take Pakistan as an example. A rather extreme example. The State Bank started monetary tightening a lot earlier with more hawkish momentum than other central banks. The State Bank began raising interest rates in September 2021, taking interest rates from 7% to the present 22% within a period of less than two years. This implies a monetary tightening spread of 9.75% between State Bank and Fed rates.

Despite this, the Pakistani rupee has depreciated from Rs 168 to Rs 287 relative to the dollar – since the start of State Bank’s monetary tightening cycle. What gives? To answer this, one has to understand why free-floating exchange rates move.

The long run

In the long run, the exchange rate of a currency is determined by the country’s purchasing power parity. That is what every macroeconomics course across the world teaches students. Economist Atif Mian simplifies this by saying, “Exchange rate in the long run reflects a country’s productivity relative to rest of world”. Other factors that influence exchange rates in the long run include relative price levels, trade barriers and net export demand.

But this understanding of exchange rates in the long run is based on a few assumptions – as always is the case in economics. And who knows when the long run would arrive? This is where our buddy short run steps in.

The short run

In the short run, there are two key economic theories about interest rates affecting exchange rates. One is called International Fisher Effect (IFE). IFE assumes that changes in inflation don’t impact real interest rates. Hence, the theory states that lower interest rates give way to lower inflation rates which translate into an appreciating currency (through purchasing power parity aka price level differences). This implies that in the goods market, there is no opportunity for arbitrage.

The other economic theory is the uncovered interest rate parity (UIRP) which states that arbitrage is not possible if there is an interest rate differential between the money markets of two countries. Assuming like IFE that real interest rates are same, let’s say USA has an interest rate of 10% and UK has an interest rate of 5% with an exchange rate of 1 dollar for 1 pound. UIRP says that if British investors perform a carry trade (take advantage of higher interest rates in USA), there would be no arbitrage as lower interest rates in UK would mean appreciation of the pound. Hence, gains from higher interest rates in the USA are cancelled out by relative depreciation of the dollar.

Empirical evidence

Unfortunately, both these economic theories are not supported by empirical evidence. Traders have been able to make arbitrage profits on interest rate differentials and usually the exchange rate doesn’t depreciate when interest rates rise, although not always, due to future expectations.

So, what does practice tell us? Practice tells us that the exchange rate usually appreciates when the relative interest rate increases. This is exactly because UIRP fails to hold true in the short run causing traders to perform carry trades which appreciate the currency in which interest rates are higher. This flow of capital is what allows appreciation of the currency with higher nominal interest rates. Note that the key difference between IFE+UIRP and capital flows is that IFE+UIRP take assumptions in real interest rates while capital flows are thought of in terms of nominal rates.

An interesting application of the capital flows phenomenon is that raising interest rates is the dominant strategy for central banks in a rising inflation environment. For instance, if the Fed raises interest rates, the US dollar would appreciate causing imports to become cheaper and leading to lower inflation (lower prices of imported goods). This would cause inflation to increase abroad, and other central banks would follow the Fed by raising interest rates to keep inflation in line. So, the Nash equilibrium is for every central bank to raise interest rates when inflation rises (given central banks are targeting inflation).

The Pakistani Rupee

So why doesn’t the Pakistani rupee appreciate then? Because risk premium also comes into play. When investors look to invest in a country or profit from arbitrage, they also add in a risk premium. In Pakistan, this risk premium is currently very high due to a mix of political instability, balance of payment crisis and government interventions.

For this same reason, when a global recession is expected, investors flock to safe haven currencies like the euro, pound, dollar or Swiss franc and away from emerging market currencies. The markets tend to give developed economies the benefit of the doubt at the cost of developing economies which face destabilizing capital flight in such scenarios.

Another factor also comes into play: market reflexivity. When the rupee depreciates, it sets off a chain reaction whereby a weaker rupee causes more investors to sell their rupees and this feedback loop continues until the rupee depreciates to a low enough level. So, investor expectations play a huge role in currency markets as well.

Finally, Pakistan runs a criminally high current account deficit which is poorly financed. A current account deficit, by default, implies that the home currency should depreciate. Why? Because that country is running a capital account surplus – borrowing from foreigners. Eventually it would have to run a capital account deficit to repay the foreigners. This would entail Pakistan selling its rupees to purchase foreign currency to pay the foreigners back – causing depreciation of the rupee.

On the other hand, Pakistan’s capital account is heavily financed with debt inflows which tend to be highly volatile. As Pakistan has seen, international investors are unwilling to lend to Pakistan right now, except at prohibitively high interest rates, since investors can earn a high risk-free rate in the USA. Consequently, when the regular flow of capital stops, the rupee ends up depreciating.

 

PICT: Was it a good investment?

Pakistan International Container Terminal’s (PICT) stock has hit the lower lock for 10 straight sessions now. Over the course of those 10 trading sessions, PICT’s share price fell 50%. It has plummeted from Rs 134.5 on 12th June to Rs 66.68 on 23rd June. So, what caused this monumental drop? Before answering that question, one has to know PICT’s business model.

PICT had attained a 21-year concession agreement from Karachi Port Trust (KPT) starting in 2002. The agreement was a typical build-operate-transfer (BOT) contract. In a BOT contract, the concessionaire (holder of concession) has to build an asset and is allowed to operate it with certain conditions.

Upon the expiry of the agreement, the concession can be extended or renewed. If not, the asset is transferred to the host. In this case, the host was KPT (a federal government agency). PICT’s concession agreement with KPT allowed it to build and operate four berths at its terminal, mostly handling cargo containers.

Under a standard BOT agreement with the Government of Pakistan, the concessionaire is allowed to publicly list its shares within three years of beginning operations. As a result, PICT publicly listed itself on the Karachi Stock Exchange in the second half of 2003. At the time, it was the largest initial public offering on KSE with over 73,000 applicants. PICT shares opened trading at Rs 12.13 per share on 2nd December 2003.

Skipping forward to present day, PICT was in negotiation with the government to renew or extend the concession agreement. Although the management had flagged the risk of possible non-extension of the concession agreement, it had remained optimistic that it would be able to operate the terminal after 17th June – as mentioned in recent financial reports. The management believed this since it had the right of first refusal when the terminal is tendered for a new concession.

On 12th June, the government decided that it would take over PICT’s terminal and operate it. But a few days later, it allowed PICT to continue managing the terminal till 30th June. Why did the government do this? Because under clause 21.3 of the concession agreement, if KPT took over the terminal to operate it, the right of first refusal becomes seemingly null. The clause also states that KPT has to invite competitive bids before expiry date if it intends not to operate the terminal.

This legal sleight of hand has dented any chances of PICT retaining its operations at the terminal. Although PICT is likely to challenge this in courts, it is unlikely to bring any change since Sindh High Court already set a precedent for the case and backed the government’s stance back in March 2023.

Consequently, chances are that PICT will wind up operations or continue offering terminal management services, which is not a stable nor a very profitable line of business.

Now, returning to the main purpose of this blog: how did public shareholders of PICT fare? To determine this, it was assumed that the shareholders:

• Owned ordinary shares of PICT
• Bought shares at open on first trading day
• Subscribed to right shares in 2004 to avoid dilution
• Were filers so dividend tax rate for filers applied
• Held shares till the end (share price hits zero after final dividend is paid)

Within the calculations, it is also assumed that PICT will wind up operations and give a final cash dividend of Rs 34.6 per share – returning any cash from sale of assets net of liabilities. Based on this, the net present value of PICT came in at Rs 860 per share. Although, NPV would’ve been higher by more than Rs 100 if the shareholder sold their shares on or before 12th June.

This is still a good sign as it means that it was a positive NPV investment for the initial public investors of PICT. So, PICT was a worthwhile investment for initial public shareholders. This is important for future investors in other companies with a similar BOT or concession agreement structure as PICT.

Currently, Pakistan International Bulk Terminal (PIBTL) is a publicly listed company which has a 30-year BOT contract with KPT which commenced in 2010. In fact, it was started by some former sponsors of PICT. However, PIBTL is not comparable to PICT as PICT has been profitable right from the start of its operations (although it began paying out dividends only in 2008). Meanwhile, PIBTL has had a rocky performance with many years of losses, and it continues to bleed red as of 2023.

A more realistic comparison could be made to Abu Dhabi Ports Group which is taking over PICT’s operations at the container terminal. AD Ports is about to sign a 50-year lease agreement with KPT for operation of the terminal. The draft agreement includes a clause which states that AD Ports could publicly list itself on the Pakistan Stock Exchange.

If PICT’s experience has any weight, initial investors in AD Ports could make worthwhile returns. However, PICT’s experience also reveals that investors should be cautious and conservative. Investors should carefully consider the legal risks in a lease or concession agreement.

 

Shell’s Exit from Pakistan: What Price could it get?

 

The rabbit is out of the hat: Shell Plc (who I will refer to as Shell global) is selling its stake in Shell Pakistan Limited. Shell global’s exit from Pakistan has been the talk of the town. Much has been said about it. Some have said that the exit is bad for Pakistan’s image – shows foreign investors that business confidence is low. Others have said the exit is good for Pakistan as it might prevent outflow of dollars through profit repatriation. Although that would only be the case if a local company purchases Shell global’s stake.

But what about the elephant in the room: Shell Pakistan’s valuation? And why does it matter for minority shareholders?

As per SECP law, in the event of a substantial acquisition, the acquiring company has to make a public offer as well. In other words, it must also offer to purchase shares from minority or free-float shareholders. The minimum offer price for this is the highest among:

(a) weighted average price of stock purchase agreement (SPA)

(b) highest price paid by acquirer for shares of target company in the past six months prior to public announcement of offer

(c) weighted average share price of target company in the past six months prior to announcement of public offer

(d) weighted average share price of target company in the four weeks prior to public announcement of intention

(e) book value per share

Now, the book value per share is Rs 46 while weighted average share prices (over any period) are much higher. So, option (e) can be cancelled out. Meanwhile, no potential buyer has bought shares of Shell Pakistan so option (b) can also be ticked off. This leaves three options.

Among these, option (a) is likely to be the minimum offer price since the market value of Shell Pakistan shares are still far below a potential acquiring price. So, this leads us onto the big question: what value can we put on Shell Pakistan?

In the event of an acquisition, the acquirer can value the target company in different ways. Firstly, it can choose to pay attention to book value. Book value is simply the accounting method of valuing equity. However, it can be highly outdated since assets purchased are valued at cost minus depreciation. This is very much the case for Shell Pakistan as well since Shell’s most valuable assets (land, an appreciating asset) were purchased decades ago and have been valued at cost as opposed to market value.

Secondly, the acquirer can choose discounted cash flows (DCF) as a method of valuation. DCF is generally a good valuation tool, but it relies heavily on a good prediction of future cash flows. In the case of oil marketing companies in general, future cash flows are uncertain due to the transition to renewables (hard to estimate terminal value). In the Pakistani context, margins are fixed by the regulator making it even tougher to predict FCFs. You can take assumptions to arrive at a DCF value, but it could be wildly optimistic or pessimistic depending on the assumptions taken. Thus, it would be a poor measure of value (easily manipulated).

There are other methods as well such as multiples valuation (revenue multiples as an example) or relative valuation, but they’re generally not used to value a large, long-term investment like Shell Pakistan’s business. This leaves us with the valuation technique I’ve used: net asset value.

Net asset value is calculated by taking the market value of assets and netting off liabilities. It is simply taking book values and updating them with market values to arrive at an estimate of the company’s equity. This is the best approach to valuing Shell Pakistan because much of its valuable assets (land) are in prime locations and can be sold or converted into other ventures readily. Also, net asset value is a good valuation indicator since Shell Pakistan used to be wildly profitable in the past. One could argue that with a change of management direction, Shell Pakistan’s assets could be used more profitably (unlocking greater value).

I have calculated a conservative estimate of Shell’s value based on this method here. The major point of contention would be land valuation. The land was valued using Zameen.com’s index tool. Commercial property rates were used if they could be found. If they could not be found, general plot rates were used. If no data was available on a location, values from a neighboring location were used. For instance, no value was available for Keamari industrial/commercial land, hence plot rates from Clifton Block 1 (located next to Keamari) were used.

It must be highlighted that the land valuation could be inaccurate. For example, Shell’s Marine Drive petrol pump land was valued at PKR 1.4 billion. But when I called a real estate broker in Karachi, he gave a rough estimate of 175 crore (1.75 bn) rupees for the same property. Since my aim was to be conservative in the valuation, I applied a 20% margin of error on the land value. Although, to get a precise estimate of Shell’s land, one would have to make use of property brokers and land appraisers from across Pakistan.

Similarly, I applied a 20% margin of safety or discount on Shell’s net value. This was done to accommodate the fact that Pakistan has a tough business environment currently with huge hurdles in profit repatriation. Meanwhile, global interest rates are high and global liquidity is constrained so a potential acquirer might be willing to pay less for Shell Pakistan.

Based on this valuation, Shell’s price per share would be 177 rupees. This imputes a market capitalization of 37.9 billion rupees ($131.9 million). So, Shell global’s stake in Shell Pakistan would be worth $101.9 million.

However, Shell’s ultimate SPA price might be wildly different. This is because acquisitions are very much about supply-demand. If there are several potential acquirers vying for a piece of Shell Pakistan, then Shell might be valued much higher than this. But the converse could be true too.

For shareholders of Shell Pakistan, it’s a waiting game now. But the good thing is that the wait might not be too long.

The Banking Sector: The Red Flags 🚩🚩🚩

 

As I’ve mentioned before, banks are notoriously tough to value. But an investor must not feel daunted by this. This should be a good opportunity to make gains where others find them hard to see.

As part of this effort, one should have a good understanding of what key metrics mean and the red flags that can pop out of evaluating them.

What to look at

Many analysts place importance on absolute values of certain metrics. For instance, investors have for a long time believed that a PEG ratio of 1 equals fair value. Or a PEG ratio of greater than 1 means lower potential returns.

However, it is very difficult to objectively assess a range for a metric which would make a company cheap or expensive. This is why a metric for any company has to be compared relative to the average (mean or median) of the metric in the sector as a whole. This is the method I use.

The median should be the benchmark if there are plenty of outliers in the data. But the benchmark could be the mean if there are little to no outliers or if there are significant outliers, they are excluded from the data.

Return of Assets (ROA)

ROA is an important metric for all sectors but perhaps even more so for banks. This is simply because banks earn directly from their assets (loans).

A higher ROA indicates better profitability and more efficient use of assets. So, one must look for banks with a ROA higher than the average. Standard practice in the banking sector is to use ROE as a judge of profitability which I believe is incorrect.

ROE is a poor measure of profitability because a bank can have a large ROE if it is highly leveraged. This means that a bank with a high ROE could carry huge risks with it too. Secondly, ROE is hugely influenced by book value which is a poor metric for valuing banks.

Book value is simply the accounting way of measuring equity. Banks generally invest in human capital to generate high returns on lending and brand image to attract deposits. Book value takes no aim at measuring either of these or the value they generate. It also must be noted that book value can be written down and it can easily be distorted by accounting measures like ‘goodwill’. In fact, book value is a measure of liquidation value for debt investors, so not very relevant for equity investors who are more interested in the returns a company can generate from its assets.  

Interest spread

In the previous blog I mentioned: the interest spread for a bank is the difference between its cost of deposits and lending rate. One fact to notice is that most banks would have very similar lending rates due to competition or in the Pakistani context, due to regulations on conventional banking. So, within the interest spread, the key metric of focus is actually cost of deposits.

How do banks lower the cost of deposits? By maintaining a higher number of current accounts (pay no interest) as opposed to savings account (which pay interest) for depositors. This can be a significant competitive advantage for banks, especially as they become larger. So, look for banks which have an above average interest spread (or below average cost of deposits).

A very high cost of deposit will be a red flag which needs further investigation by a look-through at how the bank is then investing those deposits. Will the bank sustainably generate high lending rates in the future?

Percentage of securities held-to-maturity

In bank accounting, securities can be marked-to-market (usually mentioned as ‘available-for-sale’ [AFS] or ‘held-for-trading’ [HFT] in financial statements) or flagged as held-to-maturity.

The difference is that under marked-to-market, securities are valued at their current market values which translates into unrealized losses on the income statement. In comparison, under held-to-maturity, securities are marked at their original value as opposed to market or fair value. This means that unrealized losses from held-to-maturity securities do not translate into unrealized losses in earnings.

This slight difference in accounting can be very consequential. Banks should have almost all securities under marked-to-market. Why? Because it gives an accurate picture of a bank’s investments.

Let’s say depositors withdraw their deposits greater than the bank expected – leading to a depletion of reserves for this purpose. Now, the bank would have to fund additional deposit withdrawals by selling their assets. They can’t sell loans so they would be forced to sell their securities. If securities are marked-to-market, the losses on them have already been realized so it’s not an issue. However, if the securities are held-to-maturity securities, they will have to be sold realizing the losses in the next financial report. So, held-to-maturity can be manipulated by banks to underreport their true losses especially in a rising interest rate environment.

Consequently, one should look for a bank with a below-average percentage of securities held-to-maturity. If the bank fails this check, it can also be indicative of poor management which is cooking the books to hide other losses – a common occurrence with banks.

Tier 1 Capital Ratio

Tier 1 capital ratio is certainly the most important metric for banks as it indicates the capitalization of a bank. But first, what comes under tier 1 capital? Or rather, how is capital defined for banks?

Capital is divided into tier 1 and tier 2 capital. Tier 1 capital includes disclosed reserves (retained earnings) and shareholder’s equity. While tier 2 capital includes non-deposit debt, hybrid capital (callable bonds), undisclosed reserves as well as other kinds of reserves (revalued reserves). Tier 1 capital is more important as it is far more liquid, can be measured more accurately and can readily absorb losses as they come.

Now, capital ratios are calculated by dividing the capital by risk weighted (adjusted) assets. Risk weighted assets are calculated by assigning a risk weight to each asset the bank has and summing up the multiples of the weight and asset. For instance, if a bank has $1,000 of loans with 50% risk and $1,000 of government bonds (risk-free), the risk adjusted assets would be $500.

Basel III regulations dictate that tier 1 capital ratio must be at least 10.5%. Besides this regulatory importance, the tier 1 capital ratio can reveal the risk appetite of the bank.

One should look for an above-average tier 1 capital ratio as it would mean the bank has lower risk. Well-capitalized banks generally have a tier 1 capital ratio of 15% or above. This cushion above the regulatory requirement is essential to absorb unexpected losses and stay clear of any future regulatory troubles or sanctions.

Basel III regulation also has minimum requirements for two other capital ratios (common equity tier 1 capital and total capital), but tier 1 capital ratio is the gold standard due to its liquidity and accuracy in measurement.

How does this all come together?

The difficulties in valuing banks means that analysts have to rely on certain metrics. Although there is a plethora of metrics out there, I decided to focus on the four most important ones.

Look for banks which after well-capitalized through tier 1 capital ratio, are transparent in their financial reporting (low % of securities in HTM), have a high interest spread and a high ROE relative to the sector averages. Besides these metrics, a high dividend yield would be a cherry on the top.

 

The Banking Sector: How does it really work?

 

Banks are notoriously tough to value. Regular valuation techniques don’t work on them. How do you estimate cash flows for a business which generates its bread-and-butter from cash itself? The difficulties in valuation are compounded by increasing regulation of the banking sector.

Banks are a vital piece of a nation’s financial stability. They are, what Former Fed Chairman Ben Bernanke calls, ‘systematically important financial institutions’. This causes a bank’s growth, capitalization, and risk appetite to be largely determined by regulators.

I’ll leave the difficult task of valuing banks to a later blog. I’ll also explore the red flags one should look out for when screening companies in the banking sector in the next blog. For now, one must take a step and ask: what do banks really do?

How do banks really work?

A basic lending model consists of savers (depositors) and borrowers (loanees). The bank itself is a borrower too, but in a different sense. It is what we call a ‘financial intermediary’.

The bank borrows from its depositors and lends it out to individuals and organizations at a higher rate than it borrowed from depositors – pocketing the spread between the two. But hang on a minute: why don’t savers lend to borrowers directly? Well, that’s very difficult for several reasons.

Let’s say, a saver has $1,000 in savings. Now to earn an interest on that $1,000, that saver would have to find a borrower that needs exactly $1,000 or close to that. Then, the saver would have to study the borrower’s prospect of repaying the loan and the riskiness of the loan. What happens if the borrower dips? The more you begin to think about this story, the more problems pop up. This is where a bank steps in. It allows savings to be easily directed towards those who need it and are able to return it with interest.

Now, when a bank receives a deposit, it keeps a share of the deposit in its reserves to safeguard itself against deposit withdrawals. But once a loan is made, the borrower keeps the loan in a bank too. Now the loan which was deposited is lent out again after holding a certain portion in reserves. This process continues ad infinitum. It is known as the ‘money multiplier’ process within a fractional reserve banking system.

But since a bank essentially borrows money from its depositors, what is seemingly its asset base (deposits) are actually its liabilities. Meanwhile, the loans a bank makes are its assets. Because the interest spread earned on the loan is where their income lies. This is why a bank’s balance sheet shows deposits as liabilities and loans as assets.

This slight difference in accounting makes banks completely different from usual businesses. A usual business has their cash-generating machinery or plants as assets. But banks have their cash-generating deposits as liabilities.

But what about the difference left between a bank’s assets and liabilities? That difference is known as shareholder’s equity or bank capital. If the bank makes losses, it has to dip into this equity to fund those losses. But if the equity is wiped out, the bank becomes insolvent. However, a bank may collapse even if it is solvent but is unable to match its short-term liabilities with its short-term assets. This is usually the case when a run on the bank takes place or when there is a fire sale of assets.

The bank can also borrow money from other financial institutions allowing it to expand its ability to lend (called non-deposit debt). It can also offer various financial products like investment banking services, credit cards/consumer finance, swaps, futures etc. The purpose of these products is to streamline the flow of savings to borrowers, raise capital for organizations or help businesses and people hedge the risks they face. For example, a futures contract allows a farmer to hedge the risk of falling commodity prices just like how crop insurance helps the farmer hedge the risk of extreme weather.

Financial innovation: A sham?

Although the core business for banks is still lending out the deposits they receive, there have been changes to their business model. Through financial engineering in the recent past, banks have begun to offer more and more financial products.

Famously, Warren Buffett called derivatives the ‘weapons of financial mass destruction’ in Berkshire Hathaway’s annual meeting of 2007. Similarly, people often question whether these new financial products create any value at all for the economy.

I would say Buffett’s point is well-taken that financial products like derivatives are used in an increasingly risky and dangerous manner. But to say that financial innovations do not create value would be a huge injustice.

Take credit default swaps (CDS) as an example. A CDS allows a bank to shift the credit risk of a loan (risk of default on loan) to another creditor willing to take on that risk in return for a premium. This ingenious product allows the bank to reduce the reserves it needs to hold, thus boosting its ability to lend and expand credit. If used responsibly, this would lead to a permanent increase in credit within an economy, delivering greater growth and job creation.

But as we know, CDSs were abused in the run-up to the 2008 financial crisis as the risk of the loans insured by CDSs were neglected by the underwriters or hidden by the loan originators. 

However, that does not mean that financial innovation should be discouraged or that the work banks do doesn't create value. Financial innovation should be encouraged but regulated to minimize undue risk-taking.

The work banks do is important. They hold the most important key in an economy: credit.

The IMF: A Force for Good?

 

The IMF is known to be a controversial organization. No, I’m not talking about Tom Cruise’s IMF which appears in the Mission Impossible films. I am, in fact, talking about the International Monetary Fund (IMF).

Everyone seems to have their own views on the IMF especially in Pakistan:

“They’re evil”.

“They’re wrong”.

“They represent western interests”.

“They do what is necessary”.

A lot like Tom Cruise’s IMF, people think the International Monetary Fund is a shadow organization – hiding in the shadows and dark corridors of Washington DC. But what does the IMF really do? And what are its aims and objectives?

The IMF’s objectives and role

A quick glance at IMF’s mission statement would reveal three major objectives of the organization: encouraging international trade, promoting financial stability, and encouraging economic growth.

It achieves these objectives by famously acting as a ‘lender of last resort’ under its lending programmes while also advising nations as a consultant or otherwise. Take Pakistan as an example. Pakistan has entered 22 IMF programmes mainly due to its frequent balance of payment (BoP) crises.

A BoP crisis arises usually when a nation is unable to service its foreign liabilities. Such a crisis is soon followed by speculation against the nation’s currency leading to rapid currency depreciation as well as plummeting confidence in the economy. The end result is usually a recession.

So, what does the IMF do? The IMF lends foreign currency when no one else is willing to; or if others are willing, it is at a prohibitively high interest rate. But lending from IMF comes with strings attached – its conditions. The aim of these conditions is to resolve the issues that led to the BoP crisis.

Usually, the conditions include higher taxes and reduced expenditure to decrease fiscal deficit and stabilize debt-to-GDP ratio. They also include currency stabilization plans through a free-floating exchange rate system and an increase in foreign exchange reserves (through higher interest rates). Or occasionally a currency peg if necessary and suitable.

The intention behind these conditions and IMF’s willingness to lend is to revive confidence in the economy. Normally, an IMF loan and agreement allows a nation to gain access to funding from other multilateral institutions like the World Bank or Asian Development Bank. Meanwhile, it puts foreign investors at ease and restarts the regular flow of international capital. By reviving confidence, it is expected that investment and consumption will return to their potential levels (before the crisis), hence returning the nation to a path of growth.

Besides the lending programmes, IMF also offers consultation missions. Most frequently, the gulf nations such as Saudi Arabia avail the IMF’s consultation services to help achieve macroeconomic policies and goals. The IMF also offers unsolicited advise when it feels necessary. For instance, during the UK government’s mini budget crisis in September 2022, the IMF publicly advised the UK to reverse their plans of increasing spending and reducing taxes.

Why the IMF has been controversial

IMF has come under attack from plenty of institutions and notable figures. Nobel-prize winning economists Joseph Stiglitz and Paul Krugman have accused IMF’s policies of being counterproductive. They argue that when a country falls into a BoP crisis and subsequently a recession, there is a need to revive demand by having monetary expansion as opposed to contraction. Paul Krugman goes as far as to assert that the free flow of capital has to be paused temporarily to avert speculation. The IMF’s policies are in contradiction with such views (orthodox vs Keynesian views).

The IMF is also criticized for being a political tool of the West. Western nations are the largest contributors to the IMF and have the largest voting share in the IMF. In particular, the United States has 17% of the voting share in IMF – essentially making it a veto power. This makes the IMF a political as well as economic organization, its critics say.

Moral hazard is another factor for which blame is hurled on the IMF. Moral hazard is an event where a person or organization is incentivized to take riskier actions without consequence. How does it apply to the IMF? The IMF gives a bailout with conditions attached under a programme which lasts for a few years. Once the programme is over, the concerned government returns to its old ways and falls into similar problems which brought it to the IMF in the first place. Why? Because the government knows the IMF will bail it out again. A case of heads the government wins, tails the IMF loses.

What have the results been?

The results of the IMF’s efforts have been mixed. Some countries have successfully used IMF programmes to spring themselves onto a path of prosperity like Jordan. Others have spiraled into deeper and deeper crises such as Argentina.

The key issue with IMF programmes is the nature of the organization and the length of its programmes. The IMF has significant resources at its disposal to help any country with their macroeconomic troubles. However, the political nature of the organization limits its ability to effectively act as a lender of last resort. Instead of acting like a global central bank as one of its founding fathers Keynes had intended, it acts like a commercial bank willing to take on losses for the sake of political motives. Although it must be recognized that having a global central bank is next to impossible due to issues of sovereignty in global politics. Instead, our unipolar world has to settle and compromise for an organization that is dominated by the United States.

The other issue with the IMF is one that can easily be resolved. The length of IMF programmes is between roughly three to five years. The programmes are too short to carry out reforms and see the results they bring. By extending the length of the programmes, the IMF can keep concerned governments tied to the conditions of the programme for longer, thus seeing a greater chance of success.

Still even in its current condition, the IMF is necessary for the global economic system and world order. A lender of last resort is essential to avoid the mistakes of the past. During the great depression, the world deglobalized as countries set up more trade barriers in favor of protectionism leading to a prolonged economic crisis. The IMF is essential in ensuring that international trade is maintained.

The world has come to realize that letting a nation’s economy collapse is not only bad for global productive capacity but also global demand. The IMF may not be perfect firefighter but it’s the best we have right now.   

 

KSE100 vs Global & Pakistan Interest Rates

 

Over the past year, central banks all over the world have hiked interest rates like there is no tomorrow. Pakistan’s central bank has been no exception: State Bank has hiked interest rates by 1125 basis points since January 2022. Interest rates in Pakistan now stand at an all-time high of 21%.

Unsurprisingly, the stock market has been bleeding red. The KSE100 index started off 2022 at 45,374 points. It ended May 2023 at 41,665 points. The story has been similar across the major stock exchanges all over the globe. In fact, they’ve suffered an even deeper and steeper downslide than KSE100.

So why do equities crumble under a rising interest rate environment? Well for one, the interest rate determines the risk-free rate in an economy. So, the rate at which investors discount future earnings or dividends revises upward as interest rates go up. Resultantly, the present value of future earnings or dividends falls when interest rates rise translating into lower share prices.

There are alternative explanations too. When interest rates rise, bonds pay a higher coupon relative to their price. So, a falling stock market is an indicator that investors are simply moving away from equities and into bonds because they are more attractive. Or it can also be thought of in this way: rising interest rates increase the risk of a recession so future profitability becomes uncertain leading to falling stock prices.   

Now that the relationship between interest rates and equities has been established, one might wonder: how have interest rates affected the Pakistani stock market?

There are two interest rates that are important for Pakistani stocks: Karachi Interbank Offer Rate (KIBOR) and global interest rates. KIBOR is important because it is the rate at which banks lend to each other and is the benchmark for most lending in Pakistan.

On the other hand, global interest rates are important for a different reason. Historically, Pakistan has ran a current account deficit which has been funded by foreigners (capital account surplus). Unfortunately, most of Pakistan’s capital account inflows have been volatile, debt flows instead of the more stable and productive FDI flows.

The rate at which Pakistan receives loans from foreigners is determined by global interest rates, hence making them relevant to Pakistan’s macroeconomic stability – which impacts the stock market. Global interest rate is heavily influenced by the interest rates in the West and largely follows the US interest rate. Hence, we will use the US Fed funds rate as a benchmark for global interest rates.

KSE100 v KIBOR

The above graph clearly shows that KIBOR has been inversely related to the KSE100 index over the past 20 years. In particular, the recovery of KSE100 from 2009 to 2017 happened under a low and falling interest rate environment. This makes sense because lower interest rates translate into lower financing costs, thus boosting profitability of KSE100 companies.

Also, the correlation of KIBOR and KSE100 comes out at -0.1. It confirms the negative, linear relationship between KIBOR and KSE100 although indicating that it is a weak relationship. The weak relationship between KSE100 and KIBOR can be supported by the fact that most publicly listed companies have high pricing power. This allows the companies to pass on higher financing costs onto customers in the form of higher prices, thus protecting profitability.

KSE100 v Fed Funds Rate

On the flip side, the Fed Rate appears to have no relationship with KSE100. This is confirmed by the correlation of 0.03 between KSE100 and Fed Rate. This appears to make sense as companies in the KSE100 have very little foreign debt. Most of their debt is domestic. Hence, changes in global interest rates do not have an immediate impact on the earnings of companies in the KSE100 index.

As for the Pakistani government’s debt, most of its debt is bilateral rather than commercial. Consequently, Pakistan’s macroeconomic stability depends more on other factors like geopolitics or its foreign relations rather than global interest rates.

What does this mean for KSE100?

Although further rate hikes or future rate cuts by the State Bank would temporarily sway the KSE100 index one way or another, they would not cause a sustained rally or slump. Instead, investors must focus on the growth potential in the top-line and bottom-line of the companies in the index. Remember, the value of anything is the present value of all future cash flows.

Opportunity Cost: An Impractical Concept?

 

Opportunity cost is an enduring concept in economics. Mankiw’s Principles of Economics textbook would tell you: opportunity cost is the value of the next-best alternative when a decision is made. Simply put, if you’re buying a litre of petrol, you are foregoing the option to buy a kilo of mangoes. Or half a kilo of chicken. Or all the other seemingly endless possibilities of alternative purchases. In other words, it is the tradeoff we face in a world of scarcity.

The concept is intuitive and useful in thinking about many fields. By buying a $1,000 treasury bill, you are foregoing the potential of excess returns you could have earned investing the same amount in a stock market index or mutual fund. If the treasury bill was to give a return of 5% and the mutual fund a return of 9%, then mathematically the opportunity cost would be 4%. That is the value (return) an investor would forgo if they prefer less risk.

But do consumers think about opportunity costs nowadays when making decisions?

This question arises from the countless trips I’ve made to a khokha, kiryana or grocery store. In my observations, when people buy an item, they think of it in nominal terms: “I spent Rs 500 buying yoghurt”. They might ask the price of an item they want, but rarely cross-check the prices of other products or competing brands.

Without knowing the cost or value of alternatives, how can we say the consumer made a rational decision? Wouldn’t that render much of the textbook economic theory useless then?

In a barter economy, transactions and purchases can easily be thought of through opportunity cost. After all, when a person only has the option to either consume their produce or trade it for other goods in proportionate amounts, opportunity cost becomes a dominating concept. A farmer would surely weigh the options of what they can buy or trade for a gallon of milk their cows produced.

But, as the world moved to a monetary system of banknotes and fiat currency, a big change took place. The idea of buying products with money meant that the cost of buying a litre of petrol was thought of in monetary terms. A litre of petrol cost Rs 250 instead of a kilo of mangoes or half a kilo of chicken in the consumer’s mind. The link between a purchasing decision and its true opportunity cost has been lost.

The consequence of this has been the soaring consumerism observed globally over the last century. Although one must acknowledge that the expansion of consumer credit has also played a huge role in increasing consumerism. Still, the invention of money has made phenomenas like ‘impulse buying’ common and widespread.

Despite this, opportunity cost is a useful concept in understanding why or how consumers make decisions. Even if consumers are thinking a litre of petrol costs Rs 250, they still have a limited amount of income they can spend on a limited amount of goods. The inherent scarcity of resources pushes consumers to make decisions with opportunity costs even though they may not be consciously thinking about it.

But the consumers, investors, or policymakers who thoughtfully utilize opportunity costs can gain an edge in this world. They can squeeze out efficiencies and returns that may not seem possible on first glance.

The Need for a Not-so Friendly Budget

Over the past few days, both Prime Minister Shehbaz Sharif and Finance Minister Ishaq Dar have told the media that the “upcoming budget will be a business and people friendly budget”. Initial estimates from Finance Ministry suggest that the outlay (expenditure) for the federal budget 2023-24 will be around Rs 14.6 trillion. While FBR’s tax target is projected to be at Rs 9.2 trillion.

Overall, the proposed budget might include a small primary surplus of about 0.3% of GDP. This is necessary to stabilize the ballooning fiscal debt, but may not be enough given a contracting economy, record-high inflation, and failures in meeting tax targets over the past few years. Perhaps, Pakistan would be better off with an ‘unfriendly’ budget.

Debt servicing costs are expected to eat up Rs 7.5 trillion in the budget which has prompted many commentators to endorse domestic debt restructuring. However, one must note that the high debt servicing costs are temporary due to interest rate hikes from the State Bank. When interest rates fall back to normal levels, the government’s debt servicing bill will recede given that most of the debt is of floating rate or in treasury bills which mature quickly. But the real question is when will inflation begin to fade so that interest rates can fall?

The State Bank has been vigorously hiking interest rates in the hope that inflation starts to budge downwards. However, inflation has only gone up after each interest rate hike. Analysts have given many reasons for this such as rising petroleum prices, higher taxes, revision of electricity and gas tariffs following mini-budget or the depreciating rupee. But these factors only look at nominal computing of inflation and ignore the demand side of credit.

As per SBP, July to April FY23 government borrowing stood at Rs 3 trillion while private sector borrowing stood at Rs 194 billion. During the same period in FY22, government borrowing was at Rs 1 trillion, while private borrowing was at Rs 993 billion.

It is clear that private sector credit demand has fallen dramatically as a result of interest rate hikes, showing that monetary policy has been effective. However, the massive rise in government borrowing has erased any gains that were to be made from monetary tightening.

It seems like the government is borrowing as much as it wants – the true source of inflation in Pakistan. Another factor to note is that cash in circulation stands at Rs 8 trillion while total banking deposits are Rs 23 billion. That puts Pakistan’s cash to M2 money supply ratio at 30% – the highest in the region. 

This ratio has been going up for many years now. This means Pakistanis are unlikely to convert their cash holdings to interest-yielding accounts even when interest rates are going up. All this makes fiscal policy ever-more important in fighting inflation. A fiscal contraction will lead to a far greater decline in inflation than an equal amount of monetary tightening.

For FY23, the government had set a primary surplus target of 0.3% of GDP, in line with IMF’s demands. However, FBR has missed their tax targets by quite a margin as has been the case over the last few years. This has led to a 0.8% variance in the primary budget which now comes in at a deficit of 0.5% of GDP. The effects of this can be seen in the debt-to-GDP ratio which will rise above 80% at the end of FY23.

Considering the fact that Pakistan’s economy is contracting, the government needs to target a primary surplus of at least 1.5% of GDP in the budget. This will allow a reasonable, in-built buffer of 1.2% of GDP.

So where can the government slash their expenditures? For one, Rs 1.1 trillion is being budgeted for PSDP which can be drastically trimmed. Much of the spending in PSDP is on negative NPV projects which have political motives anyways.

Another Rs 1.2 trillion is being budgeted for gas and power subsidies – mostly to industries. These subsidies have been largely unproductive and rent seeking in nature. These subsidies can be decreased significantly as well, which would have the spillover benefit of pushing businesses to become more competitive.

Both these measures will allow the government to push down their outlay to Rs 13 trillion at the very least. Although there would be more potential for expenditure reduction once more budget details come to light.

But it is clear, fiscal contraction or at the very least, avoiding fiscal expansion is necessary in dealing with Pakistan’s current issues: high inflation and rising fiscal debt. A smaller government would be better for Pakistanis.