A Case for Not Hiking Interest Rates and Tackling Risk Premium

 

Business Recorder recently proposed that the State Bank (SBP) should hike interest rates to attract foreign portfolio investment (FPI). According to Business Recorder, it would help ease pressure on the external balance, which is usually true. However, a key link is missing between rising interest rates and inflow of FPI in this story.

On a fundamental basis, the return from FPI is exchange gain/loss plus gain/loss on investment. As we’ve all heard many times, when interest rates go up bond prices go down. So why would investors buy foreign bonds when interest rates go up? Well, because on the other side of the picture, yield goes up. The picture is sweetened by the fact that when interest rates go up in a country, the domestic currency appreciates. So, foreign investors receive heftier payments in their home currency.

This story works frictionlessly for developed economies. Investors give developed countries the benefit of doubt through their confidence in them. When the currency or assets of a developed country become cheap, investors gobble them up.  

When interest rates go up in the developed world, investors’ cash flows towards that part of the world. But that cash has to come from somewhere else – the developing world. The resulting capital flight from the developing world to the developed world causes huge pain for developing countries.

Developing countries are left with depleting foreign exchange reserves and a rapidly depreciating currency which creates uncertainty. This uncertainty heightens the concerned country’s risk premium. Thus, generating a devastating price-to-price feedback loop where foreign investors sell assets in that country which produces a higher risk premium, hence more uncertainty and more capital flight and so on.

This story has played itself out many times in Pakistan. In response, IMF mandates countries like Pakistan to hike interest rates to help retain foreign capital in the country. But it usually doesn’t work.

The key friction here is confidence. Fund managers don’t want to be seen holding a pile of shit, so they avoid it even though they know it’s cheap; only until others start buying in. We observe this with the Pakistani stock market as of recent where foreign investors performed net buying of $14.91 mn in July after IMF’s vote of confidence with the approval of the stand-by arrangement.

So, the important factor to tackle here is confidence. Without confidence, risk premium remains high and so foreign portfolio investors remain on the sidelines. This is an assertion Gita Gopinath makes in a recently co-authored working paper. Hiking interest rates can actually increase risk premium by lowering a country’s growth rate or worsening its economic conditions.

To understand the importance of risk premium, look no further than what has happened this year. The regional banking crisis in the USA and fall of Credit Suisse in Europe sparked concerns of a worldwide banking crisis. Banking stocks saw massive sell-off across the board regardless of idiosyncratic characteristics of each bank.

Investors are prone to such herd behavior as, again, they don’t want to be seen holding a stinky pile of shit. The same happens time after time with emerging markets, particularly when many of them are going through a political crisis.

This herd behavior can be used to a region’s advantage too. Following elections in Brazil, investors suddenly saw political stability in Latin American countries. Brazil’s successful and peaceful transition of power acted as a trigger for inflow of capital.

This was inflow of capital was magnified by the fact that real interest rates turned positive for several Latin American countries. But all Latin American countries were beneficiaries of this in the form of improved foreign reserves. Countries like Peru, which still run a negative real interest rate, saw an appreciating currency and improved external balance.

But why would a positive real interest rate attract foreign inflows? Because, when interest rates fall, bond prices rally so capital gains on domestic bonds are in play. So, the real trigger for foreign inflows is not positive real interest rates but expectations of the central bank cutting interest rates.

By timing the market, foreign portfolio investors avoid both a currency mismatch and duration risk. And they love to jump in when interest rates are about to fall in emerging markets. 

How can Pakistan use this knowledge to their leverage? Well, a quick look across the border to India would give a good model. Invoke confidence and enhance political stability. Unlike SBP’s failed forward guidance, the Pakistani government or establishment should issue forward guidance on the path to or timeline of elections.

By clearly committing to a line of action, the Pakistani government can calm the markets and reduce risk premium. Secondly, remaining committed to the IMF programme is of the utmost importance. It would be paramount in keeping default risk at bay. By giving the impression that the Pakistani government has things in control, it can isolate itself from other emerging markets in the eyes of foreign investors.

Lastly, further hikes in interest rates should be avoided at all costs. Hiking interest rates is completely futile at this point as it does not help bring down inflation but rather causes further deterioration in the fiscal position and economic growth.

As this blog has reiterated many times, private sector credit has been curtailed as far as it could be. In fact, hiking interest rates is counterproductive. It curbs the supply side and increases inflation through higher cost pass-through due to significant pricing power of the formal sector. By avoiding worsening of fiscal debt and economic growth, risk premium will be reduced hence attracting foreign inflows and improving Pakistan’s external balance.

Inflation can only be challenged by a reduction in money supply. That would only happen when either the SBP stops accommodating government borrowing or the government induces a fiscal contraction. Raising the cost of government borrowing does nothing but harm the economy.