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Hot Money: where do our economy’s experts stand?

A group of economists and businessmen gathered on Mohammad Malick's talkshow to discuss the danger accompanied with SBP's high interest rate and the recent inflow of hot money. Experts on the opposing side took to twitter to factcheck the panels arguments and provide their analyses of PTI's monetary policies.


On Saturday 28th December, a panel of economists and businessmen sat down with Mohammad Malick on his show Breaking Point with Malick to discuss the factors responsible for the economy’s decline.

The panel hosted Dr. Muhammad Zubair former caretaker of the Ministry of Commerce, Abid Hassan former advisor to the World Bank, Dr. Mirza Ikhtiar Baig Vice President of Pakistan Chamber of Commerce and Industry, President of the Union of Small and Medium Enterprises Zulfiqar Thawar, Vice President of Lahore Chamber of Commerce and Industry Mian Zahid Javed Ahmed, and President of Karachi Chamber of Commerce Agha Shahab Ahmed Khan.

The panel addressed a clip of the Advisor to Prime Minister on Finance, Abdul Hafeez Sheikh, praising the economy for keeping the exchange rate stable, increasing portfolio investment, stock market growth, and positive reviews from institutions such as IMF, World Bank, and Moody’s.

Dr. Baig said these improvements have not translated into real growth or the creation of jobs because of the high interest rate set and practical issues such as inflation, stagnant exports, availability of energy, etc. are left unaddressed in our economy.

The panel took several hits at the high interest rate set by State Bank of Pakistan. Thawar said a the current rate is unaffordable which disallows the local community from borrowing. Javed Ahmed, while arguing that PTI’s policies are not favorable for the business community, said the 13.25% interest rate, which amounts to 17-18% when adding bank commission, does not allow any business to be viable or profitable. He said the economy cannot expect improvement until such policies are overturned and industrial growth is prioritized.

Read more: $1 Billion of Foreign Investment in Pakistan: Positive sign for the Government?

Dr. Zubair claimed the statistics and positive news pitched by the government is propaganda concealing the plight of the business community. He said the hot money coming in only favours foreign investors and banks who are not offered such a high interest rate elsewhere and their payments will go from the Pakistani community’s taxes. Dr. Zubair went as far to suggest a tax rebellion in Pakistan against the unfair collection aimed at filling the pockets of those receiving high interests.

Abid Hasan criticized the claim that hot money be considered FDI and said institutions such as IMF are mandated to extend a positive outlook, debunking Hafeez Sheikh’s claim to success based on their reports.

Dr. Baig referenced to a recent conversation he had with the Prime Minister saying inflation will shoot up till January before coming down and then the government will brown down the interest rate. However, he believes the government will refrain from bringing down the interest rate any time soon if they intend to continue their current monetary policies. As a consequence, borrowing avenues will shrink further and bring down exports.

There is the argument that local savers are suckers and easier to exploit than FPIs? Hassan says that’s a truly a rum way to run a railroad! The truth is that is all investors and capital have similar characteristics, the most basic one being the insatiable desire to maximize returns for a given level of risk. In other words, local and foreign investors are likely to be equally pro cyclical.

Adding to the need to bring down interest rates, Dr. Zubair said economic literature and global experience demands an economy like Pakistan’s, that is stuck in a debt trap, set interest rate lower than inflation and yield negative real interest. He said the increased interest rate will bear no impact on consumer spending and the country is now stuck in an interest trap which makes the economy’s future look even more bleak than before.

Abid Hassan, too, questioned their intention and ability to bring down interest rate. He said the hot money received is the worst form of foreign financing and there are easier ways to generate such money in our economy.

Prominent investment banker Javed Hassan, amongst others, took to twitter to oppose the arguments made on the talk show.

“The fear and hype being created around so-called foreign portfolio hot money invested in TBs is symptomatic of a lack of even elementary understanding of market dynamics and the associated risks, and all that combined with a healthy dose of xenophobia” said Javed Hassan before presenting the following arguments:

Are the foreign funds being given some exceptional returns that is over and above that being provided to local investors?

Hassan disagreed. He explained the TB policy rate is determined by SBP, on the basis that it wants to ensure positive real interest rates around about 1-1.5%. A positive rate is imperative to control inflation largely brought about by PKR devaluation. The real interest rates are neither determined by headline CPI rate nor core inflation as is often wrongly stated by media commentators. Instead it is calculated using forward expectations of inflation as determined by SBP (and separately by IMF) and is currently estimated to be around 11.5-12%. Therefore, if twelve-month TB policy rate is around 13% the real interest rate will be approximately 1% (13-12). This has absolutely nothing to do with trying to induce FPI investment in TBs.

Read more: Pakistani economists’ tug of war: is hot money helping our economy?

So he concluded that no special rate is being provided to foreigners. Moreover, as things stand FPIs are subject to all the normal tax applicable to local investors, for example, 10% withholding tax. Consequently, the net return on 12-month TBs held to maturity is around 11.7% & not the 16-17% often mentioned, and exactly the same as that of domestic investors.

Hassan questioned whether FPIs have been given any sort of currency guarantee such that they have no devaluation risk on their investments. This was claimed to be the case by Dr. Ashfaque Hassan Khan on TV, and something that is simply not true. FPIs explicitly take an exchange risk of devaluation when they investing PKR denominated TBs. The foreign portfolio investor has to convert his/her £, $ or ¥s through SBP’s special currency rupee account (SCRA) to PKRs before buying TBs. If PKR devalues by 10% overnight, much of the foreign investors returns will be wiped out. Let’s be very clear – FPIs are betting on no significant devaluation in the near term by investing in TBs.

Given that many of the commentators just a few months back were creating a fear of $:PKR parity collapsing to 180-200, he claimed, such confidence in the stability of Rupees by foreign investors should be welcome news. Foreigners are voting with their money that PKR devaluation will be limited.

He went on to address the fear that FPI inflow is pro-cyclical, that is, it comes when all is going well and will rapidly will exit on the first sign of bad news. A philosophical question worth asking – is there any capital anywhere in the world that’s not pro-cyclical? Also, would local savers be any less willing to dispose their PKR in preference of converting to USD if things were to go as they say ‘tits up’? In reality domestic savers are as likely as FPIs to repatriate their money or convert to hard currency if fundamentals turn bad.

Furthermore, there is the argument our economy’s local savers are suckers and easier to exploit than FPIs? Hassan says that’s a truly a rum way to run a railroad! The truth is that is all investors and capital have similar characteristics, the most basic one being the insatiable desire to maximize returns for a given level of risk. In other words, local and foreign investors are likely to be equally pro-cyclical. The only difference is that we treat domestic savers as prisoners and try limit their freedom to maximize returns. Maybe, rather than limiting foreigners from investing here, policymakers should allow local savers to invest wherever they can maximize their returns. Effectively work towards eliminating all capital controls rather than increasing them.

According to Hassan, the most important risk that is posed of so-called hot money is that it’ll cause PKR devaluation when it all exits at once due to policy changes or external shocks. That’s a risk that most central banks can mitigate quite easily if the threats of such a risk are high. The basic thing to appreciate, and it takes some effort to get one’s head round it, is that that the investment by FPIs in TBs should have zero impact on PKR value if SBP manages it effectively.

So, the issue of pro cyclicality and currency volatility is overhyped and not based on much historic evidence. The currency crises in East Asian economies in 1998 was not caused by short term investments in TBs but rather long-term borrowings that’s was deployed ineffectively.

Say FPIs tomorrow decide to invest $10bn. Conversion of such a large sum of $s into PKRs would cause it to appreciate if SBP doesn’t intervene. In order to keep PKR:$ parity of 155, and assuming a near zero BoP, SBP would have to buy dollars at a roughly similar rate as the rate inflow of FPI investment in TBS,. Effectively SBP reserves will go up by a similar amount as the $10bn investments in TBs.  We are not discussing the impact on interest rates presently of such a large inflow of dollars. That we’ll do later. Let’s just stay focused on the risk posed by inflows of dollars for the moment. In very simple terms if SBP builds up a buffer of reserves when we are getting inflows, this very buffer can be used to supply dollars if and when foreigners choose to exit TBs.

The unspoken fear is that with FX reserves increasing on the back of short-term TB investments, mad policy makers (as we have had in the recent past) decide to go on a wild international shopping spree and deplete the reserves to a level significantly lower than that of short tenure TB inflows. To mitigate that we hope the current SBP Governor is not completely illiterate in basic concepts and technology of asset-liability management (ALM). It is not rocket science and almost every central banker knows it critical importance. Hopefully the SBP Governor also makes aware the government of ALM risks and precludes any policy measures that relies on short term FX reserves for project that have long gestation periods.

So, the issue of pro cyclicality and currency volatility is overhyped and not based on much historic evidence. The currency crises in East Asian economies in 1998 was not caused by short term investments in TBs but rather long-term borrowings that’s was deployed ineffectively. Quoting another economist, “On capital flows, lets agree that if markets allocate FPIs to productive activities then these are good. We’ll have required repayment capacity when time comes. Debate then shifts to whether markets are allocating FPIs to productive activities or not?”

Read more: Foreign Investment in Pakistan hurt it’s Private Sector

Finally, he answered what the impact on interest rates of FPIS investing in TBs will be. Is SBP keeping rates high just to induce FPIs into buying TBs, asked Hassan. “Such a suggestion would be considered laughably ludicrous were it not for the fact that supposedly senior and serious ‘economists’ spout such claptrap on media”

He explained that we’ve already established that the TB rates are driven by the expectations of forward inflation, and a policy decision to maintain real rates to control inflation and improve savings. It’s completely independent of FPIs preferences whether to invest in Pakistani TBs or not. However, the inflow does have an impact on interest rates. Quite simply put, it adds liquidity in the short tenure debt market. Effectively as demand for TBs goes up, their prices go up, and therefore the effective TB cut off rate comes down. The increased marginal demand helps reduce interest rates.

Without the presence of additional FPI demand, local banks and money market funds would demand higher rates since they would be the dominant controlling players in the market. A simple fact about markets is that the greater the numbers of players and less dominant any one group if buyer, the better price a seller gets.

While the debt market may seem to the lay person quite complex, it’s not much different to any other market. A seller always benefits by having a greater number of independent buyers aggressively competing for whatever the s seller. And the more buyers there are out there, including foreign ones, the better deal, in other words the lower rates it would be able to command than if they were no FFs present. If the amount of FPI TBs investments were to dramatically increase, say to $10bn, it would per force a moderating impact on interest rates, that is, help lower rates. In fact, rather than commentators and businessmen on the TV demanding that SBP force its policy rates down, they should be asking why is not enough investments coming into the debt market to force interest down.

Concluding, he suggested the best way for rates to come down would be through the pressure of market forces rather than some misplaced desire by the sovereign to grant yet another hand out of irrationally low interest rates to rent seekers at the cost of the rest of the citizens.

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