Can Pakistan attract debt market flows?

Foreign flows to Pakistan’s government debt market – Treasury Bills to be specific – have resumed after a hiatus of about two years. The size of the inflows is still very small relative to other peer economies, as has been the case in the past, so it’s too early to cheer. But the million-dollar question is whether the size of these inflows will grow in line with market expectations which in turn are based on their perception of how SBP governor Reza Baqir might want to manage his end of the economy.

When Baqir took charge, followed by the decision to follow market-based exchange rate, financial market players started expecting that Baqir would use his prior experience to help attract much bigger dollars inflows into Pakistan’s sovereign debt market.

With the cost of borrowing (US-Libor) in international market currently at around 2.5 percent, and Pakistan’s credit default swap (CDS) at around 5.5 percent, against local 12-month T-Bill offering a return north of 13 percent, there is a clear spread of about 5.5 percent to be made. This should attract flows from foreign debt market players, as have the likes of Kazakhstan, Nigeria, Egypt, and Ukraine. (Note: Foreign portfolio investors mostly buy T-Bills rather than PIBs in Pakistan; the former constitutes 90% of their total gross inflows over the last ten years)

Recognising this potential, a few bank treasuries teams in Pakistan started pitching Pakistani papers to international clients earlier this fiscal year. After gaining confidence over the new policy of market-based exchange rate, some international players became interested and made a few deals to test the plumbing works before they open the taps. The SCRA debt inflows in July and August 2019 - first since May 2017 - reflect that pipe testing.

But then exchange rate recovery happened. From 164 in mid-June 2019 and 160 at end-July 2019, the PKR has recovered to about 156 against the USD. This has forced foreign clients to reconsider their plans, since it puts devaluation risk back on the table. Sources in bank treasury attribute rupee’s recovery to three main factors: (a) exporters are finally bringing back their dollars held outside; (b) inflows from the IMF and also from other multilaterals after IMF’s confidence; and (c) SBP’s intervention in the FX market by providing dollars at forward counter.

It is the latter most reason that has put banks’ foreign clients on a hold because now they are beginning to worry about further devaluation risks, which can erode their potential gains. The three main reasons why foreign buys are generally shy of Pakistan’s sovereign paper are: (a) political and economic risks, (b) the mismanagement of bond auctions vis-à-vis interest rate direction, and (c) devaluation risks.

The first of these can be covered by instruments like the CDS, which comes at a cost but that’s the price they have to pay to cover the risks; besides the returns are currently lucrative even after adjusting for the cost of CDS. The second leads to scrapped auctions as it happened between Oct-2017 and May-2019. The third i.e. devaluation risks can be covered but at a cost, which then erodes the potential net return to 2-3 percent; and therefore, leaving little incentive for foreign buyers to go through all that hassle and invest in Pakistan.

Now with interest rate cycle at or near its peak amid market chatter that the PM and his political team in Islamabad wants the SBP to take it easy on the interest rate, and keep rupee depreciation in check, the window to attract foreign buyers courtesy the splendid returns on Pakistan’s sovereign papers is thinning. Perhaps foreign debt market investors could be lured to Pakistan through a structured deal struck directly with the finance ministry – a deal which can lower devaluation risks. But even if bureaucrats at the finance ministry know how to strike such a deal, sources in Q-block say, they are likely to opt out for fear of the NAB.

And these are the reasons why foreign portfolio inflows in Pakistan’s sovereign debt market is unlikely to pick up significantly, despite the fact that those papers are offering fantastic returns – unless of course, Baqir decides to address the market’s concerns.