Money market and debt management

Money market has been behaving quite unusually. The standard theory suggests the yield curve on the bills and bonds (showing relationship between return and term of investment) should be upward sloping, as the investors would require higher returns on longer investments.

In normal circumstances, upward yield curve signals expansive outlook for economy and therefore the investors are confident that higher returns will accrue on longer maturities. Conversely, an inverted yield curve shows pessimism about the future and investor shy away from investing in long-term securities.

In the T-Bills auction held on 21-9-2022, the cut-off yields on all three maturities of 3m, 6m and 12m, were the same at 15.99%. Subsequently, in the auction held on 5-10-22, the yields dropped by nearly 25 bps across the three tenors except for a difference of 1bps among them. So we have almost a flat curve for shorter maturities.

Clearly, it seems there is no premium for holding longer duration bills. What is more striking is the yields on long dated securities. The 3y, 5y and 10y securities were priced at 13.65%, 13.00% and 12.85%. This is the situation which shows an inverted yields for longer maturities.

These trends, therefore, reflect investors’ assessment of impending recession. The finance literature uses the differences in yields across different maturities as a leading indicator for recession.

In particular, the negative difference between 10y bond and 3m T-Bill is considered as the predictor of recession. In our case, the difference is negative 2.88% — a level that would carry a very high probability of recession within the next four quarters. More interestingly, this inversion process started in the month of March as the difference between these two (10y and 3m) yields became negative.

But the difference at that time was negligible. This has entrenched itself gradually and presently it stands at a high of negative 2.88%. It would be recalled that this was the time when the Russia-Ukraine war had started and it was visible that global economy is facing a recessionary phase of business cycle.

Are there some other indications which may support the recession hypothesis for Pakistan economy? At the outset, we must recognize that we had started this year with an overheated economy which required cooling-off or a significant reduction in aggregate demand to achieve stability. Therefore, an inherent element of economic policy is to slow down the economy.

Furthermore, the country has suffered floods on an unprecedented scale. This has led to loss of lives, output (standing crops), productivity (water levels are not receding as expected), infrastructure (roads, schools and hospitals) and property (loss of livestock and housing units). There are many initial estimates of losses going as high as $40 billion. That is almost 10% in terms of GDP.

The combined effect of these developments is to reduce the potential growth. In its latest monetary policy statement, the monetary policy committee of SBP has noted that floods and reduced aggregate demand would indeed reduce growth to 2%. The World Bank and ADB have also lowered their forecast for similar reasons.

Technically speaking, though there are many definitions of recession, the common characteristic is two or three quarterly decline in GDP. We don’t compile quarterly GDP numbers and therefore cannot be sure what is happening to GDP on that basis. But in our case we should await for revised GDP estimates in April-May. Only a negative growth as in the case of COVID days in FY20 will establish presence of recession.

There is also another significant development which is related to rising outstanding amount of Open Market Operations (OMOs). On 10-10-2022, the OMO (injections) stood at a staggering amount of 5,269 billion. In fact in recent months the basic structure of auctioning has undergone a major shift. This was only Rs.1674 billion as on 4-1-2022. For greater part of its history, OMO operations were conducted only for few days, hardly exceeding 10 days. But of late OMOs for as much as high of 70s days have become a routine.

The high level of OMOs is reflective of large borrowing needs of the Government. The nominal federal government deficit had amounted to Rs 2,225 billion in FY18 and has sharply risen to Rs 5,611 billion in FY22, an increase of more than 250%. To sustain such massive borrowings the banking system with Deposits of Rs 22 trillion and Advances of Rs 11 trillion doesn’t have adequate liquidity to support high borrowing needs, particularly after the central bank has been prohibited to lend to the Government under recent amendments in the SBP Act. Inevitably, the SBP injects liquidity into the market for banks to lend to the government.

Not surprisingly, the debt risks indicators for FY22 have also shown some deterioration. The first indicator measures the currency risk in the public debt composition. The share of foreign debt in total public debt was recorded at 37% which is increased from 34% in FY21.

The medium term strategy (MTDS) envisages benchmark of a maximum limit of 40%. The risk of refinancing is measured by three indicators, of which the first indicator is average time to maturity (ATM) for domestic debt which is indicative of longer term of the debt. MTDS has set the benchmark of 3.5 years. In FY22 it was recorded at 3.6 year, just as in FY21, barely on target. Second indictor is ATM for external debt, which was benchmarked at 6.5 year. In FY22, it was recorded at 6.2 below the benchmark.

Third indicator is the gross financing needs (GFN) which measures the speed with which refinancing is needed. The longer the duration of ATMs, the lower GFN would be needed. GFN as a percentage of GDP has been set at a maximum of 35%. The actual in FY22 was 26%, which is quite satisfactory. Finally, the interest risk is judged by the share of fixed debt in overall debt. The indicative benchmark specified in MTDS is at a minimum of 25%. The actual outcome was 26%, which is a borderline performance.

The behaviour of debt indicators is likely would have worsened during the first quarter of FY23. For reasons explained above, the relative share of short-term financing has been very high and foreign funding has been limited. Since July, Rs.10 trillion has been raised in T-Bills compared with less than one trillion in the three auctions since July. The government has to improve the overall debt profile of the country. Better signaling for future policies would go a long way to achieve this objective.

Copyright Business Recorder, 2022