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The hot money has been flowing in and out from equity market for long. The portfolio investment in debt market is new and commentators are finding it hard to come to terms with it. Some of the reservations are warranted while others are just hyped. Informal talks with Pakistan authorities, foreign fund managers, foreign banks operating in Pakistan and independent economists have revealed a rather cautiously optimistic picture.

The flows started coming from July-19 and accelerated in Nov-19. “Earlier the amounts were coming in 3-month paper and increasingly the flows are in longer term T-Bills”, pointed out by Governor SBP last week in a talk organized by Pakistan American Business Forum. The natural progression is to have investment in PIBs. However, the capital gain tax (CGT) at 29 percent is a stumbling block, according to foreign fund managers and banks managing for them in Pakistan.

There are two types of taxes on debt instruments – With Holding Tax (WHT) at 10 percent and Capital Gain Tax (CGT) at 29 percent. WHT is applicable in other markets as well and it’s a non-issue. CGT has two issues – higher rates and it’s not full and final. The funds want to come out dry and clean. They do not want to file any return or to hire tax lawyers. A proposal is approved by ECC to have CGT of 10 percent as full and final. Till the time it is passed by parliament or promulgated by an ordinance, the investment in PIBs may remain at bay.

Foreign fund managers are sold on the reform story of Pakistan. They are in the phase of testing the market. “In first wave we are dipping the toast, second wave would to be long. The key for Pakistan is to not go back to the old habits after the IMF (programme)”, told a Middle East based fund manager investing in Pakistan on the condition of anonymity.

A treasurer of a bank in Pakistan expects the flows to double (from $1.2bn) by June-2020, and foresee the flows to reach $3-5 billion by Dec 2021. Such numbers are manageable. SBP has said in a press release that portfolio investment of $1.2 billion is less than one fifth of the net increase in SBP reserves buffers. The market participants are of the view that if the flows are to remain a portion of increase in reserves, the threat of crisis on sudden exit is hyped.

Pakistan is different from Egypt where portion of debt portfolio investment were kept in a separate pool in reserves. The fund managers had the cushion of taking money out without jittering the domestic market. In Pakistan, the central bank is not doing this. The portfolio investors are fully taking foreign exchange risk. That is why flows are to remain relatively low in Pakistan.

Some say keeping part of foreign portfolio investment in a separate account at SBP will give comfort to fund managers and the flows may accelerate. Like it happened in Egypt. But in that case stability will become dependent on these flows. And interest rates might have to be kept high for longer time. That is not the case today.

The fund managers view on interest rate is that as long as threshold of real interest rates is maintained, the investment flows will continue. “If they do (reduce interest rates) it too quickly, investors have the world open for us”, said a fund manager. The counter argument given by a treasure is that the world debt market is size of $50 trillion and out of it $13 trillion investment has negative yield. The world is hungry for yield and Pakistan’s higher spread will keep on attracting flows.

Investors are looking for avenues and safety. “Pakistan had higher interest rates earlier than what we have today, but debt portfolio investment is happening for the first time”, added the treasurer. His view is that capital market is deepening and market is getting confidence on market determined exchange rate. This will bode well for investment in equity market as well and there are some flows coming in lately.

On the concern of hot money evaporating once the interest rates are lowered, a bank president said that these are blue chip funds and globally they move from one country to the other based on yield. “Based on my experience they keep a residual investment in long term bonds”, he added.

Another fund manager was of the view that absence of Non deliverable forward (NDF) offshore market is also hindering the funds to take position in PIBs. A treasurer responded that there exists a deliverable forward market onshore, but no fund is hedging it. The cost is 7-8 percent and the return on T-bills is around 13 percent. This is in line with Pakistan Euro bond yield of 4-5 percent.

The investors coming in portfolio investment are betting on local currency. The hedgers can buy Euro bond. Pakistan should also issue Euro/Sukuk bond to fill in for the appetite of less risky investors and to have potentially lower reliance on hot money.

This raises another question of investors coming in PIBs without hedging for foreign currency risk. The yield is at 11 percent and hedging cost is 7-8 percent. The Euro bond of 2-3 years is giving return of 4-5 percent. For investor to come in PIBs either PIB yields have to go up or forward cover needs to come down. The story of reforms perhaps has to be cemented for investors to take risk on PIBs without hedging.

A fund manager said that liquidity in PIBs is low as compared to T-Bills and this is one reason funds are shying from PIBs. However, domestic players think otherwise. They say that demand is higher than supply and there is ample liquidity in long term bonds.

“The idea is to have market determined active NDF market, similar to the likes of Egypt and Ukraine”, said a fund manager. His view is that in order to take the flows to $15-25 billion, an active offshore NDF market is required. The fund managers also have concern of international banks (like Citi, Standard Chartered etc) are charging up to 60 bps for facilitating investment in Pakistan for funds who do not have SCRA in Pakistan.

In more developed capital markets within emerging economies, bonds are available on Euroclear. On this route, funds do not have to pay the access fee. Pakistan is a nascent market. Both funds and domestic authorities are testing it. It’s better to tread cautiously. The flows should increase in proportion to SBP reserves position and economic growth.

“We are getting calls on daily basis from new investors”, said a treasurer. The funds are testing the market. According to sources, 10-15 funds have already invested in Pakistan and number can reach 30-40 pretty soon. The interest might come from over 100 funds in 2 years. By that time the market might be at stage to become part of Euroclear. If the economic reform story continues and reserves grow, in 2-3 years, the time would be to shift gears to look for $15-25 billion. At this point, it’s not advisable to hit the highway and to be happy with aiming at $3-5 billion by Dec 2021.