Hot money fallacies

Whether the money or not, the topic is hot. Everyone is becoming a seasoned expert on the subject. Apples are compared with oranges. The risks associated with the foreign portfolio investment in government debt are overhyped. Some clarifications are warranted. First, a fraction of change in reserves is contributed to the portfolio investment to-date. Second, hot money is probably not the reason for keeping interest rates high. Third, the risk of sudden outflow is to be shared by the investors e.g. if hypothetically, $500 million is to be taken out in a day, the currency would move down and the return of investors in USD would be diluted by the same amount. The tail risk is assumed by the portfolio investors.

Having said that, there is no doubt that balance of crisis risks is associated with sudden outflow of the portfolio investment. Examples of East Asia and South America are well-known. Pakistan invariably had frequent boom burst cycles without an iota of hot money in debt in the past. The currency moved from Rs60/USD to Rs155/USD in the past 12 years. The crises came without hot money. On the flip, not every economy exposed to these flows have had crisis. The key is to manage external flows – capital and current account.

The talk of the town is that 13 percent plus returns are given to the foreign investors and that is fueling government debt. The return government is paying is in PKR. Minus the foreign investors, domestic banks would have been earning this invariably. Government would have been accruing the cost anyways. Out of $110 billion TB/PIB market, portfolio investment is less than $2.5 billion. This is not even 5 percent of liquid PIB/TB market of $57 billion. It is bringing competition to lazy bankers in Pakistan. The liquidity in the market can be fetched by private sector.

Some analysts are computing foreign portfolio investment return in USD; it’s in PKR.  If someone still wishes to do so, compare it with Euro Bond. Last month a 5Y Eurobond matured. It was issued in USD at 7.25 percent and PKR based IRR is computed at 16 percent annually. Isn’t this an expensive option?

There is another comparison. Industrial & Commercial Bank of China (ICBC) has invested Rs366 billion ($2.4 bn) in T-Bills and PIBs. The banks operations are Pakistan based. The amount was offshore borrowing from Hong Kong at Libor +1-2%.  It is invested in TB/PIBs. Returns are similar to portfolio investment. ICBC took the exchange rate risk (same as portfolio investment), and profits are repatriated. Why no one ever talked about its hotness?

The story of other CPEC related power projects are (more) scary. Independent Power Plants (IPPs) are quasi debt. There is long term guaranteed returns (IRR based) of 17 percent plus. Return on Equity (ROE) is computed at 27 percent. The long term borrowing is to be paid on LIBOR plus (whopping) 4.5 percent. Why no one is tweeting on it?

On the myth that balance of payment improvement (or SBP reserves building) is owing to hot money, let the numbers talk. In Jul-Dec, SBP reserves are up $4.2 billion. The current account deficit saving, relative to last year, was $6.5 billion – this mean the funding through foreign investment, loans and all is reduced by the same amount. The net external debt (not hot money) is increased by $4.2 billion. Net FDI is $1.4 billion. The portfolio investment (hot money) was $1.5 billion in 1HFY20. Rest is simple arithmetic.

On the argument that interest rates are kept high to attract hot money is misplaced. First, short term rates are less important. Back in 2014, when discount rate was 10 percent, longer term PIBs were issued at 12-13 percent. The government paid higher amount to banks in the whole downward cycle of interest rates i.e. when policy rate was 6 percent, banks were having returns of 12 percent on PIB (today 10PIB is at 11%). Why no one was complaining back then?

The industry wants lower short term rates to lower firms’ financial charges. The implication is boost in domestic demand. The risk is erosion of low current account deficit gains. The benefit of lower CAD is much higher than portfolio flows. Yes, hot money could evaporate as well. The reserves would come down. There will be pressure on exchange rate to depreciate. This will bring more inflation. Interest rates will be taken high again. What’s the fun in this exercise?

The household are not leveraged in Pakistan and not directly impacted by higher rates (yes there are indirect effects). But everyone would suffer from another round of inflation. The policy option is to keep rates high till the inflation comes down. This is to increase foreign exchange supply – this can appreciate currency or SBP can pick the excess supply to build reserves.