Why interest rates should decline in Pakistan?

With June monetary policy announcement due in few days, markets in Pakistan are still confused about the SBP expected stance on policy rate. Much of the prevailing ambiguity is due to low inflation but no clarity on foreign inflows coupled with high budgetary borrowings target set by the new government in FY14. We still believe it is not the question of whether the interest rate will come down but when and by how much the rate will come down.

Current year average inflation now estimated at 7.5% which is much lower than government's target of 9.5% and SBP's initial target of 9.1% (SBP 1Q review). Further, with Topline forecast of 8-9% inflation in FY14, the central bank is providing an arbitrage like investment opportunity to those who believe that foreign funding through IMF, KSA or US will materialize soon. Contingent upon these factors, we expect discount rate to decline by 50-100bps by Dec 2014. Whether central bank will adopt wait and see strategy in June 21, 2013 meeting and provide more time to investors to make short term gains at the cost of government will be a subjective judgment of the SBP board.

Record high real interest rate

Pakistan monthly CPI has dipped to 5.1% YoY in May 2013 which is a 9-year low. In last 3 months, average inflation is 5.8% while cumulative CPI has eased to 7.5% in 11MFY13.

On monthly basis, real interest rate has spiked to 4.4%, which has occurred after a gap of 3.5 years. Very few countries in the world would be providing such a high real interest rate. Though in FY14, we will see slight increase in inflation due to recent taxation measures in federal budget, expected hike in energy prices and excessive government borrowings but it may not be a restraining factor in monetary easing as we expect CPI to range between 8-9% against government target of 8%.

 

All eyes on materialization of foreign inflow

As pressures on current account have been eased off due to CSF (Coalition Support Fund) payment, we expect CA deficit to remain at US$2.2bn (1% of GDP) against FY12 deficit of US$4.7bn (2% of GDP). However, financing of the deficit coupled with foreign debt repayments has been the issue in FY13. Resultantly, foreign currency reserve declined to US$11.4bn as of June 7, 2013 from US$15.3bn in June 2012. However, Pak rupee has remained stable during the period and depreciated by 4.2% in FY13TD (1.5% in 2013TD) vs. 10% depreciation in FY12 and 6.2% average annual decline in last 20 years.

In FY14, we think, support to balance of payments and declining forex reserves could emerge from CSF money, Saudi facility or IMF. Though government is also expecting inflow from Etisalat US$800bn and privatization but we feel this may not happen in FY14.

Bankers/investors buying long duration papers

With an arbitrage like opportunity being provided by the SBP, bankers/investors have participated heavily in longer maturity in last T-bill auction. This coupled with declining secondary market yields are highlighting the expectation of reduced interest rates by the market participants.

Since last MPS 1-year T-bill yield in secondary market has declined by 25bps to 9.2% while cut-off yields of 1-year T-bill in last T-bill auction has also declined to 9.28% with about 84% participation in 1-year. However, yields in secondary market have spiked up marginally by 5bps after the announcement of inflationary budget with no concrete sings of foreign inflows yet.

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Source: Topline Securities