Dollar desperation

That the US dollar is increasingly becoming a scarce commodity in Pakistan is known to all and sundry by now. The question is when do market players expect the situation to stabilise.

Before we attempt to answer that, here is a bit of geeky finance stuff that few beyond the clique of forex traders and treasurers understand. When banks and NBFIs have excess dollar liquidity for whichever period (overnight, a week, 3-months or whatever), they naturally want to earn an interest on it. After all, in the field of finance idle money is a sin.

For this they have two options: (a) park that liquidity out of the country to earn an interest on that liquidity (benchmark Libor); or (b) swap it with PKR at home so they can earn a usually higher interest at home (benchmark Kibor). The latter is preferred because of usually higher interest rates in domestic market. For, example 1-week Libor is currently around 2.21 percent whereas 1-week Kibor is currently around 8.33 percent.

However, converting that dollar to PKR and back comes at a cost. For instance, a bank that has excess dollar liquidity may agree to sell the dollar at hypothetically say 133.02 and buy it back on overnight or 1-week basis at 133.04. This difference (0.02) is called the swap points and represents the cost of converting that dollar to PKR and back.

Based on whether the USD is over-or-under-supplied in the local market, the cost of this conversion moves up or down. But last week, on October 16th to be precise the desperation for dollar rose so much that 1-week rate for dollar stood at 133.79 as against the ready rate of 133.86. In other words, those who held dollar liquidity were being paid, instead of being charged, to convert their dollar holding into PKR so they could earn higher interest rates in the money market.

To put this in an illustration, the wider the difference in the implied rate (red line) and Kibor, the higher is the stress on the dollar. Throughout 2016 until October 2017, the exchange rate was kept flat under ‘Daronomics’, but the sporadic increases in the difference in the implied rate and Kibor was a dead giveaway that dollar is increasingly under pressure (see encircled part of the graph). The market in fact had priced that in a year before as in evidence by the downward sloping implied yield curve in December 2015 (black dotted line).

Using these concepts, we now turn to our original question: when do market players expect the situation to stabilise. In June 2013, the country faced a similar situation, and the then ruling party was trying to negotiate a deal with the IMF. Dollar was in short supply in the shorter tenure, but market expectations were better for the longer tenure. Which is why the yield curve (black solid line) begins from negative rate in 1-week tenure but fairly upward sloping over longer tenure.

This time around the yield curve follows a similar trend. However, even though the government has made a decision to go to the IMF, the curve is not as high as it was in June 2013. The 1-3 months exchange rate outlook is still weak; well at least weaker than the outlook in June 2013. This is attributed to the fact that this time the hole in Pakistan’s dollar kitty is bigger than the last time we went to the IMF. Second, IMF’s conditionalities may be more stringent, even more so if US President Donald Trump throws spanner in the works. And lastly, the government is inexperienced as is evident from the absence of clear-cut policy direction and clearer communication thereof. In other words, don’t expect the market to stabilise over the next 1-3 months just yet.