It was in September 1992 that George Soros became a household name. Or at least famous amongst those who read the financial press. In that month, he successfully predicted that the value of the British pound would go down and bet heavily against it, making more than $1 billion for himself and his investors over a span of just four weeks.
One of these days, somebody will do the same thing to the Pakistani rupee and they will deserve every penny of profit they make off the folly of the government of Pakistan’s macroeconomic policies.
Dear reader, it is happening again. The government of Pakistan is undertaking a series of economic actions meant to hold the value of the rupee at a stable rate against the US dollar, a policy that sounds like it is the right thing to do, but has invariably been the cause of every single economic crisis in Pakistani history except two (those would be the two that followed the 1965 and 1971 wars).
At this point, we at Profit have spent so much time trying to persuade the government of Pakistan to leave the exchange rate alone – to absolutely no avail, we might add – that we have decided to simply give up.
The point of this article is not to tell the government what it should be doing in terms of macroeconomic policy. No, the point of this story is to tell you, the reader, what you should do in anticipation of the inevitable economic crash that will come once the government is unable to prop up the value of the rupee any longer.
This story will first lay out our case for why we think the government is artificially intervening in the currency markets, why it is unsustainable and hence the wrong economic policy, why a crash is inevitable, some estimates of when we think the crash will happen, and what you can do to protect your assets when that eventually happens.
Why currency interventions are a bad idea
The single biggest problem with the government of Pakistan’s interventions in the currency markets is the fact that it does not actually have the money to do so, and so therefore relies on borrowed money to prop up the price of the rupee.
Debt, in itself, is not a bad thing. Used appropriately, it can be quite useful. But there are some rules to using debt wisely, and, more specifically, there are basically three circumstances in which taking on debt makes sense.
- It allows you to invest in assets that will increase your income by more than the principal and interest you will repay on the debt.
- It allows you to purchase an item that will reduce your expenses by more than the principal and interest you will repay on the debt.
- It allows you to buy an asset that will increase in value by greater than the amount you will pay back in interest on the debt.
Under any other circumstances, if you borrow money, you are deliberately making yourself poorer. As you can imagine, unfortunately, that is exactly what the government of Pakistan has been doing for the last several decades.
The government of Pakistan borrows money in US dollars – both from global bond investors as well as the International Monetary Fund (IMF) and other multilateral lenders – as a means of stabilizing the rupee so that the cost of imported goods does not increase. In the government’s view, since imported goods form the inputs to so many essential goods, a rise in the price of the dollar – and therefore those imports – will result in inflation. And since inflation has a tendency to hurt the poorest sections of the population the most, resisting that pain is seen as worth government effort and resources.
The problem with this strategy is that it is focused on using borrowed money to finance today’s consumption. In effect, the government wants people to have cheaper tea and bread and so it will borrow money from foreign investors in order to – through a series of complicated financial maneuvers – make the tea and the bread cheaper by paying for part of it.
By making imported goods cheaper than they should be, the government creates an unsustainable situation for itself. It wants people to have cheap goods, but if the imported goods are cheap, people will buy more of them. If they buy more of them, the value of imported goods will go up, meaning more rupees need to be sold and dollars bought in order to pay for those imported goods. That, in turn, means the value of the dollar will rise relative to that of the rupee, the very thing the government was trying to avoid in the first place, and so the government will need to borrow yet more money to push the price of the dollar back down, which then restarts the same cycle all over again.
Needless to say, this is far from a healthy situation, and one that the government of Pakistan has been caught in since at least the early 1980s.
It is this foreign borrowing, by the way, which results in the government having to repeatedly turn to the IMF for bailouts. At some point, global bond investors see that Islamabad has borrowed money only to finance consumption and has done nothing to increase the country’s aggregate earning power, and so they refuse to lend more money and demand that we pay the old loans back, which is when we go to the IMF to borrow from them to pay back the global lenders.
The ‘smart’ way to borrow
We must give the Imran Khan Administration some credit. They are somewhat more sophisticated than their predecessors in the Nawaz Administration in that they are trying to increase the flow of dollars into the country through new methods. Among the most successful programs the government has launched is the Roshan Digital Accounts, which allows expatriate Pakistanis to open bank accounts in Pakistani banks and deposit foreign currency at very favourable interest rates.
The problem with these new methods is that they share the same fundamental characteristics as the older, cruder methods of the past.
Deposits for a bank are a liability, and as such the same thing as if one had borrowed money. The government is paying the interest rates on those dollar deposits, which means that it is the government that has borrowed money in US dollars. You can call it a deposit. You can call it foreign investment. You can call it remittances. At the end of the day, it is a loan.
And like loans in the past, it is going mostly to finance consumption expenses, not investment.
To be fair to the government, the year 2020 was an extraordinary one, where the government needed to undertake a Keynesian stimulus so that it could mitigate the economic effects of the shutdowns that resulted from the coronavirus pandemic.
That meant that the government ended up being suspended out of its IMF bailout program, which it had entered in 2019. Only now is the government slowly making efforts to get back into the IMF program, by making both regulatory as well as fiscal changes that are likely to win the approval of the Washington-based lender and demonstrate that Islamabad is serious about curbing its fiscal profligacy.
But we have been here before. At the end of the day, the bureaucrats in the finance ministry do not see the IMF as a temporary bailout that they need to get the country back on its feet, but instead as a permanent source of liquidity from which they can continue to borrow ever-increasing amounts with regularity in order to finance the budget deficit.
We want to make one thing clear: our predictions about the coming crash have nothing to do with the recent run up in the price of the rupee against the US dollar. That increase is based on market fundamentals: the current account deficit is decreasing, and for the right reasons, with the rise in exports and remittances outpacing imports and capital outflows.
Now, our hesitation is based on the fact that the government just raised money in the global bond market again, a move that is eerily reminiscent of the worst tendencies of former Finance Minister Ishaq Dar’s policies.
When is the crash coming?
This is a somewhat harder thing to predict, though if the past three decades are any guide, the answer is some time in the third and fourth quarter of 2023. Yes, we recognize that we are making a remarkably precise prediction for something that is inherently difficult to predict. But we have our reasons.
In essence, we believe the next crash will coincide with the next election. Why? Because two of the last three elections coincided with economic crashes because they were run by governments that were operating in roughly the same manner as this current administration.
Here is what typically happens. The government that comes into office decides shortly thereafter to go to the IMF and seek a bailout during the period of maximum political goodwill following their election / coup. They implement the tax increases and spending cuts that slow down economic growth early, but then also set the repayment period to be just after the next election so that they can go through a full term without having to think about another bailout.
Towards the end of their term, however, every government ends up engaging in highly populist behaviour, which generally means cutting electricity and fuel prices in order to make themselves popular with the voters. This has the dual effect of cutting tax revenue and increasing government expenditures, which drives up the government deficit right before the loans are about to come due.
The inevitable happens: they lose their election. No government in Pakistan has ever served a second consecutive term at the federal level. The new government comes in, stuck with the bill the last one left them in their futile attempt to win the election. Incidentally, this whole “spend money so that people will like me” move is shared both by civilian as well as military leaders. The people matter in Pakistan, even to dictators.
But nonetheless, that is why economic crises in Pakistan coincide with elections. They are the direct result of poor political choices made by leaders – both elected and unelected. Since the next election is going to take place is October 2023, we believe the next economic crisis will take place around that time. If we had to pin it down, we would say the rupee will start crashing in late July/early August of 2023, right around the time the caretaker government is taking over in preparation for the election.
Caretaker governments in Pakistan are a bit like letting one’s muscles relax: it can get messy when you do it, but it is necessary, and you will feel better after you do.
What you can do to protect yourself
[Disclaimer: We should caution that this coming section is not to be taken as investment advice and is not tailored to any individual’s circumstances. The purpose of this section is merely to illustrate the kinds of effects economic cycles can have on investments, and how professional money managers think about such effects.
In general, timing the market is a risky proposition, and people are better off systematically saving a little bit every month and deploying that money into assets that are appropriate for their risk and liquidity needs. Consult a licensed financial advisor before making any major decisions.]
If you could predict exactly when the rupee would start to crash, the best thing you could do would be to borrow a large sum of money in Pakistani rupees, convert that cash immediately to US dollars, and then wait for the crash. Once the rupee crashed, you would then convert your US dollars back into rupees at the higher exchange rate, which would mean that you could convert fewer of those dollars back into rupees to pay back the same rupee amount. The dollars remaining in your account would be your profit.
In order for this to work, you would need to time this nearly perfectly, and have lots of real estate at your disposal.
Even when interest rates are low in Pakistan, as they are now, they tend to be quite substantial. That means that you cannot borrow for too long, since the interest on the loan would start cutting into your profits. For example, even when the State Bank’s benchmark interest rate is at 7%, you would be lucky if you were able to borrow at a 9-10% interest rate as an ordinary individual, even with collateral. If you had to hold that loan for two years, even a 20% devaluation in the rupee would not be profitable for you. To be safe, you would need to time the loan to within three months of the crash, because the crash itself is not overnight, and often takes six months or more to play out in full.
And you would need spare real estate, because banks in Pakistan would not just be willing to lend you the money unless you could pledge a substantial amount of collateral against the loan. Since this is a risky transaction, you obviously should not do this with your own home, meaning you would need to have real estate to spare in order to pull off this transaction.
Needless to say, this is a very, very risky proposition that is suitable for almost nobody. It would be a terrible way to hedge your risk and there are simply too many ways for this to go wrong.
What else could you do in order to protect yourself from a crash of the rupee? Simply buying dollars is one option, but that has its limits. The government of Pakistan restricts how much foreign currency an individual can buy, and depending on how much money you have, that may not be enough. In any case, buying large quantities of foreign currency is quite a cumbersome process.
(This is by design: the government wants to make it inconvenient for you to sell rupees and buy dollars so that you do not do it unless you absolutely need to.)
So, what else would work? Well, think about what is happening when the value of the rupee crashes. Specifically, there are two trends to think of. Firstly, the cost of goods and services priced in rupees is declining relative to the cost of goods and services priced in US dollars. And secondly, there is going to be a spike in inflation, and therefore interest rates.
Now let us think about what kinds of businesses would benefit from both of these trends. The first trend would benefit several different companies, but one much more directly than others: exporters. Any publicly listed exporter will see their profits rise because their revenues – priced in US dollars – will immediately rise, while the price of their costs – usually priced in rupees – will be slower to rise, resulting in a jump in profitability.
For the second trend, the biggest beneficiaries would be the banks, which would see the interest rates they charge on their lending increase much faster than the interest rates they have to pay out on deposits. (This trend is more apparent in the larger banks than the smaller ones, which tend to have higher cost deposits that need to be repriced faster, this leaving less room for higher profits.)
The problem with buying stock in both of these sectors, however, is that they both will first see a sharp hit to their profits when the rupee crashes before they will see any increase in profits. In the case of exporters, the rise in interest rates can sometimes result in a significant increase in their cost of borrowing. And banks are effectively the same as large government bond portfolios, which would first see a hit from the decline in the value of those low-interest bonds as interest rates rise, before seeing any benefit from the rise in interest rates.
So, what can you do? Should you buy these stocks while the market is crashing and hope that they will recover by the time you need to sell? That’s one possibility.
A safer possibility is to place one’s funds in a money market mutual fund, which may have lower returns, but returns that are nonetheless higher than savings accounts, and have the benefit of being invested in short-term fixed income instruments, meaning they fluctuate far less with interest rates than the longer-tenor bonds that form the bulk of the portfolios at fixed income funds.
Park your money in those money market funds, wait for the market to crash, and then – when everyone is screaming in pain – start buying stocks in the two sectors laid out above, or buy an equity mutual fund with substantial exposure to those sectors of the economy.
What about the two methods of investing Pakistanis love above all others: gold and real estate? Gold can be quite volatile during an economic downturn, and hence, while it might end up being profitable, is a high-risk proposition in times of turmoil. Yes, that is despite its reputation as a safe-haven asset. As for real estate, yes, prices do tend to tumble during a downturn, but people in Pakistan also tend to hoard real estate. Sure, prices will be down, but try actually buying anything. People will not be selling if they do not like the price.
In short, there are a few ways to protect yourself from the government’s folly, and even make some money along the way. Just because the government does not plan its money decisions wisely does not mean you should not either.
The writer is the founder and CEO of Elphinstone, a US-based registered investment advisor regulated by the United States Securities and Exchange Commission. Elphinstone’s Pakistan subsidiary is currently seeking – but has not yet been granted – a Securities Advisory license by the Securities and Exchange Commission of Pakistan.
