The Big Short: inside the exchange rate volatility in Pakistan

Monday, July 18, was going to be a difficult day by any reckoning given the headlines of the night before. Imran Khan’s blitz through Punjab in preparation for by-elections had produced spectacular results on Sunday, with an unofficial count showing him carrying 15 of the 20 seats under contest, enough to allow him to form the government in Punjab.

These were no ordinary by-elections. Their outcome held the destiny of the federal government in Islamabad in balance. As the results rolled in, the clouds over the government of Shehbaz Sharif thickened and frenzied media commentary speculated on whether the central government can survive now that the country’s bellwether province had fallen to the opposition.

Meanwhile, a dollar shortage was intensifying in the country’s financial system. The curtain rose on the interbank market on Monday morning with these uncertainties at play, and the result was 48 hours of mayhem. What happened in the interbank on Monday and Tuesday of last week (July 18 and 19) was born of this uncertainty, coupled with a series of developments that had no link to the political scenario.

The interbank market is fed with dollar supplies from two main directions: remittances and exports. As these proceeds pour in, they are drained back out as the banks move to settle payments for import Letters of Credit (LCs) and private sector debt obligations. Government debt obligations are paid out of the reserves held by the State Bank of Pakistan (SBP) and do not impact the interbank market directly.

But the days after the Eid holidays see thin remittance inflows as a norm, and it had been barely five days since these holidays had ended. Moreover, exporters usually have 120 days to bring their export proceeds back, and even after that, they have another three days to “keep the funds onshore before surrendering them to the interbank market” as per a knowledgeable source. This gives importers some leeway to see which way the winds may be blowing before deciding to surrender their funds.

Market in windfall after LCs

What happened on Monday was that inflows slowed down – remittances because of the Eid holidays having just passed, and export proceeds because of exporters eyeing the political scene – while a number of large payments materialised suddenly and together in a stroke of bad luck.

“Under such conditions, the State Bank tells us to open a short position, pay on our account and pay for the position, then over the next five to 10 days we cover the position,” says another senior executive from a large bank. “For four or five months, the SBP has been asking us to run a short position to cover our payments, and we cover it from exports and remittances.”

The payments related to imports of oil cargoes that had landed in May and June but their LCs needed to be retired in July. “For the month of July, we have $1.7 billion worth of oil-related payments to make, minus LNG,” says a senior executive from the oil and gas sector who had the full picture from the sector’s payments before him. “These are hard figures, not estimates,” he added.

He could not say how much of this $1.7 billion has already been cleared and how much remains in the pipeline. On Tuesday night, in one of his many televised appearances during the week in which he sought to calm the markets down by telling them that underlying fundamentals do not justify panic, Finance Minister Miftah Ismail said $700 million worth of oil imports have been seen in July. But he was sharing data from the Pakistan Bureau of Statistics, which measures the value of cargoes landing at the port, not State Bank data, which measures the payments made for imports via the banking system.

Things get intense in the interbank: The SBP steps in

The interbank market reacted to the combined impact of a constriction in inflows and the sudden materialisation of a set of lumped payments in the opening days of the week. On Monday, the gyrations began early as trading opened, but according to one source from the banking system with visibility of hourly trades in the interbank market, the SBP finally intervened to dampen down the volatility, but not until 1 pm. The rupee plummeted against the dollar by PKR 5 on that day, triggering alarm bells.

“They entered through select banks to pour liquidity into the market as the demand for dollars was spiking while bids from other banks were in short supply,” the banking source tells Profit. This intervention helped stave off a rout, but only temporarily.

The next day – Tuesday, July 19 – the opening rate for the dollar plummeted to PKR 221 as the market opened, and had dropped to PKR 225 by market close, according to data from the Pakistan forex association. Taken together, the rupee had plunged PKR 15 in two days and fears intensified in the country of an impending rout.

“Last week, there was heavy payment pressure,” says a high-level source in the banking system with wide visibility on the interbank market. “Normal payment pressure is known a few days in advance and can be managed, but this was not normal.” In addition to payment pressure, exporter inflows were also hanging back. 

What was happening, in reality, was a few large banks were scouring the market to retire the large oil-related LCs that were due in those days. Banks use dollar liquidity from two sources when meeting payment obligations on behalf of their clients. The first route is to use what they call Nostro liquidity – funds they have in their possession from the inflows into their accounts from remittances or exports, or in some cases funds they can access from their counterparty banks abroad. The second is to borrow from each other. 

When banks borrow they can either do it in the ready market or borrow via swap instruments where they furnish Pakistani rupees in exchange for dollars at a pre-agreed exchange rate. This is done with an agreement that they will reverse this position down the road, either one week, one month, two months, three months or more.

On Monday and Tuesday, the banks turned to these swap instruments heavily to arrange the liquidity required for the large payment obligations that fell due so close to each other. When they did so, the premium that is usually charged in these swap transactions began to fall. Under normal conditions, this premium should roughly track the Karachi Interbank Offered Rate (KIBOR) within a difference of about 100 to 200 basis points, since dollars are being borrowed against rupees, and the KIBOR tells you what the banks can earn on those rupees if they were to be lent out directly.

But when large numbers of banks enter the swap market to fund their Nostro account by seeking dollars from each other, the premium drops as they outbid each other for the small supply of dollars, agreeing to enjoy a smaller premium for themselves from this transaction simply to meet their payment obligation. And that is what happened in the market from Monday onwards.

Forward premiums for these swaps were under pressure for many days already. With the KIBOR at or above 15%, the forward premium on the dollar (for one-week trades) was already showing pressure, oscillating between 6 and 11% in the opening days of July. But on Monday (July 18) it dropped to below 5% and then plunged below 1% for the remaining days of the week.

This is not the worst we have ever seen. In the middle of June, these premiums had dropped steeply into negative territory as many banks had depleted their Nostro accounts and were forced to rely on liquidity from the swap market to meet their payment obligations. In doing so, they showed a willingness to complete their payment obligations at a loss rather than default.

This time, the premiums remained positive, but the enormous gap between the swap market and KIBOR shows the interbank market was under severe stress to meet its payments. The SBP is being careful about intervening in this situation, partly because the impending resurrection of the IMF programme prohibits it from doing so, and partly also due to its own liquidity shortage, forcing it to husband its reserves.

“Disorderly conditions merit intervention,” says a SBP source who did not wish to be named given the sensitivities.  “If the market starts to freeze, we intervene, for example, if bids are either not attracting offers or offers that are so wide that even a small trade causes an exchange rate movement.”

Last week’s growing pressures on the interbank market seem to have tested this standard to determine when an intervention is merited. The direct intervention did not come, but the SBP did use its power of “moral suasion” to encourage some banks to offload liquidity into the market to mitigate the volatility. To some extent it worked. From Wednesday onwards the interbank rate continued to slide, but the extreme volatility had disappeared. Losing a rupee or two every day, the rupee ended the week at just below PKR 230 to the dollar.

Along the way, however, a few oil-related import LCs were closed at PKR 241 or above. News ran about this throughout the week, with some journalists tweeting that four oil companies – two refineries and two oil marketing companies (OMCs) – were charged PKR 241 to close an LC that they had opened in May and June. Profit has been able to confirm three oil companies (two refineries and one OMC) with no confirmation on the fourth. In addition, some private debt payments from the power producers also had to be settled on the same days, with ticket sizes said to be between $30-40 million. One of the oil LCs was $70 million, and the size of the other is estimated by oil sector executives at around $60 million. No estimate could be obtained for the amount of the third oil LC. Those with visibility on these transactions are extremely reluctant to discuss them, even off the record.

In the meantime, calls rose that some banks are engaged in “speculation”. It is next to impossible to determine where normal trading behavior under conditions of extreme stress crosses the boundary to become “speculation” though.

“What you’re seeing is a slow collapse over the past few weeks,” says another senior source in the banking system. “It is culminating in the market becoming almost dysfunctional.” When asked about details on the lumped payments falling due in the early days of the week, he replies calmly: “Lumpy payments are made every other day, what’s so unusual about that? What can you say about a market that is jolted by a $70 million payment?”

His point is simple: As banks scramble to arrange the dollars needed to settle basic trade-related payments for imports that have already arrived, they will inevitably land up in the swap market to borrow in order to stave off a default on their LCs. 

As the scramble intensifies, the banks will reduce their expectations of a premium from these transactions, and instead demand a premium from the customer to be able to close the LC. This is why forward premiums are falling, while clients with large ticket sizes were asked to pay PKR 238 and above to close their LCs, even though the interbank was operating at PKR 225 on that particular day.

As part of the effort to stave off a default, a wide slew of payments has been thrown into a lengthy process of “administrative approvals” by the SBP. “Contract payments are not being processed, royalty payments, dividends, service payments,” says a second senior source in the banking system. “A huge backlog of these payments is building up,” he adds, estimating the size of this backlog to be “in excess of $2 billion”.

Go ‘short’ or go home

Today Pakistani banks’ dependence on ‘short’ trades to meet their foreign exchange (FX) needs has hit an all-time high.

One senior source who deals in FX trades says the dependence on shorts is the highest in a very long time, thus further pushing up the dollar against the rupee.

These days, if a bank executes an LC payment for the import of fuel, it has been asked by the SBP to maintain a short-term Net Open Position (NOP) and cover it over the next five to seven days from inflows via remittances or exports. Banks lose out if the exchange rate goes against them. While banks generally do earn on FX transactions, they can afford to lose money temporarily through shorts.

Smaller banks, however, have limited FX inflows so they can afford only small net open positions. Sometimes they are unable to cover their FX outflows from their inflows. They try to cover up the difference by buying from the interbank, which has limited liquidity.”

Essentially, what this means is that banks are undertaking a balancing act in terms of inflows and outflows while maximizing their exposure to short trades. This leaves the system in a fragile position. 

Profit asked a source in the treasury departments at one of the biggest banks whether freezing withdrawals from foreign currency accounts could be a possibility. 

“Freezing is a remote possibility,” he replied, before hastening to add that, “almost anything is on the table at the moment, that is not the central forecast right now, but anything is possible.”

Yet another treasury executive also pointed to underlying vulnerabilities as the most important factor in the volatility. “Bottom line is very clear,” he said. “Pakistani bonds are showing clear signs of default risk being priced in, humongous current account deficit facing us right now, no credible financing lined up to meet these requirements.”

Banks unconvinced with the financing plan

The treasury executive was referring to the financing plan announced by the finance minister on Saturday. “Why do you think he took to the airwaves on that day to announce how he intends to fill the $4 billion financing gap facing the countries’ external accounts this fiscal year,” asked a third senior bank executive. “He was trying to assuage the pressures building up within the system”.

Bankers tell Profit they are not convinced with the financing plan announced by the minister, which is central to obtaining approval from the IMF board later in August. In that plan, the minister said he intends to fetch $1.2 billion via an oil facility, another $1.5 to $2 billion from stock investment in a government-to-government arrangement of some sort, LNG on a deferred payment basis, and so on.

The State Bank is aware of these concerns and moved later in the week to try and assuage them. In remarks emailed to Bloomberg and reproduced in their report on Friday, for example, Acting Governor Murtaza Syed said “concerns about Pakistan are being unfairly overblown. The recently secured staff-level agreement on the next IMF review is a very important anchor that puts a lot of daylight between Pakistan and more vulnerable countries.”

Then on Saturday he gave much the same language to Reuters. “Our external financing needs over the next 12 months are fully met, underpinned by our on-going IMF programme.” Later on Saturday, when approached directly by Profit with an even more pointed question, he said “The staff level agreement with the IMF would not have been reached had there been lingering questions about the credibility of the financing plan for the $4 billion gap.”

But on last Monday, the market seemed to be reacting as much to the credibility – or lack thereof – of this plan as to the results of the by-elections in Punjab that took place the day after the minister’s announcement. 

On Tuesday night, the finance minister again took to the airwaves, this time on anchor Shahzeb Khanzada’s show, to try and assuage the markets and underline his financing plan one more time. “There have been $2.6 billion imports so far this month in July,” he said, adding that, out of this, $700 million were oil imports.

He went on to say that the monthly current account deficit for July will be less than $1 billion, because of the reduced imports so far. His point was that there is no real reason for the market to be seeing this kind of stress in making payments.

Foreign banks are unconvinced too

Refineries and OMCs have been complaining about issues with LCs for much longer, although their troubles owe more to the demands of foreign banks than the SBP here. “As Pakistan’s credit rating has declined, foreign banks have become ever more careful of dealing with Pakistani banks,” says an oil sector executive. He was referring to the downgrade of Pakistan’s credit rating outlook by Moody’s in June. But on Tuesday Fitch followed suit and also downgraded Pakistan’s rating outlook to negative.

Another source at a refinery explains, “International banks do not trust our LCs anymore. They need us to bring in a guarantor. In the past, the rates the guarantors charged were between 0.25-0.5%. A month ago it was between 1-1.5%. They have now climbed up to 4-5%. This shows you how significantly worse foreign banks think our position is. This is only adding to the cost of our imports.”

Fuel imports adding to the frenzy

However, these days OMCs and refineries are feeling the pinch from the depreciating currency. “Many of them booked their cargoes when the rupee was below 210 to a dollar,” says the executive. “Now they have to close their position to make the payment and they were being quoted rates around PKR 225 to a dollar instead, the exchange rate risk is too large for them to absorb.”

Sales of petrol and diesel have fallen sharply in June and July. Demand for diesel dropped 20% in June, the same executive says, citing industry figures. “In July it has slumped by almost 50% so far!”

Petrol sales show similar declines, which he attributes to the larger slowdown in the economy as well as the price hikes that have caused people to consume the product more sparingly. “Motor gasoline sales were down 20% in June as well,” he says, “and July saw a drop of 30-35%.” 

May and June are months of high consumption because these are the months when the wheat harvest comes in. To prepare for this, oil companies order higher quantities of petrol and diesel. “Today we are sitting on the largest inventories of petrol and diesel ever,” the executive tells Profit, referring to industry-wide figures. “Petrol stocks are sufficient to cover 32 days of consumption while diesel stocks are enough for almost 60 days,” he says. 

Stocks imported in May and June have their payments due in the month of July, and the executive says a total of $1.7 billion has to be paid this month just for the import of oil products in the preceding two months. He could not say how much of the amount has already been paid considering we are now well past the midway mark in the month, but he emphasised that the coming months are likely to see a smaller oil import bill due to the high inventories the industry is sitting on, coupled with the falling demand. 

These payments are part of the reason the SBP has imposed an unofficial regime of rationing dollars to be able to cope with the shortages gripping the interbank market. 

Other sectors feeling the burn

As uncertainty swept the market, a chorus of voices from importers, other than fuel importers,  came forward to share stories of consignments stranded at the port while their banks awaited permission from the SBP to clear payment. Profit spoke to a number of businesses in this situation.

A palm oil trader told Profit he has been facing issues with LCs since the first week of May. “The SBP is only allowing $100,00 per day. We’re having issues with the opening of new LCs and the retirement of old ones. Our bank needs approval for every LC even though we have limit approvals.”

But since then, far from lifting or easing the bans, the SBP has increased the number of items that are subject to the “prior permission” requirement before their payment on an imported consignment can be processed. On July 5, the SBP issued a circular requiring importers of all goods whose HS codes begin with 84 and 85 to also obtain prior permission “before initiating transactions”.

Muhammad Nadeem of Kehkashan Enterprises, based out of Lahore in the business of importing embroidery machines, has two consignments stuck at the port with two more on the way. “Since July 5, my bank has created a portal from where I have to apply to make the payment,” he tells Profit. “We have worked with the same supplier for almost 20 years now so our work is largely on the basis of trust,” he says. He does not use LCs for payments, like many others in his industry, preferring instead instruments bankers refer to as “contract payments”. 

He has been waiting since the Eid holidays ended. “It is now eight days since my consignment landed and demurrage charges have begun to be applied, and I still don’t have even the password with which to access the portal,” he says. “All required documents have been submitted by my suppliers’ bank, but Meezan Bank here is telling me that it could be up to a month or even two before my permission is received to make the payment.”

Each machine he imports costs around $19,000. At the moment he has 14 machines at the port awaiting payment. “We have halted the lading of other cargoes until the problem passes,” he says.

Profit spoke to many others in the same boat. Mohammad Zeeshan of Ramzan Enterprises, also Lahore-based, is one of them. He was just getting off a call from one supplier who was pressuring him to lift a new consignment that he had ordered earlier and he was trying to explain that it was not a good idea to issue a Bill of Lading for that order since payments were being delayed here. 

“I have 20 containers stuck at the port,” he says. “The Financial Instrument was given by the bank against 100% cash margin before July 5,” he says, adding that he had been experiencing problems in processing payments as far back as the middle of June, but after the circular of July 5, his payments have halted.

Another small- and medium-sized enterprise businessman, who did not want to be named, says he had to let go of his entire staff. “We have no raw material and are producing nothing. I can’t afford to keep my staff idle. I had to make a tough choice.”

Yet another businessman stated that he had to pay demurrage charges for delays in clearance at the port as the SBP held back LCs. “It’s better to sit this out and wait for things to get better than to bleed company resources on demurrage and minimal production in wake of input shortages.”

On Tuesday, the Federation of Pakistan Chambers of Commerce and Industry voiced alarm at the volatility in the exchange rate, saying “imports of essential commodities and industrial raw materials are also under threat” if the spiral continues.

What now?

For now, most experts believe Pakistan will have to continue this method of restricting outflows, pushing banks to go short as much as they can, and dealing with the uncertainty of a volatile foreign exchange market – that is, until the country gets significant foreign currency inflows through the IMF tranche or support from friendly countries. 

To some extent it is working. Figures shared by the finance minister show a sharply falling current account deficit in the month of July, $500 million till the 18th. With record high inventories of petrol and diesel, coupled with furnace oil stocks accumulated at the refineries, shutdowns in the fuel supply chain could still be a long way off, and the import bill for energy is also likely to be much lower in the weeks ahead. The more immediate danger of default seems to be held in abeyance at the moment, but the underlying weaknesses of the foreign exchange market will remain in place. If inflows pick up momentum, and outflows remain constricted, the market may well see a period of some stability at the level where it opens on Monday morning. Banking sources confirmed to Profit that week ahead has no lumpy payments and inflows may well show a recovery. 

But for the period of troubles to pass convincingly, the IMF programme has to be approved by the board, and the associated inflows conditional on that passage have to come into play. The period of difficulties may not aggravate in the near future. But it is also not likely to pass any time soon.