The Government of Pakistan is currently experiencing an unprecedented surge in liquidity, both domestically and in its international reserves. This favorable position is partly due to the International Monetary Fund’s recent disbursement of a $1 billion loan tranche. More notably, the local liquidity situation received a significant boost from a record Rs2.7 trillion dividend announced by the State Bank of Pakistan (SBP).
This substantial dividend was made possible by the central bank’s extraordinary profit of Rs3.4 trillion, marking a staggering 200% increase from the previous year. The root of these enormous figures lies in the SBP’s generous lending to financial institutions at record interest rates through open market operations.
Ironically, most of these funds were subsequently invested in government securities at even higher rates, creating a circular arrangement where the government of Pakistan essentially enabled its own profitability and is now reclaiming the same funds.
While the focus of this article is not to critique this unconventional arrangement, it aims to elucidate the sequence of events leading to the buyback and its future implications. The stage for higher dividends was set during last month’s post-MPC analyst briefing when the SBP governor hinted that the government’s share of SBP’s profits would likely exceed budgeted expectations.
This prediction materialized in the form of the Rs2.7 trillion dividend, providing the government with a temporary liquidity surge, which it promptly utilized to announce a buyback of its securities.
The first of what may be a series of buybacks occurred last week, with the SBP intending to repurchase Rs500 billion of T-bills but ultimately securing Rs351 billion worth. This context leads us to a crucial question: Why is the government suddenly so keen on buying back its own securities?
The rationale
The government’s strategy is straightforward: it aims to reprofile its debt by swapping expensive securities for lower-cost alternatives. The recent buyback transaction illustrates this approach. The Rs351 billion worth of T-bills repurchased were set to mature in December and had been issued at high interest rates of around 20%-21%. With current yields at approximately 16%, the government seized the opportunity to avoid these exorbitant interest rates, resulting in debt servicing cost savings of about Rs 11.61 billion.
“The government’s primary objective is to reduce its debt servicing costs. They are repurchasing high-yield securities (with returns of 19%-20%) and perhaps plan to refinance these with new, lower-cost issuances later. At present, the focus is on buying back 6-month to 1-year Treasury bills. Further buybacks are anticipated,” opined Naveen Ahmed, a Karachi-based investment banker.
“Regarding longer-term instruments, Pakistan Investment Bonds (PIBs) are predominantly floating-rate securities, benchmarked against the 6-month Karachi Interbank Offered Rate (KIBOR). Only about 20% of these are fixed-rate bonds. Consequently, there’s no necessity to repurchase securities of other maturities, as their yields will automatically adjust downward in tandem with falling T-bill rates,” she added.
However, the strategy extends beyond mere cost savings. Nearly Rs9.5 trillion of conventional market debt, roughly 25% of the total, is due to mature between October and December 2024. Faced with such substantial upcoming maturities, the government has opted to buyback short-term debt and issue bonds and bills with maturities of one year and beyond.
“The government currently enjoys a liquidity surplus due to the recently announced SBP dividend. They aim to utilize this excess liquidity to optimize the domestic debt profile by repurchasing high-cost short-term bills and replacing them with more affordable long-term debt,” remarked Mustafa Pasha, Executive Director and Chief Investment Officer, Lakson Investments.
The Ministry of Finance has been striving to extend the maturity profile of its market debt, but unfavorable market conditions in recent years have hindered this effort. The current market expectation of approximately 4% in rate cuts by January 2025, driven by falling inflation (latest figure 6.9%) and a balanced current account, has finally presented an opportune moment.
This climate allows the government to issue longer-term fixed-rate bonds, complemented by long-term floating-rate bonds, thus achieving its goal of debt reprofiling and maturity extension.
Reading between the lines
The government’s buyback transactions serve a dual purpose: managing debt and reining in banks’ strongholds on the market. Through these buybacks and the anticipation of further policy rate cuts, secondary market yields are plummeting. This marks a significant shift from the past two years when the government had to acquiesce to banks and other financial institutions to meet its liquidity needs at exceptionally high rates.
Now, with the advantage in its court, the government is asserting its position. Recent T-bill auctions, where all bids for the 3-month tenor were rejected, exemplify this new stance. However, the sustainability of these buybacks as a recurring feature remains questionable.
In the short term, more buybacks are likely as the government aims to replace maturing debt with longer-tenor securities. The next buyback auction, scheduled for October 10th, underscores this strategy. Yet, extending this approach beyond December 2024, when major maturities occur, seems improbable.
“This buyback strategy is unlikely to become a regular practice, given the substantial fiscal deficit we continue to face. It’s primarily a signaling mechanism through which the government seeks to lower market expectations for returns on future debt issuances and influence secondary market rate,” Pasha reiterated.
This perspective aligns with Pakistan’s fiscal outlook. With the country projecting a significant fiscal deficit for FY 2025 and the Federal Board of Revenue (FBR) falling short of its first-quarter tax target, the government may need to explore alternative means to address the fiscal gap.
Amidst these developments, the State Bank of Pakistan (SBP) governor’s recent statement about increased private credit flow due to buyback-induced liquidity injections also raises questions.
Adnan Naqvi, Group Head Corporate & Investment Banking at Pak-Brunei Investment, offers a nuanced view: “Post-buyback market sentiment is likely to favor rate reduction, supported by the current 6.9% CPI reading. Expect progressive rate cuts in upcoming MPCs. However, increased private credit remains contentious due to significant government financing needs. This will likely eventually redirect surplus liquidity towards the sovereign, albeit at lower rates.”
The government’s buyback strategy is not intended to operate in isolation. Instead, these buybacks will be coordinated with T-Bills and PIBs auctions, aiming to replace short-term debt with longer-term securities. Even if the government doesn’t fully offset the buybacks, the market has the potential to reduce its leverage position of Rs 9-10 trillion.
However, this strategy comes with a caveat. Market observers might notice a surge in private sector lending over the next quarter, but this increase would likely be unrelated to the liquidity injection claimed by the SBP governor. Instead, it would be driven by banks striving to achieve an Advance to Deposit Ratio (ADR) of 50% by year-end to avoid additional taxation.
This tactical approach is already evident, with recent lending transactions offered at rates up to 6% below KIBOR to encourage short-term borrowing in the private sector. However, similar to the pattern observed in 2022, this lending is expected to reverse after the year-end.
For sustainable growth in private sector credit, the risk profile of this segment needs to improve. With only 300 to 400 large blue-chip borrowers available in the country, many of whom are grappling with a slowdown in aggregate demand, near-term changes in private credit are likely to be more about complying with ADR regulations and avoiding penal taxes rather than genuine economic expansion.
Therefore, the final quarter of the calendar year is poised to maintain a high level of activity in Pakistan’s financial markets. Multiple auctions are anticipated, with a focus on long-term Pakistan Investment Bonds (PIBs) featuring maturities from 2 to 30 years, while simultaneously retiring significant amounts of short-term debt (3 to 12-month T-bills).
Concurrently, shifts in private sector credit are expected to contribute to this momentum, with the year likely concluding amidst a series of policy rate reductions.
