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Money Plus
January 2006
Something large looms in the sky as you drive up the road that leads to Allama Iqbal Airport in Lahore. It’s not a plane flying overhead. It’s something vastly different, yet equally impossible to miss: high interest rates.  On a huge roadside billboard, Saudi Pak Commercial Bank (SPCB) proclaims a solid 9.5% rate of return on one-year term deposits. A near double-digit fixed return would have been unimaginable just one year ago — average lending rates were less than 6% in December 2004.  Yet SPCB is not the only bank grabbing the attention of the passing airport traffic. KASB Bank, opting to stay away from one towering advertisement, has dozens of smaller signs running up the centre of the road on the legs of lamp posts. The ads promote KASB’s “Maheena Asaan” three-year term deposit that currently offers a whopping 10.5%.  In fact, advertisements offering high interest and profit rates have become increasingly common along the major streets of Lahore and Karachi. Soneri Bank has billboards offering 8.5% and Habib Bank recently had a banner outside one of its branches screaming double-digit returns.  The message is clear. The banks want your money – and they are willing to pay for it.  “You have to remember, for commercial banks, December is year-end. Everyone wants to increase their deposit base so their balance sheet looks good,” says Ayaz Dawood, CEO, Guardian Modaraba.  Increasingly stiff competition has created an interest rate war of sorts. The fight for deposits is so tough that “banks are actually paying higher than KIBOR, higher than what they can borrow from other banks,” says Dawood. KIBOR, the inter-bank borrowing rate, is approximately 9% right now. “And banks are actually giving depositors (corporate and big deposits) higher rates because they want deposits on their balance sheets. So there is huge competition on deposits.” Competition for deposits is also high because of the State Bank of Pakistan’s renewed moves to tighten the money supply. Last month, the SBP picked up some of the over Rs90 billion it had added to the money supply since October. By the last week of November, money managers were already describing the market as illiquid.  All this demand for money – and the accompanying higher rates – may look great to those sitting on cash. After suffering stock market losses and watching the value of newly acquired real estate plummet overnight, it’s not surprising to see the curiosity of individual investors piqued by billboards proclaiming 9% and 10% interest rates. Isn’t a steady, risk-free 10% return a dream compared to the wild swings of the stock market that tested the stomachs of the inexperienced and ripped the shirts from the backs of so many small investors?  Of course, nothing is as it seems. While a 10% return is definitely better than the losses swallowed during the stock market’s nasty tumble in April this year, it’s really not all that great. There are costs to these high interest rates: costs to the investor and risks to the economy. Interest rates don’t rise in a vacuum. Rates are in double-digit range not because banks are feeling generous. The rates offered on term deposits by the commercial banks are directly related to the discount rate fixed by the State Bank of Pakistan. And the SBP fixes rate levels based on the state of economy. Currently, economic output is quite healthy. In fact, this is exactly the main point Prime Minister Shaukat Aziz loves to trumpet in his speeches to national and global leaders in industry and trade: With Pakistan’s economy growing 8.4% last year and likely to grow 6.5% this fiscal year, it has much more robust growth than developed nations, as well as many other developing nations. But the economy is not a picture of perfect economic health – other economic indicators can not be overlooked. “The fundamentals of the country are bad,” says Dawood of Guardian Modaraba. Economic activity may be brisk, but Pakistan is holding mounting trade and current account deficits. Both are problems that push interest rates higher. The trade deficit has expanded from a modest US$1 billion in 2002-03 to $3 billion in 2004 and to $6 billion in 2005. By the end of fiscal 2006 it is expected to be $9 billion. “If the trade deficit keeps on ballooning then there will be pressure on exchange rates.” In other words: devaluation.  And then there is inflation. Inflation has become a dirty word and hence a hot topic in financial circles. Inflation is enemy number one right now – the SBP has admitted as much. In its latest monetary policy statement for 2005 the SBP writes that “the key objective of the monetary policy would be to fight inflation and bring it down to a reasonable level during the next six months. The monetary policy stance of a tightened monetary expansion would, therefore, continue until inflationary pressures are eased off.”  With inflation hitting double-digits and a six-year high, the SBP hiked the discount rate to 9% in April. A quick scan of Treasury bill rates illustrates the dramatic rise in interest rates early this year. In fact, rates have been moving higher for two years. In 2003 T-bill rates in Pakistan were under 2%. Now 12-month Treasury bills are hovering above 8.5%.  So if high inflation has been driving interest rates up, what has been driving inflation skywards? “The main cause was food price inflation,” says Riaz Riazuddin, Economic Advisor at the SBP. “There was an increase in food prices from staple items like milk especially, sugar and wheat.” The Karachi-based economist also points to a rising house rent index and escalating world oil prices as other contributors to rising domestic prices.  Ali Shirazee, Chief Executive of Finex Securities, also lists “inward remittances by Pakistanis” as a major cause of inflation. With US$4 billion flowing back into the country by overseas Pakistanis, all that new money ended up chasing the same limited supplies of food, automobiles and property. In the end, all citizens experienced firsthand the rapid erosion of the rupee’s domestic buying power.  By aggressively raising the discount rate to 9%, the SBP hoped to put an end to stubbornly rising core inflation. The good news is that early signs point to success: The latest figures show inflation slipping to 8.3%. That’s down from the annualized high of 11% reached in April.  Despite the progress, Pakistan’s high inflation continues to receive frowns from the International Monetary Fund. In its most recent country-specific analysis, the IMF’s directors “expressed concern about the increase in inflation in the last two years and the widening of the current account deficit.”  Interestingly, SBP Economic Advisor, Riaz Riazuddin, believes the current rates of inflation are not all bad. “One study done by the State Bank of Pakistan, and published in the SBP Research Bulletin, says that an inflation rate higher than 9 percent hurts growth, but lower than 9 percent it is conducive for growth.”  “So I think that for Pakistan inflation between 7 to 8 to 9 percent is good for growth. And say 5 percent or 4 percent inflation is not good for growth. It can retard growth,” says Riazuddin.  But investors need to be aware of the realities: Inflation erodes wealth. As such, investors shouldn’t get overly excited by high interest rates. If the current figure of 8.3% inflation is accurate, a 9.5% return on your money from a term deposit is barely preserving the value of your money. Your real rate of return (the real growth in your money) is a mere 1.2%. So with real interest rates hovering around zero percent, there must be better investment options out there, right? When it comes to investing, the stock market is often the first thing that comes to mind. Unfortunately, higher interest rates and slowing growth don’t usually bode well for the stock market. So while the KSE has seen great gains this year (it currently sits at eight-month highs) more gains are no guarantee. Industrial production is already feeling the effects of high inflation and high interest rates. Growth rates dropped to 10.2% in 2004-05 from 12% in 2003-04. Unfortunately, this downward trend is continuing, as indicators already show slower growth in the first two months of the current fiscal year.  The effects are being felt across all sectors: food and beverage, metal industries, textiles, and fertilizer. Higher prices not only drive up the costs of production, but inevitably drive up interest rates. Higher interest rates increase the cost of borrowing, put a damper on demand and, as a result, cause inventory levels to rise. And with higher interest rates, the cost of holding that inventory rises too. The outcome is falling profits, which of course affects reinvestment, growth and further hampers demand. In the end, the cycle of slowing economic activity starts to starve itself and stocks suffer. Though the slowdown may not seem huge just yet – overall economic activity is still expected to grow at a healthy 6.3% – it is big enough to get the attention of Industries and Production Minister Jehangir Tareen. During the last week of November, the federal minister announced plans to hold a conference with business leaders and industry experts in the hopes of finding solutions to reverse this sluggish trend before it gains real momentum.  While the movers and shakers of politics and industry try to keep Pakistan’s economic engine firing on all cylinders, it would be wise for individual investors to find ways to protect their money in this toughening economic environment.  That is easier said than done.  With the market nearing 10,000 all over again and high interest rates impacting growth, it’s only natural to question how much upside potential remains. “It’s becoming tougher that way,” says Dawood. “You can do nothing, and invest into a money market fund and earn 11 or 12 percent. Why take a risk on equities?” Still, the healthy GDP forecasts are hard to ignore. Some professional money managers will stay bullish as long as growth looks sustainable. And while tight monetary policy is already having a dampening effect on the economy, Dawood insists that stocks and the economy should be fine because profit growth is still strong.  “Bank profits are going to increase, because higher rates actually help the banks.”  But what about industrial corporate profits?  “That gets hurt,” says Dawood, “because most companies are in debt. It helps the companies that are cash rich. And in Pakistan the cash rich companies are in the auto sector. It will help those, but the textile and the export sector gets hurt.” Given that the textile sector is really just a small portion of the index, the stock market should hold up well for now, says Dawood. “You have to realize our stock market has two sectors that are performing really well: cement and banking.”  Furthermore, heavy foreign investment actually makes the market safe and secure. Dawood says foreign inflows are coming in at a rate of $1-2 million a day. One reason Pakistan is such a big draw is because of the cheap price to earnings multiples found here. “Much cheaper than India and much cheaper than the region,” says Dawood. “Plus most of our stocks actually pay cash. Remember the NASDAQ? No one paid cash. Here everyone pays cash.” In fact, dividends are overlooked by small investors who often focus on share price. According to Dawood, dividend yields alone can be higher than some fixed-rate term deposits, and he offers his company’s stock as an example.  For about six years straight, Guardian Modaraba has paid out dividends. Last year the dividend was increased to Rs 1.15 cash from Rs1 a year earlier. At the recent share price of Rs 9.10, the dividend yield is an impressive 12.6%. “And you have to realize that dividend tax is just 10% for individuals. And so even after-tax it’s over a 10% yield.” Of course the modaraba sector is a high yielding sector. “This is because a modaraba, for tax exemption purposes, has to pay out 90% of its profits in cash. So I have to pay out my profits.”  The key in any equity market, especially overbought markets like the KSE, is to find undervalued companies. Of course, finding those hidden gems and then keeping abreast of industry and company-specific news is time-consuming, hard work.  That’s why mutual funds make sense for many small investors. Mutual funds eliminate the hassle of vigilantly watching stocks since a professional manages the portfolio. Further, mutual funds allow someone with limited funds to pool their resources with other investors, thereby creating a much more diversified portfolio than would otherwise be possible.  The fund universe in Pakistan today is small. A handful of companies offer up approximately 40 mutual funds to choose from. Still, for those keen on getting involved in the stock market, mutual funds are often the smartest and easiest ways to get started.  For those wary of overpriced stocks, balanced funds, income funds and money market funds offer further diversification by investing in corporate bonds and government paper, like treasury bills. These debt instruments provide regular income and add stability to the share price of the fund.  Beyond stocks and bonds, another old faithful asset is property. But land prices, as we all know, are substantially lower than the highs reached with the KSE’s meteoric rise earlier this year. But does that mean it’s a good time to pick up depressed real estate? “I wouldn’t journey into property right now,” says Dawood. “It’s stagnated.”  Shirazee offers similar advice. In an inflationary time with very low real interest rates, the best investments are liquid assets like term deposits, stocks and bonds, says the Karachi-based finance professional. Of course, holding a diversified mix of all these is best. High interest rates also make buying property costlier. Despite drops in property values, prices are still much higher than they were a couple of years ago. As such, many home buyers are taking out mortgages. But double-digit loan rates make it difficult to carry those monthly payments. “When interest rates go up, it helps the savers and hurts the borrowers,” says Dawood.  That simple fact is a valuable lesson. Often the best investment decision involves eliminating high-interest debt. Paying off personal loans and credit card debt is the first move many consumers and small investors should make because earning equivalent rates of 15 - 20% or higher on investments is tough.  Interestingly, while high interest rates seem to have impacted property, they haven’t affected automobiles. Car sales are skyrocketing. “Lending against cars is one of the biggest consumer products,” says Dawood. He’s right. Car loans make up 32% of consumer lending and are up 318% since 2002.  It will be interesting to see if the government can control inflation. With current inflation at 8.3%, the target of 8% is within reach. Getting there and staying there, though, is another issue. The SBP reports that potential poor crop yields due to flooding, continuing high oil prices, aggressive consumer borrowing and supply issues in the fertilizer, paper and steel sectors will continue to push prices higher.  Some analysts believe double-digit inflation looms on the horizon and could saddle the country within the coming months; others are not so sure. Inflation seems to be tapering off, according to Shirazee from Finex Securities. As such, he sees interest rates only moving a little higher at the very most. And he even qualifies that statement with a big “maybe.”  Dawood agrees. He says “the earthquake has hurt consumer sentiment so much” that he believes the discount rate “will be stable for the next six months.” For now, inflation seems to be the price of Pakistan’s economic success. Consumers just need to be cognizant that as inflation drives up the cost of living, they need to be constantly searching for investment alternatives that preserve and enhance their savings. So while high-paying term deposits might not always provide impressive real returns, they are always a good option for those who value security more than super-sized gains. And between the banks, non-banking institutions and Government of Pakistan, there is no shortage of fixed return instruments to choose from.  In fact, under the National Savings Scheme, the government offers savings certificates with rates that rival the commercial banks. A three-year Special Savings Certificate pays out an annualized return of 8.74%, a 10-year Defence Saving Certificate returns 9.46% annualized and a Pensioners Benefit Account delivers 11.04%. While some of these rates may be bettered by private institutions, these government deposits are often more accessible because their minimum investment requirements are typically lower than banks and investment houses.  In fast-changing, uncertain times, it’s good to know a variety of safe alternatives are out there. Perhaps the parable is true? Slow and steady wins the race.=
from:
In Pakistan’s high interest rate environment finding a truly lucrative investment idea is hard. What makes it harder is that the economy is not as rosy as some would like us to believe.
The Truth About Returns
© 2006 Talib Qizilbash. All Rights Reserved.