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I. INTRODUCTION
Definition
The money market is a wholesale market for low risk, highly liquid,
short-term1 & long term debt instruments. It serves as an avenue
through which banks and financial institutions can offload their
excess liquidity or meet their funding requirements. To the
government an organized money market represents a means for it
to implement its monetary policies in a more efficient manner.
Moreover, it provides it with a liquid market for securities through
which it can finance its own borrowing requirements.
Trading in the money market only began in Pakistan in February
1991 with the switchover of the Government from on-tap to auction
system. As per the previous system interest rates on T-Bills were
fixed at 6% and anyone could buy as many of the securities as one
liked through this on-tap system.
This market can be classified into:i. Primary market
i. Secondary Market
Primary Market:
The primary market constitutes the government of Pakistan selling
its securities through the State Bank of Pakistan. This is done
through T-Bill auctions and PIB auctions, T-bill auctions held
fortnightly and PIB auctions as per government requirements (no
fixed schedule). Through these auctions the government invites
bids for its Market Treasury Bills in fixed tenors of 3, 6 and 12
months and for its PIBs for 3,5,10,15 & 20 years. Presently only
1
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designated Primary dealers are allowed to participate in these
auctions with their own funds, which is usually a corporation. A pre-
auction target for T-bill is announced a day or so and PIB auction is
announced 14 days prior to auction in advance to indicate the
amount that the SBP intends to pick up. The amount that is
eventually picked up depends on both the actual requirement of the
government as well as the bidding pattern. The bid at which an
institution enters the auction is denoted by the price at which it
proposes to purchase a specific amount of T-Bills or PIBs. The higher
the bid the lower the cost of funds to the Ministry of Finance and
therefore the greater the chance of the bid being accepted. An
institution can submit more than one bid in the same tenor for
different prices and amounts.
Designated Primary Dealers:
1. Habib Bank Ltd
2. United Bank Ltd
3. National Bank of Pakistan
4. Muslim Commercial Bank
5. Prime Commercial Bank
6. Union Bank Ltd
7. Citibank
8. Standard Chartered Bank
9. Abn Amro Bank
10. Jahangir Siddiqui Capital Markets
11. Pak Oman Investment Company
12. American Express Bank
Secondary Market:
The securities issued in the primary market are then traded in the
secondary market, which basically constitutes the various financial
institutions trading among themselves through brokers. The two
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markets are inextricable linked in the sense that the rates at which
bids are accepted in the auction have a direct bearing on the rates
prevailing in the secondary market. These auction cut-offs also
reflect the State Banks current monetary policy and players in the
secondary market develop an interest rate outlook based on their
interpretation of the trends found in these rates. Besides this the
market rates are also dependant on a number of market
fundamentals such as inflation expectations, the foreign exchange
situation, budget deficit, the liquidity situation in interbank etc.
Purpose of Money Market
The need for financial institutions to indulge in money market
transactions arises primarily from the reserve requirements
imposed by the State Bank. All commercial banks are required to
maintain 25% Statuary Liquidity Requirements (SLR) of their
Demand and Time Liabilities (DTL)2 in FIBs, PIBs (5% of the DTL) T-
Bills, KESC Bonds and other specially approved government
securities. NBFIs on the other hand have to maintain 14% of their
DTL in government-approved securities, which constitute TFCs, NIT
Units and WAPDA Bonds, in addition to the securities approved for
commercial banks. Commercial banks and NBFIs also have to
maintain a certain portion of their DTL in a cash reserve maintained
with the SBP at 0% interest. This ratio is known as the CRR (Cash
Reserve Requirement) and stands at 7.00% for commercial banks
and 1% for NBFIs.
MAJOR PLAYERS
2 Demand & Time Liabilities comprise of current and checking accounts under the head of demand liabilities,
and all time deposits under the head of time liabilities.
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II. MONEY MARKET INSTRUMENTS
T-Bills: T-Bills are short term securities issued by the State Bank on
behalf of the Ministry of Finance through auctions or OMOs (Open
Market Operations). They are zero-coupon bonds issued at a
discount, have a par value of Rs 100 and a maturity of three, six or
twelve months. Bank borrowing is one of the various measures the
government takes to fill its budgetary deficit and this bank
borrowing currently takes place against T-Bills. 20% of the interest
earned on T-Bills is retained by SBP as advance income tax.
Price of a T-Bill: Assume a 6 month T-Bill with a par value of Rs.
100 and a yield of 7.23% is to be sold in an auction. Its price would
be calculated in the following manner:
= 100
(1+T-Bill yield)tenor
= 100
(1.0723) 180/3653
= 96.6161
PIBs: These are long term bonds of three, five, ten, fifteen, twenty
& 30 years, maturity issued at market price and carrying a different
coupon rate according to the interest rates scenario. Since Dec 14th
2000 the SBP start issuing fresh PIBs for a number of reasons. For
one thing, T-bills offer the SBP a better opportunity to monitor
interest rates in the short term. Moreover, another reason for
issuing PIBs is to set up a yield curve and corporate, mutual funds
3 The number of days of each T-Bill issue are specified at the time of issue and therefore vary. For instance
each 6 month T-Bill may not necessarily be of 180 days and can often vary from 180-182 days.
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etc to invest in long term,. Commercial banks are restricted to
maintaining a PIB portfolio that is within 5% of their DTL (Demand &
Time Liabilities). A calculation for the price of PIB is demonstrated
on page 14.
Features of PIBs
Withholding tax is 10%
Shut period of 3 days
Coupon will redeemed Semi Annually
Primary Dealers can only participate in the auction and can
short sell 5% of the target.
Short Selling period is 14 days prior to auction date.
TFCs: TFCs are redeemable capital instruments and may be issued
by a company directly to the general public, which includes
institutions. Unlike straight bonds, they are redeemable capital and
are of long tenors i.e. more than one year. They are quoted on a
price basis rather than yield to maturity. Earnings from TFCs are
taxable @10% (Withholding tax) in the case of institutions, whereas
in the case of individual investors there is no withholding tax and
zakat is deducted @2.50%. Some of the TFCs are listed on the stock
exchange and are traded in the capital as well as in the money
market. TFCs are a most promising instrument for bond market
development. Over the past few years, a modest beginning has
been made with the floating of a number of public issues. The
issuing of TFCs by any corporation offers various advantages to
both the issuing organization as well as the investors. Some of
these advantages are:
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Advantages for the Issuer:
They provide an alternative for long term financing
since direct loans are usually not available for such
long tenors due to the uncertain interest rate scenario.
Issuers can diversify their funding sources and obtain
funds from a cross section of society including
individuals as well as financial institutions. This widens
the overall pool from which the corporate can borrow.
The gradual repayment of the principal makes the
burden of repayments lighter for the issuer.
Advantages for the Investor:
For a risk-averse investor TFCs offer attractive returns
as compared to other alternatives.
TFCs are exempt from capital-gain tax, thus providing
an attractive investment opportunity on an after-tax
basis.
Being traded on all the three stock exchanges, TFCs
provide a fairly liquid investment alternative.
They contribute to the SLR of NBFIs
COIs: COIs (Certificates of Investment) are issued by investment
banks in exchange for deposits and constitute the source most
commonly used by investment banks to obtain funds. By law COIs
can have a minimum tenor of 30 days and a maximum of 5 years.
Leasing companies however, need to take special approval from the
State Bank in order to issue COIs of less than a three month tenor.
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The law also requires that the rate on all the COIs of the same
tenor, issued by the company must be the same, regardless of the
status of the depositor. The salient features of COIs are as follows:
COIs can be of a tenor from 30 days to 5 years.
The rate of return on the COIs depends on the
profitability of the issuer.
COIs are in direct competition with clean rates since
the return from COIs is subject to a 10% withholding
tax.
Some COIs allow premature encashment, which cannot
be less than the minimum maturity set by the State
Bank. Further, early encashment results in a loss of
return to the holder.
COIs are not backed by any specific assets and are
rated above senior debt.
COIs are non-negotiable instruments.
WAPDA Bonds: These are fixed coupon bonds issued by the Water
and Power Development Authority. Seven issues have been floated
so far, of which only three have been retired to date. The seventh
issue was privately placed. Each issue has a different structure in
terms of the rate offered, date of issue, collateral, guarantee etc. Of
the outstanding issues the only one guaranteed by the Government
of Pakistan is the fourth issue. WAPDA is also planning to float
another issue bearing the following features:
Tenor 5 years
Rate (floating) SBP discount rate + 2%
Year 1 Floor of 12.5%
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Year 2-5 Floor of 12.5% and Cap of 16%
KESC Bonds: In order to refinance KESCs outstanding fuel
payables, issued many bonds over a five-year tenor, the institution
on January 31st, 1999 floated a Rs. 11.50 billion TFC issue, referred
to as KESC Power Bonds. These PBs are accorded approved security
status whereby commercial and investment banks are allowed to
hold the instrument in their Statutory Liquidity Reserve (SLR) and
are freely transferable. The maturity date for these bonds is
February 1st, 2004 and they bear a coupon rate of 17.50% p.a. Profit
repayment is on a semi-annual basis with principal repayment on a
declining basis with an initial two-year grace period.
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III. TYPES OF TRANSACTIONS
Repurchase Agreements (Repos and reverse Repos):
Repos are basically a means of raising funds by selling government
approved securities at a fixed rate, with the intention of
repurchasing them at a specified future date. For the party selling
the security (borrower of funds) the transaction is referred to as a
repo whereas for the party purchasing it (lender of funds), the
transaction is referred to as a reverse repo. Funds transacted
through repos do not fall under the category of demand and time
liabilities and therefore 5% cash reserve is not required for them.Presently this type of transaction is the most common among
financial institutions because of its flexibility, simplicity and security
of principal.
Example:: Bank A wants to borrow Rs. 100 million
from Bank B for a period of one month. Bank A has
securities so it can enter into a repo in order to raisethese funds. Bank B offers to lend Rs. 100 million @
9.00% (per annum). Bank A now has the option of
borrowing these funds against T-Bills or FIBs.
Option 1 T-Bills:
ParticularsIssue Date May 4th 2000Current Date June 29th 2000Tenor 6 monthsMaturity Date November 2nd,
2000DTM (Days to 126
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Maturity)MTM (Mark to
Market)
7.73%
Repo Rate 9.00%Tenor of Deal 1 month (30
days)
First price (P1)= Face Value
1+{(MTM Rate/365) x DTM}
= 100
1+(.0773/365 x 126)
= 97.4009
Second Price (P2 or Repo price)= P1 x [1+(Repo rate x
term of repo) ]
365
= 97.4009 x [1(+0.09 x 30)]
365
= 98.1213
P1 (in Rs.)= 97.4009 x 100,000,000= Rs. 97,400,916.58
100
P2 (in Rs.)= 98.1213 x 100,000,000= Rs. Rs.
98,121,399.81
100
Option 2 FIBs:
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ParticularsIssue Date December 15th
1992
Maturity Date December 15th
2002Current Date June 29th 2000Tenor 6 monthsRepo Rate 9.00%Tenor of the
deal
1 month (30
days)
(PIBs are issued according to market trend (as opposed to T-Bills),
therefore the first price is always equal to the face value.)
First Price (P1)= Face Value=100
Second Price (P2)= P1 x (1+Repo Rate x Days of
transaction)
365Banks dealing in government securities maintain book based
security accounts known as Subsidiary General Ledger Account
(SGL) with SBP. On the date of the transaction i.e. June 29th 2000
Bank A will send an SGL to the State Bank directing it to transfer
the specified securities to the lenders account. The lender on the
other hand will issue a State Bank cheque in favour of the
borrower of the value of the first price. At maturity, the same
transaction will be reversed with the borrower issuing a cheque
of the value of the repo price whereas the lender will send an
SGL directing that the same securities be returned to the
borrowers SGL account.
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Security Lending/Borrowing: If a bank is falling short of
securities it may either lend funds by entering into a reverse repo or
it may simply borrow them from another bank under a securities
lending agreement. In such a transaction the borrower of securites
borrows funds in call from another bank and then lends to the same
bank in repo at a spread, which becomes the cost of securities.
Example:Supposing Bank A is short of securities and
wishes to enter into a securities borrowing agreement
with Bank B for Rs. 300 million for one month, at a cost
of 1.75%. The issue that bank B decides to lend is May
4th 2000, 6 months T-Bill with the MTM being 7.73%.
The transaction will take place as follows:
On July 1st 2000 (Value date): Bank Bank A will
lend Rs. 292,323,348 (P1) to Bank B in repo @
9.00% against the 6-month issue, May 4th,
2000.simultaneously, Bank B will also lend Rs.
292,323,348 to Bank A in call @ 10.75%.
On August 1st, 2000: Bank B returns Rs.
294,557,820.2 which is the maturity amount for
the one month repo transaction, whereas Bank A
will pay Rs. 294,992,300.2 to Bank B as the callamount. The difference between these two
amounts, Rs. 434,480 then constitutes the 1.75%
cost of security borrowing to Bank A.
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Outright Sale/ Purchase of Government Securities: Outright
transactions involve the direct transfer of securities from one owner
to another without any sort of future obligation being a part of the
transaction. The seller of the securities claims the profit/ interest for
his holding period and foregoes the right to any future
profit/interest on the security. The tax burden in outright
transaction is borne by the purchaser of the security. In order to
price an FIB the future coupon payments as well as the face value
are discounted at the YTM (Yield to Maturity)4 and the accrued
interest is added to this figure.
E.g. Assume a Rs. 100,000,000, 10 year PIB bearing a coupon
of 15%, issued on July 14th 1992. The price of the PIB may be
calculated as follows:
Security 10 year PIBIssue Date July 14th
1992Price 110.5565Settlement
Date
July 6th 2000
Face Value 100,000,000
Transacted Amount = Face Value x Price
100
= 100,000,000 x 110.5565
4 YTM expresses the annual ratio of the total of all coupon income for the holding period and redemption
profit/ loss to the amount of investment. The formula for YTM can be expressed as:
YTM = [{Coupon + (Redemption value Bond Price)/ Number of years to maturity}/ Bond Price] x 100
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100
= 110,556,500
Accrued Interest = Coupon Rate x Accrued Number of days x
Face Value
Coupon Period (in days)
= 7.50% x 174 x 100,000,000
182
= 7,170,329.67
Total Cost/ Cheque Amount = Transacted Amount +
Accrued
Interest
= 110,556,500 + 7,170,329.67
= Rs. 117,726,829.7
Based on the above particulars the YTM can be approximated as
follows:
YTM = [{15 + (100 110.5565)/ 2.0219}/ 110.5565] x
100
= Approximately 8.845%
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IV. OTHER TRANSACTIONS
Coupon Washing: In order to avoid taxes and still collect the
coupon on the PIBs that a commercial bank holds, banks sometimes
indulge in a transaction known as coupon washing. In such a
transaction the bank holding the PIBs sells them to an institution
that is exempt from taxes or paid excess tax on PIB returns a week
or so before the coupon is due with the intention to buy them back
after the coupon has been paid. The institution collects the coupon
on the due date and on maturity of the deal sells the coupon back
to the initial owner at a slightly lower price that incorporates theinstitution charges for coupon washing. The coupon that the
institution received on behalf of the commercial bank is also
returned. Details of the calculation are appended at the end of
report.
Security Parking: All commercial banks have to comply with an
upper limit in their FIB portfolio due to which they cannot invest
more than 5% of their DTL in PIBs. In cases where a bank does hold
more PIBs than it is allowed to, it can engage in a transaction known
as security parking, whereby it parks its excess securities for a
specified period of time with a financial institution that can afford to
hold more PIBs for the moment. Detailed calculations of such a
transaction are appended at the end of this report.
Mismatching transactions: Such transactions are often
structured with a clients peculiar needs in mind and is based on
implied forward rates5. For example a bank may have a borrowing
5 Implied Forward Rates are rates derived from observed spot yields of differing maturities. All spot yields
have forecasts of future short-term interest rates embedded in them. E.g. Three month rate one month forward
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position for three months, but with the value date being one month
forward. However, he may feel that the three-month rate that might
prevail one month from now is higher than the three-month rate
that he may get at present. In order to lock in the low rates
prevailing in the term structure right now he can borrow funds for
four months today and lend them for one month at such a rate that
his break-even rate (i.e. the rate upto which he can afford to borrow
three month funds at the maturity of his one month deal) is below
that which he expects to prevail for three month funds after one
month.
Conversely, a bank may feel that rates are expected to go down in
future and therefore may wish to lock in the higher rates available
to him at present. If such a bank does not have funds of his own
that he can place in a tenor he may borrow funds in a shorter tenor
(for instance, one month) and lend the same funds for a longer
tenor (such as three months). On the maturity of his first deal (in
which he borrowed funds) he may in fact fund his lending at a lower
rate provided his view of declining rates does materialize. Another
kind of mismatched transaction is based on effective cost. For
instance, if a bank needs to borrow funds for six months however,
at present hes getting six-month funds at 9.00%. On the other
hand he can borrow three-month funds at 7.50% and at the same
time borrow three-month funds value three months forward at
8.50%. The effective cost of these two transactions comes out to
8.00% for six months, which is lower than the six-month cost of
funds prevailing right now. It would therefore be far more feasible
for him to enter into the two transactions today rather than borrow
six months straight.
= {(4 month rate x 120 days) (1 month rate x 30 days)}/ (120- 30)
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BOND STRATEGIES BASEDON IMPLIED FORWARD RATES
In the case of bonds the implied forward rates imbedded in the term
structure can be analyzed in contrast with the view a portfolio
manager may hold about interest rates in order to exploit any
differential present. For example, if a portfolio manager feels that
interest rates in the future are higher than the implied forward rates
imbedded in the term structure at present he would be inclined to
hold a bearish position on his portfolio. That is to say he would
prefer to sell his bonds at present since he feels that the price he
would get for the same bonds in future is likely to be much lowerthan the prevailing prices. Conversely, if the manager feels that the
interest rates in the future are likely to be lower than the implied
forward rates prevailing presently he will be inclined towards a
bullish attitude on his portfolio.
V. REGULATORY FRAMEWORK
The two main regulatory bodies in Pakistans money market are:
The State Bank of Pakistan
The Ministry of Finance.
THE STATE BANKOF PAKISTAN
As the central bank of Pakistan, the SBP is the key regulatory body
in the country. It is regulated by the SBP Act of 1955, which outlines
the banks primary responsibilities as the controller of the countrys
money supply and foreign exchange reserves, as well as the
guardian of the interest of all the depositors in the financial
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be maintained everyday. Government approved securities
are defined differently for commercial banks and NBFIs.
For the former they comprise T-bills, PIBs, FIBs and KESC
Bond. For NBFIs they consist of all these along with TFCs.
Open Market Operations: OMOs are a tool for
controlling the money supply directly. For instance, if there
is a liquidity crunch in the market and funds are trading
close to the discount rate, the SBP is likely to intervene by
injecting funds through either a scheduled OMO or a
special OMO which would eventually be expected to bring
about a slide in the rates through its effect on the demand
and supply situation prevailing in the market. Likewise, if
there is surplus liquidity in the market, or if the SBP has its
own borrowing requirement, it may borrow funds from the
commercial banks through an OMO thereby having the
opposite effect on market rates. OMOs are regularly
conducted every alternate Thursday whereas a special
OMO can be announced any time during the week as and
when the need arises. The tenors for which funds can be
injected through an OMO are usually for 3 days to 1 week,
two weeks and one month. On the other hand, funds are
normally picked up in an OMO for either 1-month, 3
months, 5 months or outright sale of T-Bills (the latter
being a little less than six months). The reason for the
outright sale tenor not being exactly equal to six months isthe fact that the SBP here floats a T-Bill that has already
been issued to it by the Ministry of Finance against the
latters own borrowing from the central bank.
THE MINISTRYOF FINANCE
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This ministry represents the government in the debt auctioning
system. Its responsibility is to provide adequate funds for the
government, which may be generated through direct and indirect
taxes, foreign aid, foreign borrowing and domestic debt.
Government expenditures can be funded by its revenue receipts or
by borrowings. Tax and non-tax revenues form the revenues
whereas domestic and foreign debt comprise the government
borrowings. One of the roles of this regulatory body is to strike a
balance between revenues and expenditures and hence determine
the size of the fiscal deficit. The objective of containing the budget
deficit has been far from achieved as the overall deficit has gone
way above its targets. For the fiscal year 1999-2000 the initial
budget deficit target was 3.6% of GDP, which was later revised to
4.50% of GDP. However, the actual budget deficit for this period
was 6.30%.
There are basically three avenues available to the government in
order to bridge its budgetary gap: bank borrowing, non-bank
borrowing and other inflows comprising of miscellaneous heads
such as bilateral and multilateral funding. With the limits on bank
borrowing set by the IMF, non-bank borrowing is a preferred option
available to the government. The main reason for these restrictions
is the crowding-out effect such borrowing can result in as far as
private sector credit is concerned. If both corporates as well as the
government are competing for funds from the same pool (i.e. the
inter-bank market) the interest rates are bound to experience
upward pressure. Non-bank borrowing comprises of funds mobilized
through prize bonds and national saving schemes. With the recently
imposed restrictions on institutional investment in NSS, in order to
bridge its budgetary gap the government is relying more on
external inflows. In the absence of these external inflows the
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government is left with no other option but to increase its bank
borrowing which could in turn result in the interest rate shooting up.
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VI. IMPACT OF EXTERNAL FACTORS ON
THE MONEY MARKET
Since the money market is based on the basic principles of demand
and supply, any external factor affecting either of the two plays an
important role. Even though factors such as a sudden political event
(freezing of foreign currency accounts etc) cannot usually be
predicted, there do remain a few cyclical changes in the economy,
which have a significant and somewhat predictable impact on the
market. In this section we will elaborate on some of these economic
cycles.
SBP BORROWING FOR COMMODITY OPERATIONS: Since Pakistan is
primarily an agricultural based economy, the recurring cycles
prevailing in the agricultural sector often have a significant impact
on the trends in the money market. The government has set
specific targets for financial institutions for the minimum financing
that they have to provide the agricultural sector. These are often
short-term loans for purposes such as purchase of essential
seasonal inputs e.g. seeds during the sowing season etc. the
demand for funds in the agricultural sector therefore can result in a
temporarily tight position in the money market since for funds to
leave the system in the shape of loans to farmers and then return
as deposits made by the recipients of those funds often takes
atleast three to four weeks. An example would be the cotton
season. Since cotton exports form a significant part of the countrys
export earnings the sector receives considerable financial support.
The sowing of this crop starts from April-June whereas the
harvesting takes place in October-December. Credit for cotton
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starts to flow out from the system from November to May. Another
example would be the import of a commodity such as wheat. These
follow a particular pattern with major imports in April, May and June.
During this time the government need for funds increases and thus
the market experiences a shortage of funds.
The sugarcane-crushing season is another cycle to be considered.
The sugar mills have to book the harvest in advance in order to
ensure a consistent supply of sugarcane for their mills. For this
purpose advance credit has to be provided to them, which results in
a significant portion of the systems liquidity tied up in advances to
suppliers. Even though such advances only result in a changing of
pockets and the money effectively stays in the system, it can
however have impacts on the status of the major lenders and
borrowers in the market.
YEAR/QUARTER-END REQUIREMENTS: At the end of the fiscal year as
well as the quarter end the money market usually experiences a
liquidity crunch for a number of reasons. For one thing, the IMF
keeps a check on the NDA (Net Domestic Assets) at the end of each
quarter. Due to this the SBP cannot afford to lend in the market for
a duration crossing these quarter end dates, which is one of the
reasons why the market is often tight during these periods.
Secondly, the SBP also has to collect taxes at these times on behalf
of the government which in turn result in outflows from the system.Another factor that comes into play is the government borrowing
from the State Bank itself. The government throughout the year
borrows from the SBP for various purposes such as deficit financing
and project development. When the SBP lends to the MoF at such
times it results in an asset shown on SBPs books and which it
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eventually will have to fund through bank borrowing. This position
has to be squared at quarter and year ends which is why the State
Bank often ends up mopping excess liquidity at such times leaving
the market fairly tight in most cases.
SBP BORROWING FOR BUDGETARY SUPPORT:The government has
budgetary targets to meet throughout the year in terms of the total
revenues it earns in the form of taxes, duties etc versus the total
expenditure on development and other projects. In cases when this
budgetary deficit is larger than the target initially set by the
government or, as is the case at present, by an international
regulatory authority such as the IMF, the only other option left to
finance this gap is through bank borrowing. This bank borrowing
results in a direct upward pressure on the rates prevailing in the
inter-bank market.
IMPACTOF FOREIGNEXCHANGE MARKET:The foreign exchange market
has a significant impact on the activity in the money market. A brief
overview of the foreign exchange market would help in
understanding the relationship between both the markets. Liquidity
in the foreign exchange market is based on imports, exports and
remittances. Trade imbalance results in demand for foreign
exchange, which in turn results in a downward pressure on the local
currency. In times when this pressure becomes excessive or
prolonged it results in speculation over the chances of an official
devaluation. Importers holding this view would therefore be inclinedto book dollars in advance causing the dollar to trade at a premium.
Theoretically, according to the exchange rate parity the premium at
which a currency trades in relation to the other should be equal to
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the interest rate differential between the two currencies6. In cases
where the premiums are higher than the interest rate differential it
calls for the need for a correction in the rupee rates. If not, it
presents an arbitrage opportunity. For example, a banker can
borrow 6 month rupee funds in call @9.25%, enter into a USD buy-
sell transaction at a premium of 7.00% and then keep those funds
in its Nostro earning a return of 5.00% on these deposits. On
maturity of the buy-sell transaction, it can sell the dollars at the said
premium, pay off the rupee loan at the same time enjoying an
arbitrage of 2.75%. Such an arbitrage opportunity would result in
greater demand for call funds causing in turn the call rates to go up
thereby causing this spread to narrow and resulting in an automatic
correction of the rates prevailing in the money market.
6 The currency that has a higher interest rate should theoretically trade at a discount whereas the one with a
lower interest rate should trade at a premium. For instance the interest rates on the dollar are presently 7%
(six month LIBOR) whereas the interest rate on the rupee is 7.4% (six month T-Bill return) indicating that the
dollar should trade at a premium.
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VII. RISKS INVOLVED IN MONEY
MARKET
The various risks that come into play for the players in the moneymarket are:
Interest Rate risk
Liquidity Risk
Credit Risk
Sovereign Risk
As brokers in Pakistan are not allowed to take positions on their
books, the risks are somewhat limited. Brokers are, however,
exposed to price risk in the sense that if they get hit on a price by a
bank and fail to complete the transaction because the other party
may have gone offline and in the meantime the market moves
against the bank that had accepted the price, the broker involved
may be asked to compensate for the loss. Brokers are also
responsible for the physical settlement of the transaction. They
have to make sure that the cheques are deposited at the State
Bank, the SGL collected from the bank and deposited at the State
Bank before the dealing time ends, which is at 1:30 pm from
Monday through Thursday and 12:30 pm on Friday and Saturday.
Any shortfall in fulfilling this responsibility may also result in
penalties. Moreover, some brokers have been known to be
blacklisted and some have also been fined in the past. Their names
however, cannot be mentioned.
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