Animal Spirits

October 2010
Abdul Shakur
abdul.shakur@bmacapital.com

Currency Swaps; A Money-spinning Voucher for Pakistan Banks

ƒ Upward trajectory of domestic interest rate environment in contrast with the stable interest
rate regime in US provides lucrative currency swaps spreads for banks
ƒ At present the domestic interbank benchmark 12M KIBOR and LIBOR hover around 13.36%
and 1.47% respectively. With interest rate differential standing around 12%, trading off USD
for local currency expose the participant to opportunity loss of 1.47% while for the same
period PKR holding ensures interest based return of over 13%
ƒ Comparing adjusted Fx-premium (forward USD pricing against PKR after incorporating the
opportunity loss in terms of LIBOR) with respective period’s lending rates in PKR reflects a
possible arbitrage spread of 1.3% p.a.
ƒ Persistent inflation and fiscal imbalances are likely to instigate further monetary tightening of
50-100bps during FY11. On the contrary US government plans to inoculate more funds to help
economy come out of recession
ƒ Divergent economic policies should help PKR stabilize against USD and widen the currency
swap spread going forward; therefore providing profit making opportunity for banks with
adequate foreign currency supply!
After maintaining the policy rate for a period of 7 months, SBP increased the discount rate by 100bps
during the last 4 months. As Inflation and fiscal imbalances are not expected to abate at least during the
current fiscal year, it instigates further monetary tightening. In contrast, recently announced quantitative
easing by US government is expected to continue and keep USD under pressures against major global
currencies.
Contrarian economic policies adopted by Pakistan and US have thus been leading to widening interest
rate differential between KIBOR and LIBOR. Impact of these policies together with strong financial inflows
expected in FY11 helps rationalize consensus PKR devaluation of 4-5%; and hence make currency swap
transactions more profitable for banks. In this month’s edition of Animal spirit we discuss the assumptions
regarding inflation and PKR devaluation for FY11 and its impact on prevailing currency swap
opportunities.
Case for currency swaps transactions
Upward trajectory of domestic interest rate environment in contrast to the stable interest rate regime in the
US leads to a short term trading opportunity in currency swaps. As corporates and individuals are not
allowed to take part in currency swap transactions, banks’ treasuries are likely to be the beneficiaries of
prevalent spreads.
Banks normally deploy USD reserves (Ex-CRR) for trade activities or placing funds in the inter-bank
market. Excess liquidity is made available for LIBOR based lending for which banks normally charge
premium of 1-2% over LIBOR. Since credit demand is yet to recover amid slow economic environment
and embedded credit risk concerns, banks with adequate liquidity opt for financial instruments for revenue
generation i.e. currency swaps transactions as it currently ensures over 1.3% return annually.

BMA Capital Management Ltd, 801 Unitower, I.I.Chundrigar Road, Karachi , 74000, Pakistan
For further queries, please contact: bmaresearch@bmacapital.com or call UAN: 111-262-111
1 This memorandum is produced by BMA Capital Management Limited and is only for the use of their clients. While the information contained herein is from sources believed
reliable, we do not represent that it is accurate or complete and should not be relied upon as such. Opinions expressed may be revised at any time. This memorandum is for
information only and is not an offer to buy or sell, or solicitation of any offer to buy or sell the securities mentioned.
 Animal Spirits
October 2010

Cash flow analysis for 12 Month currency swaps

Sell / buy transaction - 12M swaps Cash Flow (PKR)
T=0
Sell USD ready @ PKR86.08/USD 86.08
Buy 12 month forward USD @ PKR95.08/USD (Fwd spread of 10.46%) -
Lend PKR for 12 months at 13.36% -86.08
T=1
Principal + interest earned in PKR 97.58
Buy back USD at pre-defined rate of 95.08 -95.08
Gross gain 2.5
Opportunity loss on 1 USD if invested at LIBOR @ 1.47% 1.40
Net gain/arbitrage (1.28%) 1.1
Source: BMA Research

At present the domestic interbank benchmark 12MKIBOR hovers around 13.36% while for the same tenor
LIBOR trades at 1.47%. Trading off USD for local currency would expose the participant to opportunity
loss of 1.47% and for the same period PKR holding ensures interest based return of over 13%. This
interest rate differential stands around 12% - ignoring the 2-2.5% premium which banks normally charge
on lending.
We have also accounted the future value of currency for calculation purposes. In this regard, we compare
adjusted Fx-premium (forward USD pricing against PKR after incorporating the opportunity loss in terms
of LIBOR) with respective period’s lending rates in PKR. It is evident that the aforementioned premium
(10.46% + 1.47% in our example) is lower than the prevailing lending rates in domestic market (13.36% in
our example), leading to a possible arbitrage of 1.28% p.a.

12M period lending rates for PKR & USD Forward USD rates against 12M KIBOR
LIBOR KIBOR READY 3-MONTH
6-MONTH 12-MONTH
KIBOR (RHS)
18

%
%

100 17
PKR

16 95
(
16
14 90 15
12 85 14
10 80 13
8 75 12
6 70 11
4 65 10
2 60 9
- 55 8
04-May-07

04-May-08

04-May-09

04-May-10
04-Jan-07

04-Sep-07

04-Jan-08

04-Sep-08

04-Jan-09

04-Sep-09

04-Jan-10

04-Sep-10

04-May-07

04-May-08

04-May-09

04-May-10
04-Jan-07

04-Sep-07

04-Jan-08

04-Sep-08

04-Jan-09

04-Sep-09

04-Jan-10

04-Sep-10

Source: SBP, Bloomberg, BMA Research Source: SBP, Bloomberg, BMA Research

While the bank treasuries actively monitor these differentials to benefit from any arbitrage opportunities,
we believe that such spreads will continue to exist as trade financing and USD based lending remain the
preferred avenues for banks. However any surplus Fx liquidity can and will continue to be used to initiate
these swap transactions and boost income from dealing in foreign currency.

BMA Capital Management Ltd, 801 Unitower, I.I.Chundrigar Road, Karachi , 74000, Pakistan
For further queries, please contact: bmaresearch@bmacapital.com or call UAN: 111-262-111
2 This memorandum is produced by BMA Capital Management Limited and is only for the use of their clients. While the information contained herein is from sources believed
reliable, we do not represent that it is accurate or complete and should not be relied upon as such. Opinions expressed may be revised at any time. This memorandum is for
information only and is not an offer to buy or sell, or solicitation of any offer to buy or sell the securities mentioned.
 Animal Spirits
October 2010

Historical analysis of spreads through currency swaps

6
%

5
4
3
2
1
-
04-May-07

04-May-08

04-May-09

04-May-10
04-Mar-07

04-Nov-07

04-Mar-08

04-Nov-08

04-Mar-09

04-Nov-09

04-Mar-10
04-Jan-07

04-Jul-07

04-Sep-07

04-Jan-08

04-Jul-08

04-Sep-08

04-Jan-09

04-Jul-09

04-Sep-09

04-Jan-10

04-Jul-10

04-Sep-10
(1)
(2)
(3)
(4)
(5)

Source: SBP, Bloomberg, BMA Research

Monetary tightening and stable PKR signifies it even more…

SBP is expected to continue policy tightening up to the tune of 50-100bps during the remaining period of
FY11. Assumption for further tightening is primarily based on burgeoning inflation and fiscal imbalance.
Inflation is expected to keep upward trend up till 3QY11 and settle in the range of 15-16% for FY11
against 11.7% for FY10. On the other hand, government is keen to build up fiscal space through subsidy
elimination and implementation of Reformed General Sales Tax (RGST). These reforms will
subsequently fuel inflation through direct and indirect impact on cost of production going forward.
Monetary authorities are however more concerned with increasing budgetary borrowing from central
banks. Therefore, by increasing interest rates, SBP targets both of these concerns.
Although challenges to the economy are of great concerns, we remain positive on currency outlook with
reasonable expectation of 4-5% depreciation during FY11. Our assumption is primarily based on the
excess supply forecast through financial account (aid inflows) and swelling overall balance of payment.
Just to give a perspective, despite higher inflation and current account deficit during FY05-07, PKR
depreciation was negligible due to higher financial account inflows.
PKR Depreciation and select Economic Indicators
PKR / USD Annual Depreciation C.A Deficit (USD mn) CPI
FY05 59.64 -0.2% (1,534) 9.3%
FY06 60.22 1.0% (4,990) 7.9%
FY07 60.37 0.3% (6,878) 7.8%
FY08 68.35 13% (13,874) 12.0%
FY09 81.47 19% (9,261) 20.8%
FY10 85.52 5% (3,507) 11.7%
Source: BMA Research

In addition, the Fed has already announced the upcoming quantitative easing to bring economy out of the
current recessionary cycle. For PKR, quantitative easing implies broadening of the existing interest rate
differential and support against the greenback.

BMA Capital Management Ltd, 801 Unitower, I.I.Chundrigar Road, Karachi , 74000, Pakistan
For further queries, please contact: bmaresearch@bmacapital.com or call UAN: 111-262-111
3 This memorandum is produced by BMA Capital Management Limited and is only for the use of their clients. While the information contained herein is from sources believed
reliable, we do not represent that it is accurate or complete and should not be relied upon as such. Opinions expressed may be revised at any time. This memorandum is for
information only and is not an offer to buy or sell, or solicitation of any offer to buy or sell the securities mentioned.
 Animal Spirits
October 2010

Upside for banks’ income from dealing in foreign currency

Banks’ income from dealing in foreign currency is normally driven by a combination of trade finance,
interbank placement and currency swap transactions. Trade financing and credit demand have stayed on
the back foot in the current economic environment while currency trading has been driving growth under
this head. Historical data shows that Fx income move in tandem with domestic bench mark lending rates
which is the primary determinant of return being generated in local currency through swaps.
Historical analysis of banking income through dealing in foreign currency

Fx income banks Qtr. avg. KIBOR

3,000 18

2,500 16

2,000 14

1,500 12

1,000 10

500 8

- 6
Mar-07

Mar-08

Mar-09

Mar-10
Jun-07

Sep-07

Dec-07

Jun-08

Sep-08

Dec-08

Jun-09

Sep-09

Dec-09

Jun-10
Source: BMA Research

As banking industry preemptively price in the anticipated change of interest rate regime, we expect
secondary market yields and bench mark lending rates to continue northward move. Therefore, with
stable PKR assumption, potentially increasing spread in currency swaps would further shore up non
interest income of the banks going forward.

BMA Capital Management Ltd, 801 Unitower, I.I.Chundrigar Road, Karachi , 74000, Pakistan
For further queries, please contact: bmaresearch@bmacapital.com or call UAN: 111-262-111
4 This memorandum is produced by BMA Capital Management Limited and is only for the use of their clients. While the information contained herein is from sources believed
reliable, we do not represent that it is accurate or complete and should not be relied upon as such. Opinions expressed may be revised at any time. This memorandum is for
information only and is not an offer to buy or sell, or solicitation of any offer to buy or sell the securities mentioned.
 Animal Spirits
October 2010

Economic Statistics
FY08A FY09A FY10A FY11E
Economic indicators
GDP growth % 3.7 1.2 4.1 2.1
Agriculture % 1.0 4.0 2.0 (1.4)
Manufacturing (LSM) % 4.8 (3.7) 5.2 2.4
Services % 6.0 1.6 4.6 3.5

External Account 3MFY11 3MFY10 Y0Y

Trade balance USD mn (2,966) (2,809) 6% (14,970) (12,627) (11,377) (14,117)
Exports USD mn 5,244 4,620 14% 20,427 19,121 19,636 20,618
Imports USD mn 8,210 7,429 11% 35,397 31,747 31,055 34,735
Remittances USD mn 2,646 2,331 14% 6,451 7,811 8,906 10,509
Current account USD mn (545) (587) -7% (13,874) (9,261) (3,495) (5,557)
FDI USD mn 381 477 -20% 5,410 3,720 2,201 2,409
Overall balances USD mn 88 1,796 -95% (5,290) (3,002) 1,266 5,731
Trade balance as % of GDP (9.0) (7.6) (6.4) #VALUE!
Current account as % of GDP (8.3) (5.6) (2.0) #VALUE!

Fiscal Account * 4QFY10 3QFY10 QoQ

Total Revenue PKR bn 676 491 38% 1,499 1,851 2,027 2,411
Tax Collection PKR bn 458 355 29% 1,051 1,312 1,513 1,779
Current expenditures PKR bn 726 601 21% 1,853 2,042 2,231 2,433
Development expenditures PKR bn 289 125 132% 452 480 646 663
Fiscal deficit PKR bn 303 223 36% 777 680 723 685
Tax Collection as % of GDP 3.5 2.4 10.0 10.0 10.2 #VALUE!
Budget deficit as % of GDP 2.3 1.5 7.4 5.2 4.9 #VALUE!

USD Reserves Sep-10 Aug-10 MoM

SBP reserves USD mn 12990 12,240 6% 8,577 9,177 12,951
Banks' reserves USD mn 3830 3,737 2% 2,822 3,307 3,816
Total foreign reserves 16,820 15,977 5% 11,399 12,484 16,767
Reserves in months of imports 2.0 2.2 3.9 4.7 6.5

Interest Rates ~ Aug-10 Jul-10 MoM bps

Weighted avg. lending rates % 13.38 13.35 0.03 11.96 14.02 13.44 13.90
Weighted avg. Deposit rates % 5.82 5.84 (0.02) 5.18 6.50 6.05 6.50
Banking spreads % 7.56 7.51 0.05 6.78 7.52 7.39 7.40

Sep-10 Aug-10 MoM bps

6M KIBOR % 12.92 12.83 0.09 14.19 12.76 12.37 12.60
12M T-bills % 12.86 12.72 0.14 11.79 12.15 12.38 12.95
10yr. PIB % 13.36 13.33 0.03 13.42 11.99 12.84 13.50

Banking Sector ^ 8-Oct-10 8-Oct-09 YoY

Currency in circulation PKR bn 1,441 1,264 14% 982 1,152 1,295 1,399
Money supply PKR bn 5,813 5,143 13% 4,689 5,138 5,777 6,355
Deposits PKR bn 4,671 4,133 13% 3,839 4,120 4,775 5,253
Advances PKR bn 2,934 2,864 2% 2,669 2,917 3,009 3,159
Investments PKR bn 1,822 1,553 17% 996 1,349 1,823 1,969
Pvt. Sector credit PKR bn 2,947 2,826 4% 2,888 2,907 3,019 3,110

Price Indices Sep-10 Aug-10

CPI % 15.70 13.2 12.0 20.8 11.7 16-17
SPI % 19.10 16.2 14.2 22.7 13.2
WPI % 21.50 19.2 16.4 18.2 12.6
* Budgeted expected for FY10 & 11
~ Monthly average, Jun-end for annual numbers
^ Stock at period end

5
 Animal Spirits
October 2010

Economic Snapshot
Reserves USDbn Fiscal account PKR bn 6 Months Kibor, 10 Year PIB & T-Bills
18 Revenue Expenditure Deficit 10YPIB 12MTB 6MK
1,200 - 14.0%
17
1,000 (50) 13.8%
16
(100) 13.6%
15 800
(150) 13.4%
14 600
(200) 13.2%
13 400
(250) 13.0%
12 200 (300) 12.8%
11
- (350) 12.6%
10
1QFY09

2QFY09

3QFY09

4QFY10

1QFY10

2QFY10

3QFY10

4QFY09

20-Oct

21-Oct

22-Oct

25-Oct

26-Oct
Jun-09

Aug-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Aug-10

Oct-10

Inflation USD PKR Rates EURO PKR Rates

CPI WPI SPI 87 130
NFNE
40% 86 125
35% 85
30% 120
25% 84
115
20% 83
15% 110
10% 82
5% 105
81
0%
100
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
May-10
Sep-10

80
Jun-09
Jul-09
Aug-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Jun-09
Jul-09
Aug-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10

Trade Balance USDbn Remittances USDbn Current Account Deficit USDbn

FY10 FY11 FY10 FY11 FY10 FY11
- 3.00 0.6
2.65 0.45
Sep Jul-Sep
(0.50) 2.33 0.4
2.50 0.17
-0.60
(1.00) -0.78 0.2
2.00
(1.50) 0
1.50
Sep Jul-Sep
(2.00) 0.92 -0.2
1.00 0.8
(2.50) -0.4
0.50
(3.00) -2.77 -0.6
-2.97 - -0.59 -0.55
(3.50) Sep Jul-Sep -0.8

Yield Curve
26-Oct-09 26-Oct-10
15%

14%

13%

12%

11%

10%
ON 1M 3M 6M 1YR 3YR 5YR 7YR 9YR 15YR 30YR

* Reserves as of 15-Oct-10