LAHORE:
Financial globalization has facilitated the flow of capital between countries. Financial capitalists continue to look for profitable opportunities to make a quick buck. They borrow in a country where the policy rate is low and invest in a country where the policy rate is high, provided the exchange rate remains fixed. In terminology, this is known as carry trade.
Carry trade is taking place around the world, where differences in policy rates provide profitable opportunities for investors. For example, the policy rates in USA, Australia and Europe are 5.5%, 4.35% and 4.25% respectively, while the policy rate is around 19.5% in Pakistan.
Since the exchange rate has stabilized in the last six months, investors have started investing in Marketable Treasury Bills (MTBs) in Pakistan. The Special Convertible Rupee Account (SCRA) reported a net positive inflow of funds in August 2024, which attracted the attention of the business media.
Foreign institutional investors funnel capital into a country where there is a reasonable interest rate differential along with a stable exchange rate. The rupee-dollar rate has been hovering around 280 since January 2024, which has restored the confidence of these investors to park their capital in MTB.
The business press will welcome this development and favor net capital inflows. A general view is that these inflows will bring valuable dollars into the country, which will boost foreign exchange reserves.
In case imports of goods and services are curtailed, these inflows will stabilize the rupee-dollar exchange rate. Additionally, foreign exchange reserves, held by the State Bank of Pakistan (SBP), hover around $9 billion as of March 2024.
The costs associated with capital inflows are barely highlighted and discussed. These flows are temporary to the extent that some institutional investors complete a trade within a month. They invest and withdraw their capital as soon as possible to make a profit.
Such inflows are costly for developing countries, as they amount to high-cost borrowing. The State Bank of Pakistan (SBP) will suffer a loss as it will use the domestic policy rate to acquire dollars, while foreign institutional investors will gain by borrowing at a low policy rate and investing at a high policy rate.
The gain for the foreign institutional investors will offset the loss for the SBP. This loss reduces SBP’s profits, which are recorded as non-tax revenue from the government.
Capital inflows also affect the rupee-dollar exchange rate and appreciate the value of the rupee. This appreciation provides further gains to foreign institutional investors. Along with the difference in policy rates, they also have the benefit of the cheap dollar. Hence, exchange rate appreciation acts as icing on the cake for foreign institutional investors.
Capital inflows also affect industry restructuring. The appreciation of the rupee makes adjustment of the domestic industry quite difficult. It becomes difficult for the industry to re-orientate towards exports in the presence of appreciating rupee.
In addition, the appreciation of the real exchange rate also affects the competitiveness of existing exporters. Capital inflows promote consumption in an economy as they relax foreign exchange restrictions. Cheap dollars encourage luxury imports, which satisfy the desires of those people willing to pay. This will increase the cost of imports into the economy. Hence, the increase in imports becomes faster than the increase in exports.
In short, carry trading is an integral part of financial globalization. Macroeconomic stabilization policies create variations in policy rates, which, in turn, promote carry trade.
Considering the costs associated with this trade, there is a need to monitor and regulate it. Last but not least, idle policy could destabilize the economy in the medium term.
The author is an independent economist, who worked at SDSB, Lahore University of Management Sciences (LUMS)
a href=”https://tribune.com.pk/story/2492784/financial-globalisation-and-carry-trade”>Source link
