FOREIGN investors have pumped a robust $285 million into the Pakistani equity market in fewer than five months of the current calendar year.

They are therefore regarded as the leaders of the unprecedented rally at the Karachi stock market, which has seen the benchmark KSE-100 index crash through the 21,000-point barrier, and the paper value of corporate Pakistan surpass the Rs5 trillion-mark.

Foreign inflows have been driven by the desire to reap higher gains. In 2012, the KSE produced a return of 49 per cent, and the equity market has already gained 25 per cent in 2013 to-date.

It is all due to attractive valuations of Pakistani stocks and healthy yields that the foreign portfolio inflow (FPI), which stood at $126 million during the full year 2012, fades in the face of the swift overseas investment in country’s bourse this year.

Yet, many market participants complain that foreign investment in the Pakistani stock market, which equals just 0.5 per cent of the market capitalisation of Rs5 trillion, is significantly lower than that in regional peers such as India, Philippines, Vietnam and Taiwan. Foreign fund managers have taken a comparatively much larger stake in the Indian equity market, where it amounts to 2.3 per cent of the market capitalisation of the Mumbai bourse

But there is hope of a consistently heavier entry of offshore funds in the Pakistani capital markets. An analyst at a local brokerage firm points out that the global ratings agency, Standards & Poor’s, has hinted at downgrading the Indian market, which could induce foreign fund managers to divert a bigger portion to the Pakistan market while slicing a share of the portion destined for the equity market on Dalal Street

Although the Pakistani market could also qualify for larger overseas investment on the basis of lower multiples and higher yields, there is one disconcerting point: the pressure on the rupee. A stock broker said that some of his old foreign clients were reluctant to seek entry into the equity market until they were sure of the stability of the currency.

“No one putting their money in dollars wants to make an incalculable loss,” he said. But he also offered comfort by saying, “The public is pinning hopes on the new government to revive the ailing economy and stabilise the currency. If that happens, foreigners will take heart, and even newer foreign funds may venture into the country’s capital market”. Some of the major international funds currently directing their flow of money into the Pakistani equity market include Templeton, Goldman Sachs, BlackRock, and HSBC Asset Management.

A prominent economist suggested that there was only one major reason for the faster flow of money from rich economies into emerging markets: monetary easing, or printing of currencies, by EU and US central banks. An excess supply of dollars and euros, unable to find enough investment opportunities within their home territories, flows into stock markets of developing countries such as Pakistan. They help shore up their foreign exchange reserves and the value of their national currencies.

Muzzammil Aslam, managing director at Emerging Economics Research, concurs. He says that as the economy travels from recession to recovery, equities, as an assets class, gain prominence as investors look for higher yields. Entry into equity means some shift from the bond market.

But how important is the dollar inflow in the equity market for the country’s economy? Economist Muzzammil argues that FPI helps shore up the country’s foreign exchange reserves and assists in easing external account financing.

Arif Habib Limited analyst Khurram Schehzad says that FPI, unlike Foreign Direct Investment (FDI), provides immediate support to foreign exchange reserves and gives muscle to the central bank in managing the currency market. The dollar inflow, he affirms, provides some stability to the rupee.

Yet, a well-known economist points out that FPI is regarded as ‘hot money’ or ‘smart money,’ since it can exit as quickly as it enters. ‘Hot money’ usually originates from the capital rich, developed countries that have lower interest rates, he says. Although the specific causes of hot money flow are somewhat different from period to period, he identified sustained decline in interest rates in highly developed countries as a major reason. High investment yields in developing states attract investors.

The general trend towards international diversification of investments in major financial centres and growing integration of world capital markets is thought to be yet another reason for the inflow into emerging and frontier markets, like Pakistan.

Professor Ahmed Subhani, who teaches economics at a local business school, says several studies have suggested that the motivation for investing in emerging stock markets comes from their high growth potential and low correlation with developed markets. Modern finance theory suggests that an internationally diversified portfolio offers a higher risk-adjusted-return performance than a portfolio composed of only domestic assets.

He also observed that investing in emerging markets is interesting for several reasons. Firstly, emerging markets are characterised by a very low correlation with other markets of the world. Secondly, the rates of return of emerging stock markets have been found to be higher than those of developed markets, thanks to high potential of economic growth that transforms into corporate earnings and dividends.

“Yet, the political risk, liquidity risk and monetary risk significantly affect the willingness of foreign investors to invest in emerging markets,” the economist affirmed.