A three-member team of State Bank officials was in Dubai last week to explore the possibility of investing $750 million in international bonds market.

The members included Deputy Governor Tawfiq A. Husain (who led the team); Foreign Exchange Advisor Zafar M. Shaikh and Executive Director of Foreign Exchange and Debt Management Department Farhat Saeed.

There is no official word on the outcome of the meetings that the central bankers had with the fund managers in Dubai. But senior bankers well-versed with fund management say that the SBP can hardly come upon a suitable mode of investment at a time when the world markets are in recession.

What makes it all the more difficult are some key conditions that the SBP has reportedly set for investing $750 million in global bonds market.

The first condition is a hundred percent guaranteed access to the principal amount of investment. In other words the SBP is looking for such a bond that gives it the right to make premature withdrawal of the principal amount.

The second condition is that the SBP wants placement of funds only through triple A-rated investment banks. The third—and perhaps the most difficult—condition is that the SBP wants to have the right to borrow in foreign currency against the bonds upto 95 percent of their face value.

To top it all the central bank is initially looking for only US-dollar denominated fixed income government (sovereign) bonds.

“The conditions that the SBP has attached to its investment plan are too tough,” says treasurer of a leading foreign bank. “It is possible that the SBP may find a triple A-rated bank for making investment but then the yield will be too low as these banks offer below LIBOR interest.”

“Secondly it is difficult to find a respectable sovereign bond that guarantees access to principal amount and also offer a good return.”

Currently one-year LIBOR [London inter-bank offered rate] is a few basis points below 2 percent.

Senior bankers say the State Bank will have to accept a very low yield (two percent or less) if it goes for sovereign bonds of strong economies.

And if it wants a higher yield than it will have to go for sovereign bonds of such economies as Nigeria or Egypt or Iran or Lebanon. Nigeria is offering six percent yield n its 20-year bonds.

The other three countries are also offering almost the same rate but certainly their bonds cannot be a good choice for the SBP as it is focussed more on the access to the invested fund rather than the yield.

Since the US interest rates are at historic lows the SBP also cannot get a decent return if it makes investment in US bonds market. The European markets can offer similar or a little better interest rate but the difficulty here is that the State Bank is interested in investing foreign exchange only in the US- dollar denominated bonds.

This poses an even bigger problem: To make investment in the bonds denominated in non-dollar currencies the country needs that particular currency in the first place.

Take for example the case of euro. If SBP decides to invest in euro-denominated funds than it will have to convert $750 million in euros before doing that.

Now if the euro falls from its current level than the SBP will incur a loss. The same holds true for other non-dollar currencies like pound sterling and Japanese Yen.

Seen in this light the SBP decision to initially go for the US denominated bonds seems quite logical.

Top bankers say investing $750 million in sovereign bonds may prove difficult also because the SBP will find it near impossible to ensure premature liquidation of the bonds purely on commercial considerations. “When it comes to a country investing in other country’s bonds diplomatic considerations overshadow commercial feasibility,” remarks a foreign banker.

“And expecting a 95 percent repo facility against a sovereign bond is not very easy—particularly not in case of the sovereign bonds.”

Bankers say since currency market has been very volatile for some time and since the equity bonds and debt bonds are not very lucrative at the moment the options available with the SBP for investing $750 million becomes all the more limited.

So they can see reason in the SBP decision to invest initially in sovereign bonds.

Apart from whether the SBP finally selects some gainful investment or not, some central bankers believe that the SBP should focus more on sustainable development of foreign exchange market rather than worrying about how to employ a friction of forex reserves profitably.

Currently Pakistan has some $7.5 billion gross liquid foreign exchange reserves including $2 billion plus held by the banking system.

An investment of $750 million or 10 percent of it in the bonds market may not raise the State Bank’s earnings throug foreign exchange by a handsome margin.

“Suppose the SBP is able to increase the net return on $750 million by a maximum two percent (the chances for which are very remote) how much the SBP will gain—only $15 million,” says the head of treasury of a major local bank.

“I believe there are so many other ways of earning this $15 million—if at all the central bank is bent upon making more money through forex reserve management.”

Many bankers believe that the risks the SBP will ultimately have to take in investing $750 million to earn an additional 2 percent return on it will nullify the $15 million gain every year.

“Translated into rupees $15 million comes to Rs 900 million. Subtract from it the fund managers’ fees and other expenses and you get a very small amount—maybe not more than Rs 500 million,” says treasurer of a major local bank.

“Now if at all the State Bank wants to make more money it can do so by lowering the interest rate by one percent and saving more than a billion rupees?” he asks.

A one percent cut in interest rate is supposed to lower the domestic debt servicing of the government by several billion rupees as domestic debt currently stands at Rs 1700 billion and the cost of servicing this debt comes to roughly Rs 170 billion. A one percent cut in the interest rate structure would naturally save Rs 1.7 billion.

“Besides there is always room for making money—if the SBP so desires through purchase and sale of foreign currencies into the market,” he says meaning that the SBP can buy cheap dollars from fthe banks when there is excess supply and sell the same at a higher price when the market is short.