September 10, 2019 (MLN): The US dollar liquidity remained one of the important aspects of connectivity in domestic financial markets in CY18.
Forex market developments have affected equity market through lower dollar adjusted returns on foreign investment and rising inflation (exchange rate pass-through impact), a report on Financial Stability Review by State Bank of Pakistan said.
Pursuant to the further details provided by the report, the lower dollar adjusted returns resulted in net outflow of foreign portfolio investment exerting pressure on equity market and exchange rate.
With rising inflation, SBP increased its policy rate, which in turn translated into higher lending rates thereby increasing cost of borrowing for the corporate sector. Resultantly, increased financial expenses undermined corporate earnings and added to selling pressure in the equity market.
Also, rising yield in money market instruments (treasury bills) concomitant with falling stocks prices triggered investment flows towards money market funds from the equity market. The link between forex and money market is also reflected through forward premium.
Rising interest rates in the domestic market –relative to the interest rates in foreign markets—should make up higher forward premium in forex swap transactions. However, despite notably higher interest rate spread, forward premium during H2CY18 remained squeezed due to the dearth of dollar liquidity coupled with expectations of PKR depreciation in the domestic market. However, the latter doesn’t hold anymore as PKR is now being determined by the market forces.
To conclude, US dollar liquidity has played vital role in explaining the behavior and inter-connectedness of financial markets during CY18.