Rupee volatility hinders Pakistan’s startup funding

KARACHI: The sudden yet short-lived US dollar surge following Donald Trump’s victory in the Nov 5 US elections has once again rung alarm bells for currency markets in Pakistan, a country that is still recovering from its economic crisis that deepened in 2022 right after the vote of no-confidence that saw the country’s now-incarcerated former prime minister out of the office.

The sharp depreciation of the rupee then touched almost all industries, but one industry that was hit hard by these fluctuations is startups.

A report by Data Darbar, a website that provides insights into Pakistan’s tech sector, titled ‘Tech and VC Landscape Pakistan 2023’ uncovers the tumultuous period for startups here: “In 2023, 97 unique investors participated across deals in Pakistan, versus 209 the year before. Of this, just under half, 48, were new, which again is significantly lower than 103 in 2022.”

The report adds: “In line with the global trends, deals in Pakistan have also become much smaller. The average ticket size slipped to $2.2 million in 2023. This represents a 64.2 per cent decline from $6.3 million the year before.”

Keeping multiple global trends aside, how much did the rupee devaluation factor affect Pakistan’s funding landscape? Pointing to the sharp decline of the rupee in January 2023, when the currency depreciated around 9.6 per cent against the dollar in a single day, co-founder of Data Darbar Mutaher Khan says that the 2023 devaluation was a “serious hit” to the economy. “Before that,” he adds, “the five-year average depreciation was around 6-7 per cent.”

The rupee fell 20 per cent against the dollar in the interbank market in calendar year 2023. In absolute number, it dropped by Rs55.43 to Rs281.86 per dollar in 2023 from Rs226.43 in 2022.

The rupee factor comes in when investors convert the performance of startups here in dollar terms. Mutaher adds that if an investor wants to invest in a company whose revenue is, say, around $1 million, the rupee devaluation impedes local companies’ ability to reach the threshold. “If, say, we had 50 companies with $1 million revenue, the sharp rupee devaluation would kick out most companies from this pool, leaving only a handful of companies, say 20, behind.”

‘Patient capital’ and ‘dollarised returns’

Startup Lawyer and Founder of Carbon Law, a law firm that specialises in commercial and legal advisory for startups and investors, Mubariz Siddiqui says that “rupee devaluation presents a special kind of risk to any business in Pakistan that is trying to raise or that raises capital from foreign investors.”He says that investors here have dollars, and they look for an “x” per cent return on their investments. “In the short term, the [rupee] fluctuation is not so bad, and most investors do not have to worry about it.” The problem, per Mubariz, arises when an investor makes a long-term plan. “If an investor is looking at the company’s five- or seven-year growth, this is where the investor meets with uncertainty regarding the rupee value.”

This makes investors cautious of their investment choices. Mubariz adds, “the investor will have to see that the return on investments is a) profitable and b) large enough to offset the effect of any devaluation.”

If an investor looks at a company’s 10-year growth plan, s/he factors in rupee devaluation. “Investors have concerns about rupee devaluing by even 100 per cent.” In that scenario, a business will have to double in value to hit breakeven. Mubariz says that on top of maintaining their initial investments, the investors will have to worry about “inflation and return when projecting a business’s long-term growth. This makes investors invest in businesses that can provide ‘extraordinary’ returns, or else the investor will risk losing the amount of investment.”

This, according to Mubariz, makes it harder for businesses in Pakistan to secure ‘patient capital’. “Most industries are built on patient, or long-term, capital. They are not reliant on capital that comes in and flies out quickly.”

Uncertainty around rupee devaluation ends up preventing Pakistani businesses from attracting the best long-term patient investors or long-term patient capital because of which we cannot build sustainable businesses here, Mubariz adds.

Mutaher calls it ‘dollarised returns’ and says that the rupee’s decline affects a company’s ability to meet growth targets set by investors in USD. “Investors will then not be interested in coming here.” But he also thinks that even if devaluation was not a concern, attracting investors would still be a challenge. This he places on the global trends where most startup markets have shown a decline. At present, the Middle East is a lucrative market for startups, but this positivity is mainly because of the capital that Middle Eastern companies have, which they inject in their businesses, Mutaher explains.

The way forward

Former chairperson of the Pakistan Software Houses Association (P@SHA) Muhammad Zohaib Khan provides an overview of the challenges faced by the IT sector. He says currency fluctuations add “insecurity” among people to do business here. But he also adds that the problem is not limited to Pakistan. “We have examples of countries like Turkey and Hungary that went through a similar devaluation crisis.”

What makes Pakistan stand apart is the government’s reluctance to introduce the right solution to tackle the challenge. Zohaib adds, “In these countries, you may see circulation of euros and dollars in the market. In Turkey, for example, purchases can be made in foreign currencies in the retail market, with the Turkish lira having a low presence.”

He says that [IT experts] have requested authorities several times to let them create “100 per cent dollar retention accounts”. While there have been some improvements (50 per cent retention accounts), a lot is still needed to be done. “Many people from the IT sector park their earnings in foreign accounts because they want to keep their amounts safe against any disruptions in the currency market.”

All that is brought in Pakistan is the amount that companies use to meet their operating expenses. If companies are allowed to maintain their dollar accounts here, they will not have to worry about losing their asset value. Besides this, there are regulatory challenges that make it harder for businesses to make payments abroad -- this payment could be for anything, stalls at exhibitions, subscription fees, etc. All of this, per Zohaib, needs an overhaul.

In 2023, external financing gaps, challenging global financial markets, and local political instability badly affected foreign exchange reserves, building pressure on the rupee.

However, the reduction in the current account deficit, improved financial inflows supported by the International Monetary Fund’s $3 billion loan programme, and reforms in foreign exchange companies led to the strengthening of the rupee against the dollar since September 2023. As a result, the exchange rate has remained broadly stable since January 2024.

The rupee has appreciated almost 10 per cent from its peak of 307 in early September 2023, holding steady below 280 for over 10 months.

Zohaib also mentions tax laws that make Pakistan not so attractive for the local IT sector for maintaining deposits. “Even if we allow companies to maintain foreign currency accounts here, we charge them a high tax. A 10 per cent tax on withdrawals, for example, will keep investors away from bringing their earnings here, depriving the country of much-needed remittances.” He further adds that while the SBP has released circulars, prompting banks to introduce products for such repatriation, the implementation has been quite slow. Leniency in regulations and tax laws will make people bring money here and invest it in the domestic economy. Digitisation of transactions, Zohaib believes, could resolve much of the challenges that the IT sector faces, prompting businesses to park money in the country.