Think of a Zebra

Did Pakistan’s financial sector reforms introduce in early 1990s fall short of their objective? Was there a problem in their design or implementation; was their success marred by an unhelpful macroeconomic environment; or did the delays in structural reforms in other sectors of the economy (fiscal and debt, for instance) prove to be the barrier to success?

These are some of the questions that the economists at the State Bank of Pakistan have attempted to answer in their recently published paper (SBP Staff Note 03/17). Titled, “Bank Credit to Private Sector: A Critical Review in the Context of Financial Sector Reforms”, the paper makes an honest assessment that the credit momentum of 2004-2007 was lost not merely because of the exogenous factors, but because of incomplete reforms.

“Essentially, the reform process was found wanting on some key dimensions, mostly on account of unintended consequences, implementation gaps, and improper sequencing of interventions,” Asma Khalid and Talha Nadeem, the paper’s co-authors wrote.

These include the overlooking of the inclusion dimension as improvements in depth or banking inclusion (especially the liability part) was simply assumed to be “almost a certain outcome” of financial reforms. The reality was quite the contrary. Delayed enactment of non-judicial foreclosures, and weak implementation of the foreclosures laws in general had also prevented private credit from taking off.

Similarly, the sequencing of reforms also backfired. Thus “while it might be true that rationalizing the profit structure of NSS in line with the banking sector did lead to re-intermediation of bank deposits, its impact on private credit was sizably offset by an increased recourse of government borrowing from the banking system,” the authors wrote.

While these and many other reasons cited by the authors may be true, these are also the usual suspects; problems which Pakistan’s economists’ community has long known, researched, commented and critiqued upon. There may be other reason as well; a matter that is not well researched: and that is the nexus of taxation and private credit.

The staff note in question did allude to this. The authors wrote: household savings in Pakistan “are mostly in the form of physical assets like livestock, gold, hard cash, and real estate; the culture of financial savings has failed to catch on in the country over the years.”

There may be many reasons behind this phenomenon. But one of the main reasons is also the fact that many people avoid financial savings to avoid becoming a part of ‘the system’ because their earnings are through ill-legal means or they are not fan of paying taxes even if the business or trade they are in is completely legal.

Unless the state fixes this problem, people will continue to park their money in real estate or gold or bearer certificates, leaving the pool of formal financial savings at an inadequate level. Merely fixing the awareness problem, or increasing the return or incentives on formal financial savings, or lowering the cost of financial savings will not lead to the ballooning of formal financial savings to the desired level. Efforts have to make to divert the flow of money from Panamas within the state of Pakistan (real estate, gold etc,) to formal financial savings.

Another area the economists’ community needs to dwell on is to explore whether boosting private sector credit is the only way forward for development. Increasing credit to private sector is not the ultimate aim in itself; it’s about making financing available for investments. Could there be another model?

The varieties of capitalism approach tell us there are other forms available, of which Germany is one such example from within a broad classification of coordinated-market economies (which also include France and Belgium). Financing through stock market or via box standard private sector credit through banks in Germany is one of the lowest compared to its peers in the developed world.

Instead, because of the nature of the industries in Germany or coordinated-market economies in general, firms in such economies have concentrated financing structure since they pursue strategic business interests, so much as that even banks in these economies tend to view their shareholdings as a mechanism to safeguard their loans and build business relationships with companies rather than as a direct source of income.

Quite naturally, therefore, the labour market and corporate governance structures in coordinated-market economies also differ from that in liberal market economies such as the US, UK and Canada. (See BR Research column published on June 9, 2016 “Finding the right corporate framework” for more discussion on varieties of capitalism).

This column is not making a claim that tomorrow onward policy wonks must start following the German or other coordinated-market economies model. But blindly following the mantra of the multilateral-led Anglo-Saxon world is be a part of the problem. When you hear hoof beats, must you always think of horses or donkeys; sometimes it may be a Zebra.