The economic literature suggests that credit expansion promotes economic activities through the efficient allocation of resources and higher output in turn also drives credit growth in the economy. SBP in its recently published annual report has devoted a section on this topic to explain the reasons behind the falling credit to GDP ratio in the country.
Credit to the private sector continued to grow between FY03 and FY08 when it increased from 18 percent of GDP (FY02) to 27 percent of GDP (FY08). However, since then it is on a southward journey and is down to 13 percent of GDP in FY15. The risk-free public sector financing has crowded out private borrowing as overall credit (Including private sector and government borrowing) has ranged from 34-42 percent of GDP in 2002-14 and the ratio was above 40 percent in FY13 and FY14. This implies that the overall pie is marginally expanding but incremental lending is primarily in the public sector.
What SBP missed an analyzation of the credit situation in the 1990s and its extrapolation in the 2010s? According to a study by Asim Khwaja and Atif Mian (April 2005), public sector banks’ lending was plagued by rent seeking of politically associated firms. During 1996-2002, political firms borrowed 45 percent more and had 50 percent higher default rates. The findings were intuitive that the political rent seeking increased with strength of firms’ politicians and was confined to government-owned banks.
The research was on the dot however this trend has changed after the deregulation of the banking sector and privatization initiated by technocrats under Musharraf regime in 2003. Now the majority of banking segment is in private sector and no more political firms are having loans for willful default. That is why private sector credit picked up in 2003-08.
However, with the return of democratically elected governments, the political elite found a new method of extracting rents with no default risk for private lenders. The losers are tax payers of Pakistan – the abuse has become more obscure. The model is tweaked; instead of not repaying individual loans (in 90s) and causing losses to government-owned banks (in turn to tax payers), the abuse may have moved to the central budget. And it has become difficult to track political favours extended from the large pool of fiscal budget compared to individual NPLs of public sector banks.
Had the government borrowing deployed for effective and efficient development projects it would have induced private investment. According to SBP’s report, the correlation coefficient (2000-14) of public and private investment is very low in Pakistan (0.4) as compared to India (0.9).
The capture of credit by political elite or inefficient allocation by government is one aspect of low credit availability to the private sector. The second leg of the equation is that the overall credit pie in Pakistan is too small. In 2014, the Indian central government’s borrowing was 24 percent of GDP which is marginally less than 27 percent in Pakistan. However, the credit to private sector in India was 52 percent of GDP as compared to a meager 13 percent of GDP in Pakistan.
Thus the overall credit was 76 percent of GDP in India as compared to 40 percent at home. The need is to explore why the credit is so low in Pakistan. SBP did not explain that national savings in Pakistan in GDP terms are almost one-third of those in India. The deposit to GDP ratio is also too low in Pakistan.
In 2008, only 11 percent of adults in Pakistan had bank accounts; now this proportion has increased to 16 percent, while including M-wallet, NSS, pension and other services the ratio increased to 23 percent. The access to finance is miserably low with only 2.4 percent of the adult population using formal channels of financing for consumer finance. The financing structure of Pakistan is based on collateral-based borrowing and its recipients are only big names. The share of large-sized borrowing (Rs10 million or more) is more than 80 percent while such borrowers are less than two percent. The skewed distribution of credit was similar ten years ago and so far financial inclusion has not changed the borrowing profile in the private sector.
Taking government borrowing out of the equation, there are two issues. The first is that both the base and size of deposits are too low. Secondly, whatever is available for lending is only for big ticket size. The low financial penetration is partially attributed to the informal economy which is evident from the fact that broad money (money in formal system) as a percentage of GDP is quite low at 41.2 percent in Pakistan as compared to 62.7 percent and 76.7 percent in Bangladesh and India, respectively.
Within broad money, the higher the currency in circulation (cash out of the banking system); the bigger is the informal economy. It is at 9.4 percent of GDP in Pakistan which is the second highest in the region after India (10.6%). However, in India CIC to deposits ratio (15%) is half that in Pakistan (29%) which implies that money flying out of the system is at double the pace in Pakistan than in India.
The problem of access to credit for big borrowers is attributable to the lazy attitude and low-risk appetite of banks along with poor foreclosure laws and lengthy judicial procedures. While the private sector’s lack of interest towards borrowing could be attributed to higher real cost of borrowing – in 2012-14 the real cost of borrowing in Pakistan was 5.5 percent as compared to 3-4 percent in India, Sri Lanka, Malaysia and Philippines.
But that is not the sole reason as the real cost of borrowing in Bangladesh is higher than Pakistan yet its credit to private sector was over 40 percent of GDP in 2014 as compared to 13 percent of GDP at home. In Bangladesh, 88 out of 1,000 adults borrow from commercial banks while in Pakistan 25 out of 1,000 borrow. In case of firms, only 10 percent of firms use banks to finance investment in Pakistan while it is 20, 30 and 42 percent in Bangladesh, India and Sri Lanka, respectively.
There are a few issues such as energy shortage and poor law and order which had adversely affected Pakistan relative to peers however these are not enough to explain the low and selective financial penetration which predates the energy and security problems. The need is to identify the market failures and try to plug in the holes by necessary regulations, incentives, literacy and capacity building.
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