Macroeconomic and financial policy framework: budget formulation for 2007/2008

Being the text of key note address of the Governor, State Bank of Pakistan, Dr Shamshad Akhtar, delivered at a seminar on "Budget 2007-08 - A Milestone in continuation of Economic Reforms" organised by the Press Information Department, Government of Pakistan in Karachi on Friday.
Budget for this fiscal year is being crafted under a new economic paradigm. Pakistan has now for some years achieved:
(i) Sustained economic growth path as confirmed by the recently released National Income Accounts Committee results with FY05 being a record year where real GDP grew by 9% and FY07 will surpass the growth target of 7% as the numbers firm up.
(ii) A fair degree of macroeconomic stability and the emerging fiscal and external imbalances while higher than FY03-04 have been well contained with appropriate policy responses.
(iii) Both public and private sector have now managed to jolt the stagnating investment levels which have now risen over FY05-07 by an average of 30.0% which has helped to finally raise the investment/GDP ratios by few percentages points of GDP.
(iv) Gradual building up of investor confidence which has yielded positive outcomes both in terms of higher remittances and foreign inflows. The greater non-debt creating inflows have, for the fist time, helped finance our external account deficit while meeting our corporate and development requirements.
(v) Higher levels of employment generation and poverty alleviation programmes coupled with social spending of higher magnitudes is helping broadly improve the population welfare.
Building incrementally on a strong base and performance is always harder than lifting the economy from distressed strait. This challenge is further compounded by some of the other emerging economic and political realities which underscore the need for the budget to be well conceptualised and well balanced.
-- First, budget is being formulated in a way that it reinforces the macroeconomic stability which is critical to maintain economic growth track record.
-- Second, there is a recognition that public expectations are rising from the government both in terms of its leadership to rationalise the resource and incentives allocation mechanism while offering the right transfer of resources and blend of services.
-- Third, public resources constraints are a reality and will serve as an eventual binding constraint - ultimately budget making process is all about achieving the desired balance between the resources available and resources allocated.
-- Fourth, there is a continuity, consistency and coherency in economic and financial policies which have to be further broadened and deepened to allow for foreign and domestic private sector to further thrive in Pakistan while playing a yet more distinct role in diversifying Pakistan's industrial base and in delivering public services.
-- Finally, there is a recognition that public aspirations are rising partly because government has set a strong track record of economic performance in preceding years and partly because gaps in social and economic services continue to exist.
MACROECONOMIC POLICY FRAMEWORK AND ENVIRONMENT The National Economic Council in its meeting on 31 May 2006 has now approved the macroeconomic framework for FY08 while also in principle approving a long term Vision for 2030. Given the track record in recent years, the government is confident that the growth momentum will be maintained for FY08 and real GDP is projected to grow by 7.2%.
Growth is likely to be again broad based and will be stimulated by a further rise in both consumption and investment levels. While consumption expenditures have been undoubtedly a driver of economic growth in Pakistan as in a lot of other countries, growth in investment/GDP will also contribute significantly to economic growth.
This is largely because we expect investment to rise from 21.9% of GDP in FY06 to about 23.8% in FY08 supported by a rise in national savings and more significantly a rise in domestic savings which are expected to increase from 15.4% in FY06 to about 17% in FY08.
Underlying this growth scenario, we need to recognise that Pakistan has and will continue to seek for a quantum jump in investments. On one hand, the government plans to further go for a substantially large Public Sector Development Program to the tune of Rs 724 billion - which includes budget supported development program of Rs 485 billion and another Rs 204 billion being financed outside budget by a number of public entities.
The development program is quite strategic and fast tracks the projects under implementation as well as launching the mega infrastructure projects, while allowing for adequate growth in social investments.
Concurrent to this, Pakistan has now for some years succeeded in starting to unleash potential of private sector. It is important to recognise that private investment in Pakistan has now for some years been very buoyant and robust. In FY05-07 private investment grew by more than 30 % and has accounted for almost three fourths of the overall investment levels.
At current market prices, private investment levels for FY08 are assumed to grow to Rs 1651 billion which translates into $27 billion and 16.5% as a proportion to GDP (one percent of GDP above FY05 level), 2.8 times of the level of public investment and once again three fourths the level of total investment.
While achieving public investment levels would require a more distinct growth in revenue/GDP ratio, growth in private investment will need to be supported by improved financial intermediation and continued reliance on foreign direct investments.
I will revert to these aspects later but would like to first highlight that FY08 will be another year where maintaining fiscal and external current account deficit will be critical. On fiscal side, the government has reiterated its resolve to hold fiscal deficit/GDP to 4% of GDP and balance of payment projections consistent with the growth scenario outlined above will be in the range of 5% of GDP close to FY07 level.
As in FY07 there will be need for the government to adhere to Fiscal Responsibility and Debt Limitation Act, 2005 to reduce its revenue deficit and debt/GDP ratios and for central bank to continue to strengthen monetary management to keep a check on the demand pressures stemming from fiscal and external accounts deficits.
On the former, the government expects to reduce total debt/GDP ratio to 51.1 % by end FY07 and to use the proceeds of privatisation for poverty reduction programmes.
The monetary policy framework, like in the past years will be forthcoming as a part of the Monetary Policy Statement released end July, which is worked out after the budget for FY08 has been finalised. However, there has been intensive consultation between SBP and the government regarding the need for more consistency between the budget and monetary policy framework.
In line with the SBP Act Section 9(A), central bank has now institutionalised the process of determination of level of government's recourse to bank borrowing and its approval by the Central Board of SBP. This is the first time that as a part of the budget making process, SBP worked out different scenario's to assess the monetary implications of budget's financing requirements. There is a good recognition that upfront fiscal and monetary coordination will augur well for managing the inflationary pressures for next year.
A few important understandings are being reached in this arena to introduce fiscal discipline in borrowings:
-- One, there is recognition of the need for formally imposing a ceiling on government's recourse to SBP borrowings.
-- Two, there is need to manage better the monthly and quarterly recourse to bank borrowings.
-- Three, the government and SBP will work towards reducing its stock of bank borrowing.
-- Four, the government will continue to change its mix of domestic borrowing by relying on public and commercial bank borrowings rather than SBP borrowing.
Finally, there will be better planning for resource raising from the market to sequence the domestic and foreign borrowings more effectively. While levels and degree of dependence on SBP borrowings will be reduced most likely in a phased manner, in FY08 we will be striving to set on course a better institutional framework and process for fiscal and monetary coordination.
These and other qualitative improvements in monetary management being brought out in-house by SBP will help it to work with the government to achieve inflation rate target of 6.5% contemplated in the macroeconomic policy framework.
Progress in reduction of inflation rate has been steady, albeit slower than original targets, but the decline in core inflation which is hovering below 6% is lending confidence that monetary policy will have the desired impact in bringing inflation down subject to, off course, improved supply management of food products as these items have contributed more significantly to inflationary pressures in FY07.
FINANCIAL MARKET'S STRATEGY Pakistan's financial markets have undergone a substantive transformation. Within financial sector, banking sector performance has been outstanding. Banking profitability now is likely to exceed $1 billion mark and the sector over the last few years has cumulatively attracted $2 billion with $1 billion raised in 2007. The ratio of NPLs to net loans is at all time low at below 2% and capital adequacy is on average around 13.5%.
Since a lot has been said earlier on this, in today's remarks I am going to confine myself to forward looking direction of financial markets. First and foremost, it is critical for Pakistan to further augment and diversify financial system.
Currently, while there is active secondary trading in stock markets, it is confined largely to fewer equity scrips and is supported in the last couple of years by exclusively banking companies and by the government privatisation program.
On debt market side, the government securities primary and secondary issuance of different tenors have helped evolve a yield curve but this has, as yet, not catalysed robust corporate debt market. Primary market both of equity and debt markets is still small and boosting this is essential to diversify the financial system risks.
The anticipated insurance sector and pension reforms, which would involve restructuring and strengthening state owned companies, enhancing the regulatory and risk management frameworks and move towards voluntary and contributory retirement schemes, would help enhance market liquidity.
Robust performance of the financial markets is essential to meet the growing requirements of private investment. Over the past few years banking sector has financed well the requirements of the corporate sector, households and economy at large.
However, there is a substantial growth envisaged in infrastructure financing requirements which over the medium term could be anywhere in the range of $40 billion and long term requirements could be close to $150 billion.
For the banking system to respond effectively it is critical that financial markets are diversified faster. Assuming 7% real GDP growth and the private sector credit/GDP ratio of 50%, banking sector would be at best be able to offer $100 billion credit to the system which, alone, would not be able to meet the overall infrastructure financing requirements of next five years.
To further augment banking sector roles and responsibility in economic development process, SBP has been working on multiple fronts:
Strengthening the banking sector consolidation through a gradual build up of the minimum capital requirements and M&As to further augment its robustness. By end of this year, most banks would have met the Rs 4 billion minimum capital requirements with 8 banks even meeting the December 2009 stipulated requirement of Rs 6 billion. Companies failing to comply with the capital requirements will be stripped off the scheduled banking license. Excluding Islamic and MFBs which have resulted in issuance of 12 new bank licenses; number of banks operating is now 27.
To Improve Financial Intermediation process by enhancing its coverage and lowering cost of intermediation. Holding consultation with the banks to explore how private sector credit/GDP ratio can be enhanced. This ratio currently is quite low in the range of 27% which is only one fourth of the prevailing ratio in regional comparators.
At the same time, there is need for banks to enhance outreach to increase the number of depositors and borrowers. SBP has now operationalized its Development Finance Group and it has developed Microfinance Strategy, SME financing Strategy, Agriculture and Household Credit study and another strategy on Islamic finance is also underway.
All these pieces of work will help strategize banking role in enhancing the coverage of financial services to provide adequate service to the population. With growing competition, it is anticipated that banks will be seeking scale rather than exploiting the existing client base.
This change will help in enhancing profitability by enhancing the coverage and supply of financial services rather than relying on interest rate increases. Strengthening the risk management framework for banks. Pakistani banks are now faced with new and different nature and type of risks - aside from standard corporate assets whose credit risks is changing with the size and complexities of businesses, banks are now engaging in diverse businesses and sectors and are now extending their exposure to household sector and growth in bank trading books has increased exposure to market risk - a recent phenomena in Pakistan.
Concurrently, banks' overall risk profile is also affected by the complex interdependencies now emerging because of cross ownership of financial institutions and corporate sector. By January 2008, commercial banks have been advised to position themselves for adoption of standardised approach to Basel II.
Changed perception and approaches to safety net for depositors and prompt corrective actions. With most banking system now in private hands, the government's implicit guarantee for deposit no longer exists and now the owners and the Board of Directors as wells as top management of a bank are liable for their actions. SBP has recently enhanced its corporate governance framework.
On one hand, recently new instructions have been issued to encourage banks to adopt a more well governed Board structure where there is a balance between family or sponsor members and the independent board members.
On the other hand, Boards have been advised to play a more substantive role in oversight of banks including by way of reviews of bank strategy, risk management and audit etc.
At the same time central banks surveillance system is being enhanced to play a key role in identification of the problems, eg threat to capital, liquidity crisis at the earliest stage, and execution of prompt corrective action - the objective being to curb the problem at the onset, and if required appointing official liquidators for settlement of depositors' claims in a timely manner, in cases where the corrective actions result in liquidation/restructuring of the bank.
SBP is in the process of developing a 'Banking Supervision Risk Assessment Model' (BSRA) which will help SBP to better quantify the credit and market risks of the individual banks in terms of "Value at Risk" and forecast banks' position under various stress scenarios on a quarterly basis.
BSRA model would use information from the Data warehouse (data received through Reporting Chart of Accounts (ROCA)) for market risk and electronic Credit Information Bureau (eCIB) for credit risk. For operational risk, key risk indicators (eg frauds, systems breakdown etc) would be identified and captured and processing would be carried out after a sufficient database is maintained.
Once fully implemented and live, the risk assessment model will help Banking Supervision Department to strengthen its surveillance system through monitoring and measuring the risk profiles of the individual banks, even under stressed scenarios. The model will also help BSD to understand and monitor the credit and market risk appetite of the individual banks and proactively take corrective measures, if required.
The SBP in collaboration with the ICAP and the commercial banks has facilitated adoption of International Accounting standards (IAS) by the banks. In 2006, SBP revised the reporting formats for banks to incorporate the significant regulatory developments as well as modifications in the International Financial Reporting Standards (IFRS). With these changes, the quality of disclosure in the Annual Accounts of Pakistani banks has become at par with international best practices.
Along with this, SBP plans to operationalize Real Time Gross Settlement Systems (RTGS) and to encourage faster connectivity of branches to headquarters and eventual proliferation of e- and mobile banking which will be key to enhancing coverage of financial services.