In this paper an attempt has been made to analyse the present and future directions of the banking sector in the overall economy of the country. At the outset, attention is drawn towards two major issues. It may be recalled that after the death of DFIs, the only institutions available are the commercial banks. This is because commercial banks were functioning and had been privatised by the time DFIs were closed or became dysfunctional. Although we're more aggressive in offering the financing being sought.
Commercial banks, by definition, have asset liability maturity mismatch. Just look at the deposit side of commercial banks, 85 percent of them have a maturity of less than one year, whereas they have to have an asset profile, which is not completely out of sync with the maturity profile of the liabilities. The other issue is that all projects with long gestation periods require three things; first, a stable political and economic environment; second continuity and predictability of government policies.
The third area is concerned with the development and functioning of capital markets, which is linked to the predictability of policies, the government's financial management strategy and its efforts to create a yield curve for its own instruments.
For a variety of reasons, the government has not been able to create a proper yield curve for its PIBs; 76 percent of government domestic debt is short term, partly because offer rates for PIBs in recent auctions were being rejected. So when there is no benchmark available for sovereign debt, it hinders the development of a market for long-term financing in the shape of a corporate bond.
It appears that there is a much greater degree of engagement between the Central Bank and the government. This may bear fruit. Recently the central bank has transferred the rights to accept offers in auctions to the Ministry of Finance, which may be an appropriate approach in the circumstances.
If the role of government was to recede, then one would observe a variety of developments that would facilitate the creation of a market for corporate debt. If the government is taken out of commodity financing, and if the government reduces its reliance on bank borrowing and prohibits institutional investors and pension funds to invest in the National Savings Schemes, new opportunities would emerge.
This will help to develop a body of corporate investors, seeking financing through corporate debt markets. For example, the government has raised commodity financing in excess of Rs 390 billion from scheduled banks. And more importantly, if the sovereign is borrowing for such operations at just under 16 percent, naturally the private sector will only be able to borrow at a premium.
The pace of growth of the economy is good, which would facilitate the creation of a market for corporate debt. On the other land, non-performing loans are on the rise, having reached Rs 500 billion. With this kind of risk profile amid heavy government borrowing from banking sources, not only are banks risk- averse, but also there is little appetite for long-term financing. Under such circumstances, it is going to be an uphill task, at least in the foreseeable future, unless the situation changes dramatically.
The major changes that are being proposed include: a) amendments in the Central Bank's Regulation; once they're in place, the bank will be adequately empowered legally to check government borrowings; b) a significant reduction in the government's fiscal deficit, through an effective implementation of a reformed general sales tax, which may enable the government to reduce its borrowing, and c) a pick-up in economic activities.
To summarise, the government's heavy borrowing is not helping the creation-of a market for the corporate sector to raise long term financing. The government has indicated its intention to change the tax regime and mobilise additional resources, it is hoped that it will be able to deliver the desired results.
Part of the reason for the slippage in the fiscal deficit is additional expenditure on security and flood-related rehabilitation. What needs to be seen is the extent to which the Federal and Provincial Governments will be able to adjust the deficit under such challenging circumstances.
Under the regulations, the Government of Pakistan needs to offload the stock of Central Bank's lending in five years, from the date of enactment of new legislation. For example, the stock of MRTBs on the date the new regulation is enacted stands at Rs 1,355 billion. After the enactment of new law, the stock may touch Rs 1.5 trillion. That will place a huge demand on the financial system and managing it will be a challenging task.
At the time the new legislation was being drafted, the borrowings were lower. Now the stock has piled up. Hence, government will have to manage liquidity without seriously crowding out the private sector, it is a formidable challenge.
In the last monetary policy statement, it was stated that since the government raised less money than the targets under the announced auction, despite higher participation compared to the previous T-Bills auctions, the fact added unnecessary pressure on the government's borrowings. One cannot fix both quantity and price simultaneously. The government has, however, raised more than the target in the most recent T-Bills auction.
The first test of institutional linkages stands cleared as the government has met its T-bills target in the recent auction. If the role of government recedes, the market can probably attract venture capital firms rolling in. Much of it also has to do with greater political stability, improved law and order conditions and the predictability of government policies, lack of which naturally forces economic actors to think in the short term. The lead has to be taken by the government by giving a long-term sustainable directions.
There is no denying that at the present level of interest rates, to create a market for housing finance is difficult. But there are other issues as well. For example, the provincial and local governments are required to ensure a decent system for title veracity, provide primary infrastructure to enable development of land for housing, in which neither the Federal Government nor the central bank has any role.
Then there is the question of the structure of taxation; stamp duties, property taxes, charges for commercial development, rent control laws, foreclosure, etc. Investors will not develop a property for rental purposes if they cannot get the tenant to vacate.
It is believed that the government is currently engaged with the International Corporation (IFC) on a mortgage refinance facility. The government is also trying to learn from the Indian model. It is learnt that discussions are being held with the IFC to provide credit lines to commercial banks. Negotiations are taking place with the USAID on development of incentive packages and instruments for mid-sized enterprises that banks would find attractive to market more items, aggressively. The Asian Development Bank has been invited for discussions on this subject.
The government's aim is to devise an incentive structure for the banks that would entice them to target the SMEs. The flood-affected areas have provided an opportunity to test this strategy. The NPLs in the flood-affected areas are at 22-23 percent, but just to make these areas again, the NPLs have been frozen in those areas with relaxed provisioning requirements for overdue amounts.
The banks were reluctant to lend in the flood-hit areas, the central bank has asked them to continue lending, it is believed that government will provide them 30 percent guarantee on the first loss. So initially, the scheme will over-compensate the banks, but with a very clear strategy. As the country moves forward, this over-compensation will be phased out in a year and a half or two, and help to develop other incentives packages and instruments.
Central Bank is also looking at the whole business of Export Refinance Schemes for SMEs. The modalities and the allocations are being worked out on how to support SMEs as they are more likely to be engaged in exporting non-traditional items.
In order to bring reforms, the mindset has to be changed. With the proposed incentive structures, government may be able to change the way the banks view SMEs. Commercial banks propose that transaction costs are high for them to deal with SMEs. But the fact is that today, banks are not even looking at corporate clients, all they are doing is filling the appetite of the government. And once the economy revives, banks will have to revert again to the private corporate sector.
There are ten banks in Pakistan, apart from the three public sector banks, which are falling short of capital. Two of them are merged and three are in the process of mergers. The central bank is closely monitoring them. It is needed to find out what is making it difficult for them to "comply with the MCR while realising that the current environment for raising capital is not favourable. The central bank is looking at them on a case by case basis as most of the banks have already met the MCR requirement.
Most of the agri-sector is undocumented. But there are other reasons as well, for instance, a 0.3 percent tax on cash transactions is a deterrent, as is the high-level of government borrowing from the central bank. Increasing documentation is a solution and reformed revenue measures will go a long way to address this issue. The second solution is (for banks) to set up more branches in the rural areas, because the farm sector is now booming. The third solution is branchless and mobile banking.
Finally, tightening of the monetary policy will also bring Currency in Circulation (CIC) back to the system if it is backed up with administrative measures. Banks' deposit rates would also have to respond to it. That would mean people holding cash would like to see a decent return and revert to the banking system.
Although the Agricultural Development Bank is prominent in the rural areas, it doesn't have the financial wherewithal to provide adequate credit. The government is looking at the issue of crop insurance, plus the concept of warehouse receipts. In the case of warehouse receipts, the root of all problems can be traced to the government's policy of fixing the commodity prices like wheat for the entire season. Fixation of prices kills the incentive for the private sector to build storage.
Private sector demand is strong in some areas. Industrial sector growth has been weak, some sub-sectors are exhibiting handsome growth due to the boom in rural areas, following the increase in prices received by the farming community for their rice, cotton and sugar cane. The retail sector has also been showing decent growth.
Industrial growth is not taking place at the pace private consumption is growing. That gap is worrying the government and could put a strain on the current account. Had the interest rates not been adjusted, the need to finance the gap would have added some stress. Private demand, which is perhaps not fully serviced by the domestic sector, may have spilled over on the external account, increasing the gap between imports and exports. Although it's being narrowed down by higher cotton prices that are boosting exports.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)
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