The State Bank of Pakistan (SBP) on Thursday said that the necessary stabilization measures may further slow down the pace of economic activity and the external account imbalances and related uncertainties are likely to have repercussions for the financial markets.
According to Financial Stability Review (FSR), issued by SBP, for the calendar year 2018, the CY18 was challenging for the financial sector of Pakistan as macroeconomic vulnerabilities emerging from twin deficits and elevated inflation level have necessitated the stabilization measures that have slowed down the pace of economic growth.
The financial markets, particularly the forex and equity markets, have trended downwards with increased volatility. However, financial institutions and market infrastructure have largely remained resilient and performed steadily. The growth of the financial sector has moderated to 7.5 percent in CY18.
"The necessary policy measures for the stabilization of the economy such as rationalization of taxes in the budget FY20 and adjustment in utility prices may further slow down the pace of economic wheel," SBP predicted.
The real GDP is expected to rise modestly in FY20. The average CPI Inflation has remained within the range of 6.5-7.5 percent in FY19 but is anticipated to be considerably higher in FY20.
SBP said that there are considerable uncertainties around the projected path of the financial vulnerability index. External account imbalances may have strong repercussions for the financial markets.
The uncertainty surrounding the equity market may continue to strain the performance of mutual funds and insurance sector, which are more dependent upon the capital market. In addition, the monetary tightening may affect the debt repayment capacity of borrowers with some lag, the report said.
SBP projected that in the backdrop of this challenging economic outlook, the corporate sector could perform below its full potential. Therefore, improvement in macroeconomic conditions and successful implementation of the IMF program will be the key drivers in ensuring stability of the financial sector.
The report said that SBP is aware of these emerging challenges to the financial sector and has taken steps to foster risk management practices and enhance transparency in its regulated sectors. SBP is also working in collaboration with other stakeholders for formulating and implementing a comprehensive and well-structured Macroprudential Policy Framework to ensure stability of the financial sector.
Further, the risks related to AML/CFT and cyber security need continuous attention for mitigation. Encouragingly, resilience analysis indicates that the banking sector has the capacity to absorb adverse domestic and global stress in the medium-term.
The report said that post CY18, the macroeconomic imbalances, particularly the fiscal deficit, have widened. The current account deficit, though narrowing gradually, remains at elevated level putting pressure on foreign exchange reserves. While, SBP has raised the policy rate by 325 basis points post-CY18 (until July 2019) to address these macroeconomic challenges.
The assessment of resilience of banking sector to probable future domestic or global stress event in the medium term is of paramount importance. This year's stress testing results indicate that the banking sector can withstand for three years the severe and protracted downturn induced by hypothetical adverse global macroeconomic conditions. The large banks, however, carry sufficiently higher capital buffers and are able to sustain the impact of hypothesized shocks for around four years.
The 3rd wave of SBP Systemic Risk Survey (conducted in Jan-2019), reveals that foreign exchange rate risk, balance of payment pressures, widening fiscal deficit and increase in domestic inflation would remain the key risks to financial system stability for the next six months.
The consolidated picture thus reveals that, amid rising macro-financial challenges, risks to financial stability have somewhat increased during CY18. The tightening domestic financial conditions along with rising uncertainty among the market participants have put the financial markets under stress.
The bearish trend in the equity markets has accentuated risk-averse sentiments and flight to safety as investors have preferred money market and fixed income funds over stocks.
Due to higher volatility in the financial markets, risk averseness in equity market linked NBFIs, like Mutual Funds, has increased, that has led to contraction in assets under management and flight to safer money market instruments.
In addition, the financial institutions have tilted their investments in government securities towards short-end of the maturity structure i.e. MTBs and retired long-term.
In CY18, the operations and risk profile of the domestic financial markets have been largely influenced by the growing external account vulnerabilities, tighter monetary policy response, and uncertainty among the market participants.
While Government has succeeded in raising sizeable bilateral financial support, these flows could partially finance the high current account deficit. As a result, the SBP FX reserves depleted by around USD 7 billion and the PKR, cumulatively, depreciated by 23.61 percent against US dollar, leading to higher volatility in the FX market.
Besides, uncertainties associated with the political transition and future economic direction led to bearish sentiments in equity market that pulled down the KSE-100 index by 7.58 percent (on average) during the year. However, volatility in the money market has remained contained due to interest rate corridor mechanism in place and prudent management of market liquidity by SBP.
Banking sector, the backbone of the financial sector, has generally weathered the challenging macro-financial conditions and performed steadily. The financing growth has increased, profitability remains reasonable, liquidity buffers stayed high, and solvency of the banking sector has remained adequate.
The FSR has also highlighted few challenges facing the banking sector. The deceleration in deposit growth that is continuing over the last few years may pose funding risk for asset expansion.
The concentration of banks' exposure to public sector, though reduced due to net retirement in PIBs in CY18, remains significant. Further, the risks related to AML/CFT and cyber security need continuous attention for mitigation. Encouragingly, resilience analysis indicates that the banking sector has the capacity to absorb adverse domestic and global stress in the medium-term.
Similarly, the financial depth, as measured by financial assets to GDP ratio, has subsided to 73.0 percent in CY18 from 74.5 percent a year earlier. However, the financial institutions and financial market infrastructure have largely remained resilient and performed steadily during the year under review.
Among the financial institutions, banking sector has remained resilient, with strong Capital Adequacy Ratio (CAR) of 16.2 percent well above the minimum regulatory level of 11.9 percent and high fund-based liquidity.
Among various factors, rise in rating culture in the corporate sector has facilitated enhancement in CAR. The financial intermediation has improved with a rise in advances to deposit ratio to 55.8 percent, highest in the last eight years.
Growing advances have helped reduce the gross loans to NPLs ratio, but other asset quality indicators have slightly deteriorated due to rise in the quantum of NPLs during CY18. The banks have posted reasonable profits; however, higher provisioning expense along with rise in administrative cost and one-off extra ordinary expense has kept the profitability slightly below the last year's level.
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