On October 4th 2008, the State Bank of Pakistan reduced the Cash Reserve Ratio (CRR) by one percent and announced a second reduction effective from November 15th to cumulatively provide Rs 62 billion liquidity to the banking system. After providing Rs 31 billion in the first stage, SBP Governor Dr Shamshad Akhtar flew out to Washington D.C. to hold discussions with the International Monetary Fund and the World Bank.
Meanwhile, the banking system came under increased stress as nervousness among bankers themselves caught on with clients and the liquidity gap in the system increased several-fold. As a result, the Governor upon her return, had to inject Rs 120 billion through an additional reduction of two percent in CRR, effective from October 18. Simultaneously Rs 120 billion of bank held government securities were freed from Statutory Liquidity Requirements (SLR), enabling the banks to use them to raise cash for meeting the pressure of withdrawals.
The new SBP move is nothing more than a single dose of a sedative analgesic, when a full course of strong antibiotics is still needed to remove the deadly infection afflicting the financial system. The root cause continues to cause unabated pain.
A solution to the fast growing current account deficit needing inflows of foreign capital cannot be found in printing rupees and injecting them into the financial system. The result of this failed policy is all too apparent. The monetary overhang of Rs 600 billion plus from the outgoing financial year is the source further fuelling imported inflation arising from high oil and food prices. Framing a budget, while using the traditional methodology, has resulted in further borrowing by the government - to the tune of Rs 262 billion - in the first quarter of the current financial year. Keeping the fiscal deficit at 4.70 percent instead of reducing it to below four percent for FY09 is just not tenable. During the July-September period, net foreign assets (forex reserves) have fallen by Rs 185 billion.
The currency-in-circulation has risen by Rs 98 billion. And, bank deposits have dropped by Rs 146 billion. All this has happened at a time when bank advances are seasonally expected to peak in the next two months, mainly for agri items such as cotton, rice and sugarcane. This situation requires at least Rs 300 billion. So the challenge for the SBP is to see that the infusion of liquidity trickles down in letter and spirit to meet the immediate need, as it is an inescapable requirement for exports as well as food import programme.
Borrowing from local banking system for the budget is carried out to meet the residual gap between expenditure and resources. These sources are: revenue; non-tax income receipts such as earning of public sector enterprises and fees, and, foreign funds such as loans and borrowings. Unfortunately, however, it is the virtual drying up of the last source which has resulted in bloating government bank borrowing.
Rising bank borrowing has diluted the impact of monetary tightening as core inflation continues to swell. However, the catalyst for last week's banking crisis is the capital market. Failure to restore political stability and bring an end to persistent uncertainty have caused flight of capital. The KSE is continuously sliding since April - the month after achieving a record high. This has made investors nervous. There was a mistaken notion that a virtual bourse shutdown through the placement of a floor, while denying a quick exit to investors, could somehow bring a semblance of stability.
This in fact resulted in redemptions on mutual funds, forcing money market open-end funds to withdraw their deposits from the banking system. What was a severe headache of the Securities and Exchange Commission of Pakistan's has now turned into a full-blown infection, which desperately needs strong medicine from the SBP, while the banking system requires a prompt surgical procedure.
SBP needs now to be proactive instead of reactive. It needs to meet treasurers and risk managers of each bank to analyse gap position and review credit lines availability and utilisation. After analysing the susceptibility on liquidity gap, Advance to Deposit Ratio (ADR) - prepare an anesthetic dose - and use its Open Market Operations (OMOs) to redistribute liquidity within the interbank market and manage the rates.
Banks which cannot balance the gap book within next three months, through change in both liability and asset profile should be ordered to undertake a rights issue. The rights issue should be at least one and half times the liquidity drawn from the interbank market. Otherwise, the persistent, liquidity borrowed be converted into equity. The dilution of existing shareholders would help in arranging a sale or merger. It would be difficult, in the current business cycle. However, every effort should be made to protect the depositors. A similar surgery for the non-bank financial sector is needed. Weak institutions must be handed-over to strong commercial banks for nurturing and growth.
The bulk of reduction in CRR and SLR, etc is set to go to the big banks, while the liquidity need of smaller banks and non-bank financial institutions is going to become more critical. The high level of Advance to Deposit Ratio (ADR) has been persistent for six months or more. Now the system average is said to be 75 percent. And, according to Governor Akhtar, since some banks are highly leveraged, they are being ordered to reduce the ADR to 70 percent within the next six months.
What will be the psychology of lenders in an ebbing business cycle? They will probably become more risk averse. Some of them will have the liquidity but they will be hesitant to lend aggressively. Others, who are at 80 or 85 percent ADR, will not lend at all. Without a reduction in circular debt of oil and utility corporates from the banking system, government's continued reliance on the banks would crowd out the private sector which seasonally is in a borrowing phase.
Providing liquidity is not a solution in itself. A mechanism to refinance the mutual fund industry, suspension of subjective provisioning as well as mark-to-market accounting rules may be needed. Bankers have become gun shy and standby and back-up facilities need to be in place. They may not be needed, but confidence-building measures (CBMs) are as essential as liquidity for stabilising the financial system.