A total of over one billion dollars have been extended by the World Bank over the last ten years or so for financial restructuring in Pakistan.

Feb-04 - Feb-10, 2002

History of financial restructuring.

Financial liberalization started in the post 1988 era when the World Bank First Structural Adjustment Loan (FSAL) at U.S $ 150 million was approved.

This was followed by the World Bank Financial Sector Deepening and Intermediation Project (FSDIP) at $ 216 million. This programme provided a credit line to financial institutions, and was for private investments. It was used as an instrument to require the Government of Pakistan and the Central Bank to implement policy reforms. The only leverage was a threat of suspension. Since the credit line was not attractive and the funds did not disburse, the threat of suspension was moot. In the end the FSDIP was drastically restructured with a technical assistance project assisting, the Central Bank in strengthening its regulatory and supervising role, and the privatization commission in executing bank privatization.

A new set of Banking reforms started in 1997 with World Bank's assistance under the Banking Sector Adjustment Loan (BSAL) at $200 million and was intended to arrest the deterioration of the Banking system by bringing in professional management with NCB's, enhancing the Central BankÝs autonomy and authority, promoting greater market integration and strengthening the Banking Court system. It was also to provide a safeguard against continuation of political interference in the Banking sector.

Because of the frustration over the devastation of the banking sector by large defaulters, and quasi fiscal deficits that must now be recognized and financed by tax payers, there is consensus that the key solution lies in the privatization of state owned banks. Reduction in market concentration must be an important objective to aim for in the privatization of the NCB's.

Privatization of the banks was expected to follow and sustain the reforms. Efforts to privatize have not succeeded for various reasons.

These banks are still out of line in terms of their staffing and branch network in relation to their asset size.

It is therefore now the plan of the Government of Pakistan to restructure the banks further to improve their prospects for sale, and yet another World Bank Restructuring and Privatization project amounting to $ 450 million has been conceived. It is aimed to sustain and deepen the reforms undertaken under BSAL.

A total of over one billion dollars have been extended by the World Bank over the last ten years or so for financial restructuring in Pakistan.

Composition of financial sector and current state.

The liberalization of the financial sector has been the major policy agenda since the late 1980's. The financial sector was opened in 1992 to private investors, and after that fourteen new domestic banks and sixteen private investment banks were established.

Today the financial system of Pakistan consists of the State Bank of Pakistan, 3 nationalized commercial banks, 2 partially privatized banks, 21 foreign commercial bank branches, 9 private domestic banks, 2 provincial commercial banks, 9 development finance institutions, 60 leasing companies, 45 modarabas (mutual funds), 3 stock exchanges, and 60 insurance companies.

Although in recent years the share of the non-bank financial sector has increased, the financial system is still dominated by the commercial banks. Nationalized Commercial banks account for over two thirds of total financing, and hold over 90 per cent of the public's deposits.

However, the share of the nationalized banks in deposits and advances has shrunk to 46.8% and 48.6% respectively.

Although growing competition in the market is still limited. The NCB's continue to dominate the market.

However the financial sector as a whole has expanded. The paid up capital of KSE financial sector has increased from Rs. 32.2 billion to Rs. 35.6 billion, an increase of about 10.6% over last year. However, in dollar terms it has declined by 8% over the period.

The growth in the paid up capital of the financial sector is more than twice the aggregate growth of the other sectors of the KSE and the share of financial sector increase from 14.2% of the aggregate of KSE to 14.8%. The fastest growing segment of the financial sector has been the investment / security companies and banks, followed by insurance and leasing companies.

Although Pakistan's commercial banking system is still heavily dominated by the 3 NCBs and 2 partially privatized banks, in contrast to the oligopoly of the five NCBs in the 1980s, Pakistan has achieved a more competitive market structure, with the establishment of new private commercial banks, the expanding market share of the foreign banks and the privatization of two NCBs.

Maladies and need for restructuring.

The pricing and remuneration for most financial services after liberalization were intended to be determined by the banks on competitive basis with little intervention from the Central banks. Despite this, in order to provide succour to the banking sector, the interest rates on NSS have also been revised downwards from 16% to 11% in the last two years.

What has happened on the ground is that weighted average of rates on advances from banks dropped from 14.36 in mid 1996 to 13.5% in mid 2000. In the same period the interest rate on deposits fell from 5.15% to 4% per annum.

The spread between deposit and lending rates has not reduced and continues to be very high nearing 8.16% in December, 2000.

The increased cost of the banks as a result of inefficiency were passed on partly to the borrower by charging higher lending rate and partly to the depositor by offering lower deposit rate. So much so that the deposit rates were lower than inflation offering no real rate of return to depositor.

High lending rates increase the cost of borrowing and thus discourage investment, while low deposit rates encourage consumption rather than saving, resulting in high debt / GDP ratio, lower economic growth and increase in poverty.

The sources of long term credit too have gradually dried up as DFI's are no longer able to provide any significant volume of credit. NDFC and Bankers Equity have gone down under. The credit for long term investment by DFI's has declined from Rs. 20.69 billion in 94 / 95 to only Rs. 13.0 billion in 99 / 2000, a fall of over 36%.

The sponsors of investment projects therefore experience difficulties in accessing funds and have to approach the commercial banks. To fill in this gap, the State Bank has launched the long-term paper of varying maturities. It is expected that these Pakistan Investment Bonds would serve as a bench mark for long-term yield curve for Corporate Debt Market.

The NCB's and the DFI's have been facing the problem of non performing loans (NPL's) which increased from Rs. 230 billion in December, 1999 to Rs. 237 billion in December, 2000, although these have come down from 25.9% of the total advances of the Banks and DFI's to 23.30% of the total advances of Banks and DFI's, they are still too high.

As of end-December the banks and DFIs were holding provisions of Rs. 133 billion which covered around 47 per cent of their classified portfolios. Thus the net NPLs / net loan ratio which is a more appropriate measure was about 16 per cent. In simple terms, one out of six loans advanced by Banks and DFIs was not only a bad loan but also not covered by provisions. This reflects the poor asset quality of the banks. Since 1992 when private banks were allowed to be set up, a number of such banks have disappeared alongwith the deposits of the people. This does not inspire much confidence in the governance. The first such bank was Mehran Bank followed by Schon and Indus and the collapse of the much larger and older Bankers Equity. The latest in the series are the Prudential Bank and the NDFC.

Despite the entry of new private banks, competition in the financial markets is still limited. The NCBs continue to dominate the market.

The privatization of nationalized commercial banks and DFI's poses a serious challenge for the government. Although Central Bank has provided Rs. 21 billion to United Bank Limited and Rs. 9.7 billion to Habib Bank Limited as equity support, the banks have not yet been privatized. Although this has been part of the ongoing financial restructuring programme.

The third largest bank in terms of deposit with a market share of over 8% and fourth largest in terms of total assets United Bank Limited has been lingering on for seven years.

The Government of Pakistan has given contradictory signals on privatization. Why was it necessary for PICIC to buy back 60% of the shares in Schon Bank which was already sold to buyers from Oman.

The Allied Bank which was privatized in early 90 and sold to the employees reportedly is a victim of Rs. 1520 million scam. In 1990 fifty one per cent of the shares were purchased by the employees. At present hardly 6% of the shares are owned by the original shareholders the employees.

The government has yet to sell out 49% of the shares of Allied Bank, 30% of the shares of Bank Al Falah (formerly Habib Credit & Exchange Bank and the successor to BCCI) and 15% of the shares of Muslim Commercial Bank.

All this is happening despite that the privatization of financial institutions is part of the agreement and the government's commitment to the World Bank.

The total paid up capital of 12 commercial banks quoted on the Stock Exchange even today is $ 180 million only. The private banks which were formed were hopelessly undercapitalized at Rs. 300 million. Rather belatedly this ceiling was increased to Rs. 500 million and now this has been raised to Rs. 750 million and they will have to increase Rs. 1000 million by end of 2002. Additional equity and revaluation of fixed assets has helped to improve the Capital to Risk Weighted Average (CRWA) ratio, but this has deteriorated since CY 1998. The CRWA ratio for all banks at 9.7 is marginally above the desired 8.0 per cent level. However, five banks continue to be below the 8% CRWA ratio.

Similarly, the minimum capital requirement for investment banks and housing finance companies / discount houses has been raised to Rs. 500 million and Rs. 300 million respectively, to be met by December, 2002.

Profitability and earnings of the banks are poor. The return on assets (ROA) for all banks at end CY 2000 was a minuscule 0.1%. Deposit mobilization has dwindled considerably after CY 97. Deposits have reduced from 42.4% GDP in CY 97 to 38.5% GDP in CY 2000. The growth rate of overall deposits have also gone down from 10.1% in CY 97 to 6.7% in CY 2000.

The high nominal tax rate on Banks 58% but effective 85% is probably one of the reasons for feeble interest of the prospective buyers.

This is now progressively being reduced over the next three years, and the nominal tax rate is 50% now.

A new recovery law has been promulgated in August this year, which will empower the banks to repossess collateral property without intervention of the Courts. This augurs well for the future.

The only indication of Governance improving is that after having failed to fulfil the requirements of 10 agreements with the IFI's the Government of Pakistan has for the first time successfully implemented an SBA programme with IMF.

Results of liberalization

IMF's policy prescriptions are generally reduction in state regulation on prices, trade and finance. Reduction in subsidies, a tight monetary policy, market based exchange rates and privatization of state assets.

Structural agreement with IMF started in late 1988 but actual implementation of liberalization was introduced three years later and took the form of economic reforms order of 1991.

Most important of this was liberalization of financial sector, as a result interest rate on domestic credit was liberalized and target subsidies on credit for a number of sectors were reduced. As a result the cost of capital for domestic investors almost doubled. Cost of government borrowing too increased exponentially.

Financial liberalization has resulted in the rupee being devalued by 150% in last ten years. Inflation was 6.5% in the 80's has increased to 10.9% in the 91/97 period.

Deregulation of the financial sector has resulted in the longest and severest deceleration in gdp growth experienced in the country's history.

World Bank's recipe has not worked for Pakistan

While the fiscal deficit in the 80's was higher than the 90's it was sustainable as the Government of Pakistan could borrow at 6% from the banking sector. This rate increased to an average of 17% in the 90's.

The devaluation of the rupee has increased the debt service cost of the foreign debt exorbitantly.

The real economy should have been reformed first before the financial sector was opened up. In Pakistan the sequencing was upside down because it was much easier to reform the financial sector than the real economy

Devaluation has not worked as imports are price inelastic and exports do not respond to a lower rupee value because of excessive import dependence of exports.

Reduction of budget deficit can come from either reducing expenditure or raising revenues

Expenditures have been cut only by slashing public investments. This was 8% GDP in 80's and came down to 4% GDP in 90's. Public investments can crowd in private sector investments, they also play a vital role in the social sector and poverty alleviation

Deregulation of domestic prices has resulted in withdrawal of subsidies to food prices (edible oil and wheat). On utilities like electricity, water, gas and transport not only have subsidies been withdrawn but sales tax imposed resulting in substantial price increases.

The growth rate in GDP fell from an average of an excess of 6 per cent over the decade of the eighties to just 4 per cent in the 1990s.

Investment and growth in industrial development particularly in manufacturing has shown negative trends.

Public expenditure has fallen by almost a third in real terms from close to 9 per cent of GDP in the early 1980s to less than three per cent of GDP in the last two years.

Inflation which has never been a real problem in Pakistan's economy was in double digits for most of the nineties.

Unemployment almost doubled from around three per cent in the 1980s to closer to six, in the 1990s.

Low growth, declining investments and high inflation have contributed to increasing poverty.

Poverty has emerged as a serious economic and social issue in the last decade whereas the poverty level fell in the decade of the seventies and eighties.

The proponents of the Washington Consensus argue that increase in poverty is due to improper implementation of these policies rather than the policies itself - breakdown of governance over the last decade, increasing corruption, deteriorating law & order and political instability are indicated as the cause of increasing poverty, rather than the policy framework adopted by the Government of Pakistan since the beginning of the 90's.

Market friendly policies have to be adopted in earnest and appropriate regulatory institutions developed, only then the burden of adjustment on the poor can be curtailed.

Mr Zahid Zaheer is a former President of the Management Association of Pakistan and also a former Managing Director of a British Multinational, Pakistan Cables Ltd. He is currently the Secretary General of the Overseas Investors Chamber of Commerce and Industry and serves on the boards of several public companies. The views expressed in this article are his own and not those of the organizations he is associated with.