A majority of people do not understand the accurate definition of consumer financing

From KHALID BUTT, Lahore
 Oct 31 - Nov 13, 2005

The consumer, who goes into financing without analysing the cost benefit and applying proper tools to judge an offer of financing (from housing to durable items financing) keeps on burning his fingers. He may not be able to repay his debts.

A majority of people do not understand the accurate definition of consumer financing. They must know the answers to certain questions such as, what are their rights, obligations, pros and cons and as to how everything is supposed to be done. This consumer financing has not only intensified the ongoing rat race for a brand new car, a big house, and the latest brand of TV etc but it also has a key role in fuelling the inflation. Increase in car prices, payment of extra money as premium on car bookings and the phenomenal increase in the prices of property are some of the examples in this regard.

Keeping in view the current literacy rate, people seldom understand what consumer banking is. They are clueless about what is internal rate of return (IRR), what is a penalty in case of a premature payment? Or what annual percentage rate (APR) does mean? Majority do not understand the IRR or APR and its calculation and end up paying 18 percent IRR with an understanding of paying 10 percent interest rate only.

A majority only knows either what sales representatives of banks or leasing companies have told them or the information which is written in the product brochure. One hardly ever manages to read the fine print, which even if read, does not make much sense.

Consumers commit themselves for future payments for at least a term of three years, before they know what they are signing for and are mostly unaware of their rights. To overcome this dilemma, misleading advertisements of financing rates should also be stopped.

A sudden urge for promoting consumer finance has less to do with accepting this reality; it was spurred largely by a depressed investment climate in which reduced borrowing by industrial and commercial sectors coincided with excess liquidity in banks, thanks to 9/11. Banks are now aggressively promoting consumer financing following the shambled with liquidity proportions that had come nearly to unmanageable proportions.

Admittedly, consumer finance spurs consumption and demand which is necessary for the industry to expand its productive capacity or make full use of its existing excess capacity, and succeed in cuffing prices at the retail level. It also offers the prospects of increasing employment and, possibly, fresh investment in industrial sectors, especially those producing consumer durables.

The State Bank of Pakistan (SBP) data indicates Rs 390.3 billion credit off-take by the private sector till June, 2005, which would definitely be much higher once the full year data is compiled. Strong demand for consumer finance provided a major impetus to this rising credit growth.

The private sector borrowed Rs. 362 billion from the banking system in a little more than nine months of this fiscal year, exceeding even the revised full year target of Rs. 350 billion. This huge expansion in the private sector borrowing, part of which went into speculative areas of investment, had a role in pushing up inflation to a seven-year high of 9.06 percent in July-March 2004-05.

Data shows that banks and DFIs (development finance institutions) lent Rs. 362.4 billion to the private sector between July 1, 2004 and April 2, 2005. This is the fastest ever growth in the private sector credit in Pakistan. This huge amount borrowed by the private sector in nine months has exceeded the revised target of Rs. 350 billion set for the entire year and has risen past last year's record of Rs. 325 billion.

However, top bankers are of the view that during this quarter, the private sector borrowing would decline and the full fiscal year borrowing may close around the revised target of Rs. 350 billion. On the other hand, some analysts believe it may reach Rs. 400 billion.

The Economic Survey 2005-06 claims that the national economy is undergoing structural shifts marked by rapid changes in consumer spending pattern. The real private consumption expenditure has more than just doubled from 8.2 percent to 16.8 percent, suggesting the emergence of a strong middle class with buying powers. No doubt the per capita income has touched a record $736 as a result of a high growth rate but the weakening of the trickle down effect in the current phase of development and the absence of any effective distributive policies, or any significant avenue for the poor to access assets, the general perception is that the middle class is shrinking with rampant unemployment and incomes being eroded by unchecked inflation. In fact, latest market reports suggest that consumer finance by banks has fuelled overspending with loan defaults surfacing as a result of recent interest rate hikes. Much of consumer spending has been encouraged by consumer financing (auto, housing, personal loans and credit cards), which accounts for Rs. 77 billion or 23 percent of the total private sector credit. Whether it is income or debt driven, only time will tell.

The big attraction in extending financial facilities to the passive consumer segment is the prospect of earning high interest rate spreads as consumers are soft targets as far as haggling over interest rates chargeable to them are concerned. They are much more likely to borrow at unrealistically high rates - a convenience that is no longer available on lending to industrial and commercial borrowers who now insist on the finest possible loan rates.

With pricing consumer loans unrealistically high, banks have been making a serious mistake, as they cannot charge a high enough loan rate that could compensate for the loss arising out of an irrecoverable loan. More importantly, if consumer finance has to pick-up as a truly helpful mechanism for spurring domestic demand, it must be ensured that it remains within the consumers' capacity to repay their loans on time, and they feel confident about taking loans again and again.

As it is, ordinary consumers' capacity to borrow and repay loans out of their savings has been rendered precarious by decades long cycle of inept economic policies that have made the poor even poorer. Low rise in per capita incomes (the impact of which was compounded by falling purchasing power due to rapid depreciation of the Rupee) caused savings to fall and poverty to rise. This combination steadily depressed consumer demand even for the less expensive consumer durables. The sustained trend of depressed demand prevented the development of a sizable industrial base and contraction in opportunities for investment and employment. In the last two years, steady reductions in returns on savings have further diminished consumers' capacity to repay bank loans.

Banks are belatedly trying to redress this enormous macroeconomic structural imbalance but given the historic pattern of economic developments, they will be handicapped in their efforts to promote consumer finance. Signs are that while lower interest rates have certainly enhanced borrowers' capacity to borrow and service consumer loans, the newly created demand is pushing prices of consumer durables to unrealistic levels.

Taking the example of automobile, strengthening of the rupee and substantially lower interest rates should have brought their prices down or at least served to stabilise them. Neither of these expectations were met because the sudden rise in demand created a distortion that allowed assemblers not only to push up prices but also created a roaring black market in this sector. With banks now offering liberal consumer finance facilities for acquiring home appliances, their prices too are on the rise, although there is substantial over-capacity in this sector.

Many observers argue that this distortion is a temporary phase, which will soon become history with the increase in production capacities to fill the large supply gap.

Banks providing cheap credit to business and industry at the expense of the savers can exercise a powerful influence on the manufacturing sector to push the case for compensating the savers through lower prices. However, unfortunately the lack of social responsibility in the corporate sector is too pervasive to bring home this realisation to the market players.

Apart from the macroeconomic distortions that suppress consumer demand, there are other delicate issues that require focused attention of commercial banks intending to launch a major thrust in consumer finance. The first is the lack of institutional arrangements and practices that are hampering the assessment of consumers' re-payment risk. Ideally, risk assessment of employed individuals should not pose as much of a problem as self-employed individuals because employers could help in providing a basis for establishing the employees' re-payment capacity.

Unfortunately, that is not yet the case. Employers appear averse to taking even the feeblest responsibility on account of their employees. Many employers either don't certify, or certify very inadequately, the financial status of their employees intending to avail a consumer finance facility from a bank. Unless provisions are made in relevant labour laws, employers will not provide even this information about their employees, which they should morally feel bound to provide. Fewer among them are prepared to confirm to the financing institution that they have placed on their records the fact that their employee has availed a financing facility. Fewer still are prepared to accept the responsibility of informing the financing institution in the event the finance-availing employee leaves the employer, or is asked by the employer to leave.

In the case of the self-employed, the problems are complicated further because many potential consumers do not keep credible records of the streams of earnings from their vocations or businesses to permit financing banks a reliable assessment of their future re-payment capacity. Many consumers don't have utility service connections in their names. Given these handicaps, credibly verifying consumers' repayment sources will remain a stumbling block. Unless insurance companies lend a helping hand in this effort by providing loan re-payment guarantees to the lending banks, the prospects of expanding the consumer finance market remain dim. Bankers will have to rely largely on their own credit judgment, which may not always be correct. Given Pakistani bankers' track record in lending, such a possibility will always be there.

A factor that further complicated the extending consumer finance facilities along sound lines are the continuing inadequacies of our legal system that make it cumbersome for borrowers to collateral their existing unencumbered assets for the satisfaction of the lending bankers.

Another thorny issue is the re-possession of financed assets. While re-possessing vehicles doesn't pose too serious problem, re-possessing assets such as air-conditioners, refrigerators, televisions sets, and similar other households appliances will not be easy. It could be both painful and embarrassing for the lending institutions. Even if these items could be re-possessed, re-selling them to recover book values of outstanding consumer liabilities holds out a challenging prospect. Resorting to shortcuts in risk assessment may therefore lumber banks with thousands of small delinquent loans. In most cases, it may eventually be cheaper to write them off rather than go for re-possession and sale of used assets, or initiate court action to recover loans from defaulting consumers.

Consumer finance is considered a risky ball game for banks as the infamous yellow cabs scheme was the only big experiment in consumer finance, which was undoubtedly a bad experience for most banks that took part in it. Admittedly, political twists played a big role in the failure of the scheme but operational inadequacies of banks played a bigger role in this monumental failure. A major factor in that failure was the operational deficiencies in banks, particularly in assessing an individual's future repayment capacity keeping in view his or her changing circumstances. Foreseeing impending changes in the circumstances of individuals is not the same as sensing the impact of changing business cycles on major borrowers placed in various economic sectors. Little is available in terms of authentic statistics on this huge customer category. Pakistan Integrated Household Survey (PIHS) is a new report, and its timely release cannot be assured because it may report changes in politically sensitive indicators.

Given the absence of credible sources and bases for assessing risk, dealing with thousands of small borrowers makes consumer finance a manpower intensive business. Retail banks with large branch networks have the potential for succeeding in this business but it requires making alterations in banks' infrastructure, and a change in the focus on investigative effort for risk assessment.

There is considerable truth in the observation that lowering of interest rates by Central Bank in the mid-1990s, ostensibly to spur demand and economic activity, resulted in acquisition of excessive amounts of "easy" bank credit by businesses and creation of over-capacity there from.

Similarly, households too acquired credit (far in excess of their capacity to save and repay) for investing houses, consumer durables and company shares on visibly inflated prices. The credit boom, and the demand created there from, led to meteoric rises in prices and deluded industry into over-investing in capacity building.

Eventually, unsustainable burden of debt-servicing forced businesses to crash, and households ended up with negative equities.

Maintaining the critical balance between savings, investment and borrowers' debt-servicing ability is only possible if input prices remain stable affording businesses to sustain their profitability, and interest rates too remain stable to ensure that, in the medium term, debt-servicing burden remains affordable for both consumers and manufacturers.

Unless the system can ensure the maintenance of this delicate balance, economic instability will remain a strong possibility. Countries that tried to achieve an over-kill in spurring domestic demand sometimes overlooked the importance of maintaining this critical balance. We too are trying to achieve the same objective but regulators must ensure that we don't fall in that dangerous trap. Pakistan's economy, already rendered fragile by industrial sector loan losses, simply cannot live through another major upheaval caused by pervasive delinquency of consumer loans.