Potential is enormous but focused measures are needed

SHABBIR H. KAZMI, Special Correspondent
Feb 19 - 25, 2007

In contrast to East Asia, Pakistan's private corporate debt market could not be developed and remains below one percent of GDP. The major drivers of financial assets in Pakistan are deposits and government bonds, whereas corporate bond issuances remain a miniscule portion, with the total outstanding issues around Rs 50 billion, which is less than one percent of GDP, as compared to Korea having more than 20% and Malaysia above 40%. Pakistan's corporate debt history is short, with Term Finance Certificates (TFCs), popular corporate paper, which started appearing in 1995.

Pakistan Investment Bonds (PIBs), introduced in 2000, are now the longest tenor sovereign bonds, providing the benchmark yield curve for private issuances. The National Savings Schemes (NSS) on the other hand, with tenors up to 10 years, provide risk-free investment options to retail and institutional investors. Over the years the State Bank of Pakistan (SBP) has remained confined to the development of government securities market, which is a prerequisite for the development of debt markets. The SBP efforts have helped in the development of an effective market determined yield curve for government securities, which sets the stage for the corporate debt market. A combination of factors has contributed to this but most notable has been the autonomous status given to the SBP by the federation. This status has helped in strengthening the monetary policy, its management and its implementation. It has also helped in prudent budget financing, from both commercial banks and central bank, on market driven interest rates.

The three-day repo rate, which now serves as a key policy rate for monetary policy management, helps in determining the short-term interest rate. Maturity of the economy and the financial system, the monetary transmission mechanism, has been working effectively and this short-term rate helps in shaping the yield curve. Equally critical has been the central bank's role in the effective development of the government securities' market by ensuring proper and regular auction of T-Bills of different maturities, and conducting open market operations for the effective management of the monetary policy.

However, one may wonder why corporate debt market has remained so subdued. Governor, SBP Dr. Shamshad Akhtar has spelled a number of factors for the prevailing conditions. First is the lack of regular issuance of long-term government debt, particularly PIBs. This has caused concern regarding the effectiveness of long-term debt pricing. Furthermore, the recent decision to re-allow institutional investment in NSS has the potential to shake the market confidence in the yield curve. Rates of return on NSS, being a risk free instrument, were first reduced and then aligned to the market determined yields on government securities of similar tenors. Institutional investors were barred in 2000 from investing in NSS.

Second, a large number of Pakistan's companies are not listed. According to Credit Information Bureau (CIB) of the central bank as of 31st May, 2006, there were 30,320 corporate borrowers (including partnerships) and as of 30th June, 2006, there were about 2,179 non-listed public limited companies registered with SECP, whereas the number of private limited companies was 45,929. Also, the number of listed companies has declined from 762 in 2000 to 653 companies by end-September 2006. Most family-owned businesses are reluctant to issue corporate debt because of disclosure and other corporate governance requirements, and fear of loss of control, etc. Companies either rely on internal resource generation or are exclusively dependent on commercial banks for meeting their funds requirements.

Third, TFC issuance has also been affected by the relatively high issuance, listing and taxation costs. The listing costs are in the process of being reduced and there is discussion to rationalize the withholding tax rates and stamp duties on these instruments. SECP is also examining to reduce the turnaround time on documentation requirements and approvals needed for listing of corporate debt.

Finally, the secondary market of TFCs is quite illiquid given the small volumes, a buy-and-hold mindset (reflecting lack of expertise in trading debt instruments this is particularly true in many pension and provident funds and lack of competition), absence of market makers, and a lack of fresh supply of long-term instruments. Besides, erratic interest rate movement also discourages corporates to issue TFCs. Corporates are keen in rising interest rates scenario to lock funds but in the declining rates environment do not feel comfortable in locking funds at higher rates.

According to analysts growth of debt market is a positive development for the financial system and the economy of Pakistan. It helps in diversifying the financial system, reducing excessive dependence on banks and vulnerabilities within the banking system. At the same time it provides funding to large corporations looking for long term financing. Financial engineering facilitates for the development of innovate debt products supplement and complement bank financing.

A viable fixed-income market ensures an alternative source of finance to the business entities that exclusively rely on the banking sector. According to Dr. Shamshad, the monopoly of the commercial banking system is an impediment to the fundamental principles of a market economy based on perfect competition. It leads to inefficiency and in turn to sub-optimal outcomes in the loan market, which jeopardizes the stability of the financial system. A well-developed fixed income market helps expose banks to competition, which in turn helps improve efficiency. The extraordinary banking spread in Pakistan in recent years is an evidence of lack of competition and efficiency in Pakistan's financial markets.

The short tenor of bank loans is due to the nature of bank deposits, maturity mismatch of asset and liability portfolios. Long-term funding needs are often financed by a consistent rollover of short-term loans. During tight liquidity situation, borrowers often face credit crunch and difficulties in rolling over their maturing obligations. A developed fixed income market would help mitigate these difficulties and also facilitate better risk diversification because debt is spread across a large number of individuals as opposed to bank lending. At the same time corporates are in a better position to raise longer-term debt. With the development of the fixed-income market, banks will be able to focus more on those enterprises of the economy that typically face credit constraints due to their small size, relatively early stage of development, or simply asymmetrical information.

Pakistan has a lesson to learn from the global markets, particularly the regional markets. Reportedly, the East Asian governments have been promoting capital markets rather aggressively by strengthening the securities markets and its regulation and oversight along with instituting corporate governance standards. There has been a visible growth in equity market capitalization as efforts launched for promoting debt markets are yielding results. Bonds outstanding as a percentage of GDP have registered manifold increase in virtually all the East Asian markets. While a part of this is fueled by the growth in government securities and bonds issued for recapitalization of banks, there is also a notable growth in private corporate debt with the evolution of market determined benchmark yields on government securities. The steepest growth in private corporate debt has been observed in Malaysia, Singapore, Hong Kong and Korea.

The GoP as well the central bank is fully cognizant of the importance of the development of fixed income instruments. This is visible from the priority awarded to this important segment in the agenda for the second phase of financial sector reforms. There is growing realization that new approach and instruments need to be promoted to enhance the depth and accessibility of the fixed income market.

It is necessary to recognize that banks are benefiting the most from debt market development and can be used for further development. Banks can improve supply through issuance of bonds to supplement their liquidity beyond deposit base. This can help in meeting client's financing requirements in addition to financing tier-II capital, which facilitates eventually their compliance with Basel-II requirements.

Besides, banks are among the most important issuers, holders, dealers, advisers, underwriters and guarantors of the capital market. Given the skewed nature of their balance sheets with maturity mismatch issues, banks can also issue long-term bonds for Asset Liability Management. This is particularly relevant from the perspective of financing long-term projects.

The increasing supply of debt instruments also has the potential of providing additional impetus as the government launches some of the strategic large-scale infrastructure initiatives and addresses hurdles in housing finance. The Infrastructure Project Development Facility and the Public Private Partnership approach of allowing the private sector to bid for and execute the design, building and operating of large-scale public projects will be critical to evolve infrastructure finance structures. Not only will this help arrange financing for infrastructure projects, but add to the demand for fixed-income bond issuances and increase the pool of assets available for securitization.