May 5, 2003	Monday	Rabi-ul-Awwal 2, 1424

Until early 2002, banks in Pakistan were finding it difficult to raise fresh resources for keeping pace with the requirements of business and industry. In their drive to mop up public savings, new banks expanded their branch net-works to far off corners of the country.

The scenario changed radically with the promulgation of the “Patriot Act” by the US Congress in the aftermath of 9/11, and hounding of US citizens of Arab and Muslim origin as well as foreign banks operating in the US, by the CIA, FBI, DEA, Comptroller of Currency, IRS and the newly-created office of the Foreign Asset Control.

The Act gives these agencies unlimited powers to investigate the origin of savings of these citizen categories. They are therefore sending all their savings home rather than keep them in the US, and become the target of irritating investigations by these agencies.

As one of the beneficiaries of this flood of foreign savings, Pakistan is now flush with unusable liquidity. As admitted by the federal finance minister in a recent statement, Pakistan’s negative image (courtesy his own ministry’s tactless fiscal policies of the past three years) is preventing investors and entrepreneurs from making use of these resources to expand the existing business, let alone establish new ones.

Pakistani banks are therefore left with few alternatives for making use of this “easy money”. Besides being yet another instance of losing out on a God-sent opportunity to increase investment, growth, and employment, this is a dangerous development because a similar situation developed in the US in mid-1970s after the historic oil price increase of 1973. The US banks were flooded with surplus liquidity that had no takers in the US economy badly hit by the oil price increase.

Flushed with easy money and threatened with rapidly sliding profitability, US banks made monumental errors at that time. Authors now refer to these grave lending errors as the “MBA loans” — an acronym coined for sovereign loans to Mexico, Brazil and Argentina, that subsequently went sour. Large-scale delinquency of these loans by early 1980s, and banks’ inability to enforce their recovery rights on foreign governments brought big US banks to the brink of bankruptcy. Pakistani banks are not yet lending to sovereigns but they are becoming “overzealous” by lending to weak borrowers at virtually throwaway lending rates.

On paper they can exercise the legal right to recover loans but experience shows that this assumption is little more than a myth. Had the legal system been as effective as bankers suddenly seem to believe it is, Pakistani banks would not be sitting over un-recovered loans that form roughly 27 per cent of their loan portfolios.

The scenario created by the flooding of banks with unusable liquidity is placing them under severe strains. The unabated slide in the discount rate and profit rates on gilt-edged securities during the last two years has created a powerful movement for continued lowering of lending rates.

Today, a reasonably well off business insists on borrowing long-term at a premium of 1.5 per cent over the 3-year PIB rate, which effectively means a lending rate of around 4.5 per cent per annum. Similarly, for short-term borrowing they ask for a rate 1.5 per cent over the latest T-Bill auction rate meaning thereby that the lending rate should be little over 3 per cent per annum.

The dilemma banks face is that, in spite of their best efforts (branch closures, employee lay-off, out-sourcing of services, etc.) they are unable to cut their intermediation cost below 6 per cent. Even the smaller, more efficient banks have failed to cut their intermediation cost to 4 per cent. The scenario suggests that their profitability may fall drastically in 2003 and beyond if the regulatory push for cutting lending rates too quickly continues.

High public savings have never been the hallmark of Pakistan’s economy. The situation became worse after the tactless atomic tests of May 1998. To cope with their after-effects, and tide over the ensuing economic crunch, during 1999-02 banks kept expanding their networks thus increasing their investment in fixed assets and operating costs assuming a 3 to 4-year pay-off period.

Given the flood of external deposits since mid-2002, they find that the new branches were not really needed. As a matter of fact, these branches are now a burden on their profitability. In their efforts to withstand the pressure being generated by seemingly unending demands for cutting lending rates, and being short on the alternative therefor, banks are giving rise to practices that may prove severely self-damaging in the long-term as savers move away from banks to more profitable but many times more risky investment venues in a poorly regulated country like Pakistan.

Plagued by pre-mature retirement of loans (taken over by their competitors at lower lending rates), banks are being forced to drastically cut profit rates on deposits accepted earlier to fund those loans. The worst sufferers in this reshuffle have been small savers who are now getting profit rates well below government’s own grossly underestimated current rate of inflation.

The instability is resulting in chaos because nobody can plan any financial activity with any sense of certainty. But what is of much greater significance is the fact that in this un-ending reshuffle, sanctity of written agreements and commitments made by institutions has been seriously undermined. Expediency seems to be taking the better of panicked bankers’ senses.

The norms of ethical competition, which, in any case, were not too strong given our history of the last two decades, are being trampled upon with impunity. The young and upcoming bankers are being tamed on to the wrong road. What sort of banking culture well it nurture, and what havoc will it play with peoples’ trust in banks is not hard to imagine.

Banks alone can’t be blamed for behaving the way they are as a result of adopting an expansionary strategy during 1999-02 that now hampers their ability to cut the intermediation cost. If anything, they tried to help the government in tiding over the severe economic crunch that followed the atomic tests. It is therefore both unfair and unwise to push them into a corner by forcing them to cut their intermediation costs at a pace they simply cannot.

There appears to be scant realization of the fact that neither the post-May 1998 nor the post 9/11 scenario, are of their making. Yet, the slide in profit rates on gilt-edged securities continues un-abated welling the demand for lower lending rates.

This attitude reflects a blinkered approach to the management of the monetary system, which now seems to favour the industry and the government because lower lending rates benefit the industry and lower profit rates on gilt-edged securities lower the cost of government debt. This approach is unprofessional because it is one-sided as well as shortsighted since it overlooks the long-terms ethical consequences of adoption of such policies by the State.

Radical observers may prefer to call it “blatant state-sponsored capitalism”. People at the helm of the affairs don’t convey the impression that they consciously subscribe to such an obviously flawed thinking to base state policies thereon but even the best of intentions become doubtful if the end results of actions emanating there from seem to favour selected classes at the expense of institutions and the masses.

The push for cutting lending rates fails to take into consideration the fact that inflation is still on the rise and the much-trumpeted reduction in taxes has been ceremonial because the CBR is never pleased at the idea of losing its grip on captive taxpayers; it squeezes the most out of them because they silently pay the tax extracting it from the common taxpayers who, unfortunately, don’t have a lobby. Finally, high bank profits during 2002 were not the result of significantly upped operating efficiency.

These were largely the result of booking capital gains on outright sale of high-yield gilt-edged securities bought earlier. Prospects of booking high profits in 2003, and beyond, by such tactics are now nearly extinct because most banks rather unwittingly unloaded the bulk of these securities in 2002.

The question begging an answer is whether regulators know about these obviously visible harsh realities? Apparently not. I believe this to be the case because I place regulators’ professionalism at a high pedestal.

What seems more likely is that bank executives themselves have not fathomed the depths of their coming problems and therefore initiated no dialogue thereon with the regulators, or they tried but failed to convince the regulators about the disastrous aftermath of the gathering storm. If the later is the case then it clearly indicates a lack of vision on the part of both for which they will have to share the blame when the impending problems reach unmanageable proportions.