December 22, 2003	Monday	Shawwal 27, 1424

Why did the State Bank suffer a catastrophic decline in its profitability during 2002-03? A close look at it’s profit and loss account reveals some important home truths which the senior management of the Bank refuses to acknowledge.

First, the State Bank made an operating loss of Rs1.4 billion in 2002-2003. In 2001-02 it had made an operating profit of Rs25.6 billion. In 2002-03 the SBP had to dispose of fixed assets to realize a surplus of Rs203.8 million so as to generate a net profit of Rs243 million. In 2001-02 the net profit had been Rs25.46 billion and of course no fixed assets had to be sold. The assets disposed of in 2002-03 are not specified in the notes to the account (note 16.1). Had these assets not been sold the Bank would have made a net profit of only Rs39.3 million. This meagre profit would have entirely disappeared had the central bank not made a profit of Rs591.2 million on sale of it’s investments (note 38).

The SBP thus realized a net profit to net assets ratio of 0.38 per cent primarily through sale of its fixed assets and investments. In 2001-02 the net profit to net assets ratio had been as high as 40.9 per cent.

Let us turn to an investigation of the causes of this catastrophic decline in profitability.

The primary cause was the catastrophic loss of Rs11.8 billion in foreign exchange transactions incurred during 2002-03. In 2001-02 the Bank had made a gain of Rs9 billion on this account. The loss on foreign exchange placements and deposits increased from Rs4.6 billion in 2001-02 to Rs12.95 billion in 2002-03. Losses on swap transactions rose form Rs566 million to Rs1.7 billion. Exchange rate fee income declined by 65 per cent from Rs6.6 billion in 2001-2002 to Rs2.3 billion in 2002-2003. Earnings from forward covers declined by 85 per cent from Rs8.2 billion in 2001-2002 to Rs2.12 billion in 2002-2003 (note 34).

Such a catastrophic fall in income from foreign exchange transactions can be attributed neither to the effects of rupee depreciation nor to the decline in foreign short term interest rates. According to statistics the rupee depreciated by 6.2 per cent in dollar term during 2001-02 but by only 3.7 per cent during 2002-2003 (SBP Annual Report Vol. II p87). Similarly, the US short term interest rates fell by much more during FY2002 (from 3.69 to 1.74 per cent) when the SBP made a net gain of Rs9 billion on foreign exchange transactions than they did in FY 2003 (from 1.74 to 1.70 per cent).

The Bank has made large losses on foreign exchange transactions when the rupee was depreciating and world interest rates were relatively high. Thus, it lost Rs13.9 billion in 1999-2000 and Rs49.1 billion on this account in 2000-2001. During Dr Ishrat Hussain’s governorship (1999-2003), the SBP has lost Rs65 billion on foreign exchange transactions.

In 2001-2002 the Reserve Bank of India made a net profit of Indian Rs88.4 billion (Pakistani Rs108 billion). The RBI’s net earnings from foreign assets in 2002-2003 was Indian Rs98.2 billion (Pakistani Rs113 billion) — only about 2 per cent lower than that of 2001-2002 Indian reserves are of course much larger than Pakistan and the RBI faces the same interest rates in world markets as the SBP.

The SBP’s foreign exchange transaction loss is attributable to the ruinous policy of building up of foreign exchange reserves which rose from $4.3 billion in 2001-02 to $9.5 billion in 2002-03. It is also due to inefficient management of foreign exchange transactions, specially related to the lack of diversification of the reserve portfolio and disadvantageous deposit placements and currency and interest rate swap practices. Those responsible for these colossal losses should be held to account and severely punished for this disastrous result. There is an urgent need to conduct a detailed independent special purpose (if necessary long form) audit of foreign exchange transactions undertaken by the SBP during 2000-2003 so that those responsible for these colossal losses can be identified and dealt with accordingly.

The second most important cause of the fall in income during 2002-03 was the decline in interest earnings. These fell by 43.6 per cent from Rs32.9 billion in 2001-02 to Rs18.5 billion in 2002-03. Interest expense also declined from Rs5.8 billion in 2001-02 to Rs2.6 billion in 2002-03, i.e., by 55 per cent. Income from the MTBs fell by about Rs20 billion. On the other hand income from private sector advances (excluding the unclassifiable ‘others’ category) rose from about Rs9 billion in 2001-02 to Rs12.6 billion in 2002-03 (note 31).

The SBP losses in terms of government interest earnings are, as the SBP report points out (Vol. 11 P87-88), not a real loss to the national economy since they represent a transfer to the (federal) government and result in reduction in fiscal expenditure. The State Bank has, thus clearly done well, as far as domestic interest earnings is concerned. It has significantly increased earnings from the non-government sector despite the fall in interest rates and significantly reduced its own interest expenditure. However, earnings from the unexplained ‘others’ category in note 31 has fallen by over 80 per cent.

Commission income has fallen marginally mainly due to the fall in income from draft payment orders from Rs117.9 million in 2001-02 to Rs46.4 million in 2002-03. The unexplained ‘other’ category in note 33 shows a decline of over 20 per cent. Commission from the MTBs doubled and from savings and public debt management increased by about 19 per cent.

On the expenditure side, direct operating expenses fell from Rs9.5 billion in 2001-02 to Rs3.7 billion — but this is entirely due to the fact that (a) provisions against loans and advances fell from Rs2.3 billion in 2001-02 to only Rs500 million in 2002-03; (b) no provisions were made for diminution in the value of investments in 2002-03, whereas, Rs3.1 billion had been provisioned in 2001-02; (c) no SBP loans were written off in 2002-03 whereas loans worth Rs1.4 billion had been written off in 2001-2002. Notes to the account provide no justification for the 80 per cent fall in provisions against loans or the decision to make no provision for diminution in the value of investment in 2002-03. It is clear that these decisions were forced upon the State Bank due to the fall in net profits and cannot be justified on independent grounds.

Establishment charges fell from Rs7.9 billion in 2001-O2 to Rs6.16 billion in 2002-03. This is entirely due to a massive 46 per cent fall in retirement benefits which fell from Rs4.6 billion in 2001-02 to Rs2.4 billion in 2002-03. If these are excluded establishment costs are seen to increase by 8.4 per cent. Salary expenditure increased by 6.9 per cent. Medical expenses rose by 25.4 per cent and amounted to Rs243 million (about 10 per cent of the total salary expenses) in 2002-03. Insurance expenditure rose by 48.3 per cent. Travelling expenses rose by 39.1 per cent (note 38).

The overall picture that emerges is not a pretty one.The State Bank has produced an operating loss of about Rs1.4 billion in 2002-2003 and its net profit has declined by 95 per cent during that year. It’s net profit to net assets ratio is less than 0.4 per cent. Even this meagre profit was realized by the sale of the Bank’s fixed assets and investments and the virtual elimination of provisioning.

These figures mock the authorities’ grandiose claims about improved corporate governance, enhanced organizational efficiency and streamlining of operational and accountability procedures. The brutal fact is that the increasing State Bank autonomy has made it an inefficient organization.

The essential source of this inefficiency is the subjection of the SBP — the loss of its autonomy — with respect to the international money markets. This is reflected in the colossal Rs12 billion loss incurred on foreign reserves placements and deposits. The Bank’s apology for this loss (Annual Report Vol. 11 p85-89) is entirely unconvincing. The central bank treats exchange rate appreciation and the build-up of reserves as acts of God — developments over which-national monetary authorities ought to have no control — except through market interventions which impose an unbearable cost on the economy. This reflects the State Bank’s subservience to the IMF ideology. Both, the exchange rate and the level of reserves can and ought to be determined by the government through effective imposition of capital controls and the abandonment of market based monetary policy.

The ineffectiveness of the monetary policy — reflected in the State Bank’s virtual abandonment of discount rate changes since November 2002 and its total reliance on varying the level of sterilization to influence the interest rate structures — is a consequence of the government’s decision to accept subordination to imperialist finance and surrender national monetary sovereignty.

This becomes apparent from the overwhelmingly significant contribution of net foreign assets (NFA) to the growth of monetary assets during 2002-2003. In that year growth in the NFA accounted for 97.3 percent of total expansion of monetary assets. Net domestic assets which constituted only 2.7 per cent of monetary assets grew by only 0.6 per cent during 2002-03, whereas, the NFA grew at an astronomical rate. This is clearly an unsustainable situation as the State Bank itself admits (Annual Report Vol. 1 p80-82) and a major fall in dollar inflows and rise in world interest rates can have a disastrous impact on the economy if Pakistan remains committed to capital account liberalization and market based monetary policy.

The ineffectiveness of monetary policy is also reflected in the fact that despite the 18 per cent growth in the M2 and the increase in private sector credit — from Rs53 billion in 2001-02 to Rs168 billion in 2002-03 — investment remains stagnant, domestic savings are falling, unemployment is rising and the distribution of assets and income continues to become more and more unequal and unjust. It is this growing disjuncture between the financial and the real economy and the subordination of the national financial system to world money markets and imperialist finance which is reflected in the fact that while, the M2 grew at an average rate of a little over 18 per cent in 2001-2003, the CPI grew by only 3.5 per cent.

Financial sector liberalization is a primary cause of growing unemployment and rising levels of poverty in Pakistan. Twelve billion dollars — a sum significantly larger than annual gross fixed investment — remain locked up in useless reserves earning interest of between 0.5 to 1.1 per cent in America. We lose roughly $500 million to $800 million annually due to dollar depreciation against other hard currencies. The State Bank lost another $200 million on foreign exchange transactions in 2002-03. The abandonment of the market-based monetary policy must, therefore, be accompanied by a significant reduction in foreign reserves — to no more than three months imports equivalent ($4 to $5 billion).

Within the country the State Bank has, despite the fall in interest rates, increased earnings from the private sector and reduced its non-government related interest expenditure. There is no reason why foreign exchange earnings cannot be increased through adroit financial management.

It is clear that the State Bank’s subservience to imperialist finance has reduced its organizational and operational efficiency. More important it has reduced the effectiveness of the monetary policy.

The State Bank autonomy is clearly undesirable. It has led to a disastrous distancing of the financial and the real sector and thus sowed the seeds of an impending economic crisis. There is a need to end the State Bank autonomy and subject it firmly to the political authority of the ministry of finance and of the Parliament.

There is also a need for abandoning the market-based monetary management and for the implementation of rigorous capital controls and comprehensive credit planning. The conclusion of the PGRF arrangements with the IMF in 2004 provides an important opportunity for a fundamental redesign of the monetary and financial sector policy in Pakistan.