January 2, 2006	Monday	Zilhaj 1, 1426

In many ways 2005 was marked by developments that will have significant consequences for the financial services sector in the near future. As we come to the end on this eventful year, it is time to reflect and brace ourselves for the after effects of what we did, at times rather carelessly.

Without doubt, change in the profile of financial services during 2003-05 was a quantum leap by any standard. It modernized banking practices and brought Pakistani banks closer to meeting tough international standards but this quantum leap left some disturbing gaps in the capacity for sustaining the results that have been achieved.

It conveys the impression that competition and speed of change, rather than capacity building for sustained growth, remained a high priority.

Not surprisingly therefore, 2005 was marked by the highest-ever expansion in credit and money supply and the fastest rise in balance of payment deficit. These trends pushed up inflation too quickly and led to over-heating of the economy at an uncomfortably fast pace.

Although regulators did apply the brakes to contain these trends but a little late in the day, and not as effectively as the scenario demanded because of their sincere desire to maintain the momentum of economic growth.

What the scenario demanded was a measured hike in statutory reserve requirements, not just haggling over yields on gilt-edged paper to contain interest rate rise. As a result, monetization of large chunks of public debt was delayed.

Hopefully, this will not be repeated because such a response creates both uncertainties and imbalances that engender a less than healthy approach to liquidity management in financial institutions.

The rise in balance of payment and current account deficits has now reached a discomforting level. Although in a large measure this is the result of a meteoric rise in oil prices, the other contributing factor has been the extraordinary level of relaxations allowed to all types of importers, including those who are importing goods that aggressively compete with those produced in Pakistan. Given their overall impact on the economy, the government would soon be forced to review these relaxations.

In spite of the government’s best efforts, it would not be possible to contain public sector borrowing (PSBR) within the overly optimistic target of Rs45 billion because of the pressures created by the oil price hike and the after effects of the October 8 earthquake.

PSBR target has already been over shot and if withdrawal of grossly under-rewarded non-resident deposits continues even at its current slow pace, the money market will eventually run short of liquidity.

The combined effect of these trends would be a rise in interest rates which, at best, could be steadied but not avoided. This development will slowly weaken the competitive ability of the export-oriented sectors.

Coming in an environment of rising balance of payment deficit, this could also exacerbate problems in management of external debt. But rationalization of imports could minimize these problems and support many sagging local industries.

A consequence of credit expansion that needs close watch is value generation from the funds ploughed into business and industry in 2005, particularly because the record expansion in credit in 2005 came on the heels of unprecedented credit expansion during 2003 and 2004.

If this huge deployment of resources isn’t retrieved steadily, financial services sector may gradually accumulate non-performing loans.

The biggest chunk of credit expansion was absorbed by the textile sector in plant modernization but large export-oriented units in this sector have a challenge at their hands - the anti-dumping duties imposed by the EU. Although, the Ministry of Commerce fought hard to obtain a cut the rate of this duty, its success has been only partial. As a matter of fact, some large units have been lumbered with even higher rates of this duty.

The other big chunk that went into consumer durables manufacturing sector too seems vulnerable if inflation is not contained in lower single digits because it will dilute consumer purchasing power. Rise in mark-up rates and inflation will have a two-prong effect on the consumer loans portfolio.

On the one hand rising inflation will squeeze borrower savings and their repayment capacity and on the other hand loan instalments will go up because the bulk of these loans were extended on floating rates of mark-up.

Besides lending to business and industry, financial services sector invested heavily in Pakistan’s volatile equity markets making full use of the relaxations granted by the regulators. Many of them made unbelievably large capital gains from this activity. Thus, together with initial gains from lending to business and industry and equity trading, banks earned profits that were hitherto unheard of.

The tragic part, however, was that these gains were not shared with the savers who continued to get negative real rates of return. These low returns served as a disincentive for saving and encouraged speculation, which is a bad omen for any economy, more so for a resource starved economy like Pakistan. If the PSBR really rises beyond manageable proportions, this track record could cost banks dearly in resource mobilization.

Rapid growth in the range of financial services on offer has placed financial institutions under a variety of strains. While the sector has built up large risk asset bases by offering these services, many of them high-risk, there is a visible shortage of skilled workforce to service and monitor the risk asset bases.

In spite of their efforts at revamping their operating systems, banks continue to lack the requisite IT infrastructure. These short comings could develop into major weaknesses if not addressed immediately.

These weaknesses make cautious observers wonder whether the massive lending undertaken by banks in the past three years was based on sound risk assessment, not hasty judgments dictated purely by the urge to compete.

Hopefully, the lending was based on sound risk assessment but sustaining their huge risk assets portfolios will require banks to quickly plug the skill and IT infrastructure gaps. More importantly, banks will have to re-think their strategies because the post 9/11 flood of non-resident deposit is now a thing of the past.

High bank profitability encouraged regulators to require banks to rapidly increase their equities until 2009 and cut the loss provisioning period by half. These are tough challenges.

Based on their high profitability records banks may be able to attract fresh equity now but if their profits are not sustainable due to the weaknesses cited above, they may not succeed in this effort every year until 2009. This is, by far, the most crucial aspect of new regulation that banks need to ponder over.