January 23, 2006	Monday	Zilhaj 22, 1426

Inaugurating the State Bank sponsored conference on “Monetary-cum-Exchange Rate Regime”, former SBP Governor spoke, among other things, on limitations on the exercise of autonomy by the central bank. As he put it, “domestic financial markets do not have enough depth to absorb placement of public debt.”

It needs to be analyzed in depth whether this observation is based on the capacity of financial markets or their willingness and ability to invest in the debt.

It cannot be the capacity because the economy, particularly the banking system, has been for quite some time awash with excess liquidity reflecting a very high rate of monetary expansion in recent years. The rate of monetary expansion has been as high as 68 per cent between FY 02 and FY 05. During FY 05, it was 19.3 per cent.

According to the SBP Financial Sector Assessment, 2004, (FSA04), assets of the sector had increased from Rs2,776.9 billion in CY00 to Rs3,939.5 billion in CY04 to Rs4,508.6 billion in CY05, an increase of 62.4 per cent with annual average of 15.6 per cent, raising their ratio to GDP from 73.2 per cent to 81.5 per cent.

This points to the possibility of problems with the terms of the debt. This is conceded by the SBP as FSA04 observes, “In sharp contrast to advances, share of investment in overall assets of the financial sector witnessed a decline of 8.6 per cent during CY04 to reach 22.9 per cent. More importantly, besides a decline in their share in the over all financial assets, investments of the financial sector decreased by by13.9 per cent in absolute terms during CY04.The opportunity to divert funds towards profitable avenues, reluctance of financial institutions to invest in long-term government securities in a rising interest rate environment and the divergent views on interest rate movements of the financial institutions and the central bank, are some of the important factors behind this sharp decline in investment holdings.”

First of all, one must look at the actual experience of placement of the debt in recent years. This is what FSA 04 says, “During FY 05, SBP conducted 26 T-bills auctions. The overall target of Rs1, 016 billion was not only substantially higher than the previous year’s target of Rs670 billion but also significantly higher than the maturing T-bill (Rs881 billions). Moreover, the total accepted amount was above the target and the acceptance ratio improved substantially during FY 05. However, FY 05 was different in this respect when SBP accepted very low amounts in T-bills auctions to avoid a sharp jump in interest rates.”

In a rising interest rate environment, banks were only interested in parking their funds in short tenor securities, thus they showed very little interest in the 12-month paper. SBP, in its effort to avoid sharp jump in interest rates also accepted higher amounts in the three and 6-month paper.”

The distribution profile of MTBs, which was skewed heavily towards 12-month bills in June 04, tilted in favour of 3-month bills. The outstanding balance of 3-month bills increased from Rs30.4 billion in June, 04 to Rs254.1 billion in June, 05 and that of 6-month bills from Rs78.9 billion to Rs132.7 billion. On the other hand, the balance in 12-month bills declined from Rs239.4 billion to Rs65.8 billion.

The situation in regard to Pakistan Investment Bonds (PIBs) has been all the more interesting, rather intriguing, as there were only three auctions, as against seven auctions last year. It is significant that, in sharp contrast to borrowing of Rs107.7 billion through PIBs during FY04, government target for FY 05 was only Rs11 billion.

It was planned to have four auctions during the year, but three auctions were undertaken and the government chose to scrap them and the fourth was abandoned. Despite the small and pre-specified targets, the market response remained weak in all the three auctions conducted. This was particularly true in the second and third auction when not only were the bids made at very high rates but the offered amount was significantly below the target.

The amounts offered for 3-year bonds was Rs1.7 billion, Rs0.4 billion and Rs0.2 billion. For 5-year bond, the amounts offered were Rs1.2 billion, Rs.0.7 billion and Rs.0.3 billion, while for 10-year bonds it was Rs1.5 billion, Rs0.8 billion and Rs0.5 billion respectively. In order to avoid a sharp jump in long-term rates, SBP scrapped all the three auctions of PIBs. According to RE FY 05, “As yield on PIB serves as the bench mark for long-term interests, absence of the PIB auctions had significant negative implications for the secondary market.”

The changes in return on the debt can be better appreciated in relation to the monetary policy pursued recently. There was a slight gradual tightening of the policy beginning in the last quarter of FY 04. Thereafter, PRFY05 sums up the changes. ”The SBP raised the discount rate by 150 bps to nine per cent, thereby setting the stage for higher yields on various government papers and their inevitable impact on the banks’ lending and deposit rates.

Accordingly, the pace of interest rate hike picked up and within roughly three months, the yields on 3-monh, 6-month and 1-year Market Treasury Bills (MTBs) increased rapidly by 230 to 250 bps compared to 326-370 bps nine months prior to the upward revision of the discount rate. Similarly, the weighted average lending rate of the banking industry rose by 262 bps to 7.66 per cent during 05.” The last auction of the year saw interest rates on 3-month bill at 7.48 per cent, for 6–month bill at 7.94 per cent and for 12-month bill at 8.40 per cent. In the current year FY06, the auction on Nov 23, 05 had 8.1 , 8.26 and 8.77 per cent respectively for these maturities.

The FSA 04 says: “While the MTBs rates registered sharp rise of more than 500 bps during the year, the rise in PIBs yields could not keep pace with those of MTBs resulting in flattening of long-term yield largely due to the absence of any fresh PIBs issues. The yield curve as such favours investment at the shorter end, which may dry out long-term funds for the government besides making the yield curve unrepresentative of market expectations.” As to the rates in the secondary markets for PIBs, as of Nov 30, 05, the rate for 3-year bond was 9.03 per cent, for 5-year bond 9.23 per cent and for 10-year bond 9.45 per cent.

The strategy to reduce the cost of servicing the debt has certainly succeeded. Even though the stock of the debt increased by 24 percent between FY 02 and FY05, total interest payment declined from Rs212.5 billion in FY02 to Rs161.5 billion in FY04 to Rs157.5 billion in FY 05.

As regards the holders of the debt, this is what ER FY 05 says, ”The share of domestic debt held by banks increased for a second successive year in FY 05 at the expense of non-banks. While the rise in the share of banking system debt during FY04 was due to increased investment of scheduled banks in PIBs, and the massive government short-term borrowing from SBP, the FY 05 rise was primarily due to the heavy reliance of the government on borrowing from SBP. In both years, the non-bank stock of debt declined.

In absolute terms, the SBP T-bill holdings reached Rs337.7 billion by end- FY 05, after touching the low of Rs110.1 billion at end-FY 03. It is important to note that the banking system’s holdings of domestic debt has again climbed to 50 per cent mark after falling as low as 38.7 percent by end-FY03.” At end-CY 04, the SBP holdings of T-bills were Rs129.2 billion. They thus more than doubled in six months. At the end of October 05, the figure had gone up to Rs462.4 billion.

As such, it could not be the capacity or willingness of the financial markets to absorb domestic public debt, but the interest rates at which the State Bank wanted to raise the debt.

The SBP reluctance to raise interest rates, to the point of making them positive in terms of real interest rates, reflects its basic concern about the cost of servicing the debt because of fiscal considerations. The strategy seems have been not only to keep interest rates on the debt as low as possible but also to borrow short. The latter is fully reflected in the term structure of the debt.

As a result, the share of short-term debt, in the form of Treasury Bills, has increased from 27.9 per cent in FY 03, and 27.4 per cent in FY 04 to 36.6 per cent in FY05 and further to 38.1 at end-August 05. Even in case of long-term debt, the concentration is in the shorter end. As of end-June 05, PIB bonds for three years accounted for 4.6 per cent of the total permanent debt while the share of the bonds for five years was 14.5 per cent, for 10 years was 39.3 per cent,15 and 20 years, introduced in January 04,1.4 and 1.3 per cent respectively. It is significant that the stock of permanent debt declined by Rs35.9 billion in FY 05, despite an increase of Rs10 billion in Prize Bonds, in comparison with a steady annual average increase of Rs56 billion during the last five years.

Financial instruments used to finance the debt provide an avenue for investment for public saving, directly and indirectly through the financial markets. Any mismatching of the maturity of the savings and debt instruments would be detrimental to the former. Financial institutions are under legal obligation to keep a certain portion of their assets in government securities to ensure their liquidity. This makes them captive holders of the public debt to that extent. The contractual saving institutions, like life insurance companies, Workers Welfare Funds (WWF) and pension funds, have long-term funds to invest for which they need financial instruments with corresponding maturity. According to FSA CY04, Employees Old Age Benefit (EOB) Fund at the end of CY 04 stood at Rs81.6 billion.

WWF had an investment of Rs11,642.6 million at end-June 05, of which DCS accounted for Rs1,088.9 million, T-bills Rs2,071.7 billion and PIBs Rs7,515.0 billion. The outstanding amount in General Provident Fund (GPF), as of end-April, 05, stood at Rs21.5 billion. Total assets of insurance industry were Rs166,919 million at end-CY 04. The Report does not give the break up of the investments, but it can be presumed that government securities accounted for a significant proportion. Against this, at end-June 05, outstanding long-term government bonds were; 3-year bonds, Rs24.3 billion; 5-year ones Rs72.6 billion, 10-year ones Rs197.0 billion, 15-year ones Rs7.0 billion and 20-year ones Rs6.8 billion.

The source of financing of the debt is important for its inflationary implications. Investment of public saving directly, as in case of Small Saving schemes, managed by CDNS, is least inflationary as it means one-for-one transfer of individual saving to government.

Commercial banks’ investment is more inflationary because of their inherent ability of multiple expansion on the basis of public saving placed with them as deposits for which they have to pay. The limit for the multiple expansion is, however, set by cash reserve requirements, traditional or statutory.

Moreover, what the banks invest in government debt has an opportunity cost, as they cannot lend that amount to the private sector. The central bank is not subject to these constraints, as it can create money without cost against government debt, as if out of thin air, with practically hardly any limit. It is, therefore, most expansionary. Being a substitute for public saving, it affects the market determined interest rate ultimately to the detriment of return to individual savers.

The SBP financing of the debt increased considerably during FY 05, its investment in Central Government securities more than doubled from Rs134.1 billion at end-FY 04 to Rs332.1 billion on the corresponding date of FY 05. For this, along with other capital flows by way of investment in and loans to financial institutions, the central bank accounted for as much as 23.7 per cent of the total money supply, up from 19.3 per cent in FY 04. The monetary policy has been subordinated to fiscal policy and central bank has been single-mindedly pursuing a course to reduce debt servicing, regardless of the consequences for the rest of the economy, which, in turn, impact the overall performance of the economy as a whole. Interest rate policy giving negative real rate of interest favours the borrowers, including government, but is not conducive to the healthy development of the financial markets and the overall economy.

To indicate just two basic inter-related aspects, (a) the role of financial markets is limited and their structure extremely unbalanced and (b) the rate of domestic saving, abysmally low as this has been, declined during FY 05, more pronounced in case of household saving, which has been continuously declining since FY03. In both the areas, the role of the central bank has been crucial. Briefly put, business, particularly private industry, still mostly a close family concern, is under capitalized and highly leveraged relying heavily on bank credit.

Banking has been urban-based elite banking. It has become so in recent years with the large-scale closure of rural branches and introduction of state of the art new products and consumer credit. They have been traditionally avoiding the small man, both as a borrower and depositor. Small deposit holders are, in a way, being actively penalized. As a result, the number of personal deposit accounts has gone down to 16.7 million as of end-FY05 to account for 10.9 per cent of the population. The banking system does not have much to show as to their role in mobilization of saving.

In the absence of banking facilities, rural savings go waste. These are no doubt quite tiny individually but, if garnered properly, they can add up to a substantial amount because of the large number of savers. On the credit side, rural areas, particularly the small farmers are at the mercy of informal sources of credit, which, atrocious in terms as they are, hardly leave any thing with the borrower to survive on, hence the phenomenon of mass rural poverty. The SBP has been keen to see larger credit for agriculture and, as a result, the outstanding bank advances to this sector increased from Rs113.5 billion in FY04 to Rs127.1 billion in FY 05. However, the number of borrowers remained almost unchanged at 1.1 million.

This simply means that the increase was parked with the traditional valued urban-based agriculturist clients of the banks engaged in diversified economic activities who were already well catered. Even so credit for agriculture is very low in relation to the genuine requirements as is evident from the ratio of the outstanding advances at only 9.6 per cent of its contribution to GDP during the year as compared with the similar ratio of 70.6 per cent for manufacturing. The role of bank credit for manufacturing is much higher, if further financing through banks’ purchase of industrial shares and loans to individuals against them are added.

Important DFIs, such as ZTBL and HBFC, have not cared to develop the deposit resource base and their umbilical cord with the central bank is still to be severed, even though they are more than half a century old.