July 24, 2006	Monday	Jumadi-ul-Sani 27, 1427

ON July 18, the SBP finally adopted a regulatory measure to tighten monetary policy that many observers expected as early as June 2004. Better late than never!

It has come against the backdrop of monumental expansion in bank credit and currency in circulation witnessed during the past three years, and the credit overhang it gave rise to, which has accentuated the economy’s vulnerability to shocks.

Hike in cash reserve requirement (CRR) and statutory liquid ratio(SLR) (belatedly being supported by the IMF, as well) became necessary because banks seemed to disregard the SBP advice on areas including the credit growth (especially unsecured credit), equity trading, maintenance of liquidity, return on deposits and offering attractive term-deposit products to retain savings for commercial lending, project finance, mortgage lending, etc.

An impression was created that the SBP can’t ‘dictate’ pricing mechanisms. Surely it didn’t, but it got around this ‘free market’ taboo without upsetting the applecart; rise in the reserve requirements was engineered to penalize banks with excessive holdings of volatile (and therefore unfairly priced deposits) and reward those that have built deposit bases of longer-term (and therefore fairly priced) deposits.

The distinguishing feature of the regulation is that the reserve requirements are based on deposit tenors rather than on their maturities. Even a six-month deposit that is not cashed prematurely will continue to attract right up to its maturity the lower cash reserve requirement of three per cent and not seven per cent that now applies to volatile deposits. The message is clear: banks should offer realistic profit rates on deposits so that they revive a savings culture.

The estimated level of bank deposits is Rs2.8 trillion of which only 13 per cent (Rs360) billion have maturities exceeding six months (shocking, isn’t it?) and the remaining 87 per cent (Rs2.440 trillion) have maturities of less than six months (even more shocking, isn’t it?). This maturity profile shows large tenor mismatches between loans and the liabilities funding them. It doesn’t inspire too much confidence in banks’ management of their internal liquidity.

We are now experiencing the consequences of de-regulating the financial services sector without putting in place mechanisms that promptly check mis-allocation of national savings to marginally or counter-productive sectors. An example thereof is consumer finance (a staggering 23 per cent of the total outstanding credit in a resource-starved country) that pushed up consumption, imports and trade deficit to a record level.

For any developing country, consumer lending to this level is inadvisable, especially if it leads to higher imports, a large part of which are funded by volatile bank deposits. In Pakistan, even the entire stock of long-term deposits (13 per cent of total) is well below the level of consumer credit that constitutes 23 per cent of total bank credit. This scenario depicts over-aggressive and risky lending that borders on lack of professional responsibility.

On July 22, increase in cash reserve requirement (CRR) will suck out Rs49 billion from the banking sector. Banks already hold enough approved securities to take care of the three per cent rise in the Statutory Liquidity Requirement (SLR). Therefore, the overall impact of rise in reserves on the market liquidity will be more or less that on account of the rise in the CRR, and will suck out what the banks hold in their un-utilized liquid asset portfolios.

One view is that the move will up interest rates by two per cent. Firstly, even if such a hike takes place, it shouldn’t apply to secured-commercial credit; it should apply to consumer and unsecured credit. Secondly, believing that demand for credit will stay at its current level is unrealistic. With fewer rupees to lend, banks will re-think their consumer and lending strategies. But the illogically high profits banks had gotten used to making will certainly be squeezed.

Logic suggests that consumer and unsecured credit will become dearer and would also be curtailed bringing down the demand for credit. This is necessary for containing un-productive imports at the expense of starving the local industry. But it does pose the risk of delinquency of these portfolios.

Surely, while extending these loans banks knew the consequences of a rate hike on their borrowers. It is too bad if they didn’t. Hopefully, we will not hear sad stories about the star performers of the recent years.

An important benefit would be banks’ partial liquidation of their equity investments, which had a role in distorting the country’s stock markets of which the March 2005 meltdown has become a dangerously contested issue. Some banks got used to earning up to 70 per cent of their profits from stock trading, which was bad. This is another aspect that the SBP had hinted at but which banks decided to ignore. Now banks will have to re-think their niches in stock trading.

As far as the impact of a fractional rate hike on lending to industry is concerned, let us not forget that, recently, both the MoC and the SBP announced large packages of financial incentives, which should suffice for the moment. Industry must also realize, that the bill for the concessions it keeps demanding, is eventually footed by the ordinary Pakistanis, who have had a bad deal for decades at a stretch.

Hikes in reserve requirements are warranted by imbalances that continue to grow in spite of the central bank’s warnings. This is precisely what happened. During the past five years, the DFIs were unceremoniously wound up and development financing was shifted on to commercial banks but it didn’t arouse banks to the need for developing investment products to shore up term funds.

Banks are funding both medium-term industrial projects and mortgages out of short-term sources, which are increasing liquidity and systemic risks. This trend has to stop, the sooner the better.

Undoubtedly, the government’s refusal to float its term paper to set interest rate yardsticks is unfortunate but if banks are undertaking term-financing they can’t indefinitely wait for the government bonds to set the trend for floating their own debt paper. They must either float their bonds and collect term funds, or opt out of term financing activities. It may force the government to recommence floating term debt paper but no central bank can overlook for extended periods serious mismatches in asset/liability tenors.

The need for saving can’t be over-emphasized. Countries wherein bad lending practices encourage over-spending destroy the culture of saving and eventually fall in a bottomless pit. We simply cannot encourage wasteful consumption because it destroys the nation’s hard-earned wealth, which, in our case, has never been enough.

We seem to be developing the habit of living on borrowed money. The yawning trade, the BoP and current account deficits are growing at an alarming proportion. Rise in imports is shockingly high and has undeniably been nourished by easy availability of credit at almost throwaway prices. All this reflected an attitude of collective irresponsibility. Rise in interest rates will enforce cutting waste and unnecessary consumption, which we were becoming oblivious to.

New reserve requirements will hurt the big banks that have huge bases of the least fairly rewarded saving deposits. It is important that the SBP stands by its decision to up the reserve requirements, and not succumb to pressure for reverting back to the reserves’ 2003 levels. The country must rejuvenate a savings culture by forcing banks to offer fairer returns to their depositors. Only then will banks realize the sanctity of deposits, prevent their deployment in marginally useful imported goods and contain the need for external borrowings to pay for them.

To help banks in this endeavour, the SBP must seriously consider laying down the infrastructure (with requisite security checks) that can permit banks to issue negotiable Certificates of Deposit (CDs). It is the need of the hour because on the one hand it assures the CD issuing bank sustained liquidity and on the other gives the CD holder the assurance of ready liquidity. Admittedly, it is a risky project but it must be undertaken to strengthen a saving culture along sound lines.