THE government has again allowed institutional investment in National Savings Schemes (NSS), and added fuel to the fire in the on-going controversy about its overall funding policy that relies on short-tem borrowing and gradual disinvestment from profitable state enterprises through issue of GDRs, instead of issuing long-term debt paper.

The initial reaction from the financial services sector calls the move ill-advised because it will drain liquidity from banks that already suffer from a credit over-hang, push up deposit and loan rates, fuel inflation and pull the rug from underneath the feet of the budding mutual funds and asset management companies.

Indeed the move will have repercussions of both short- and medium-term nature for the expansion and profitability of financial services but not every bank will pay the same price.

There is also the apprehension that the move will be used as a ploy for jacking up loan rates (and therefore profit). Banks doing so could be in trouble because a general rise in lending rates will initially push up inflation and later, as consumer demand falls, render commercial borrowers vulnerable to default.

More at risk will be banks with large housing, auto and consumer finance portfolios. If inflation and interest rates were to rise in tandem, borrowers’ income will contract rapidly, and reduce their ability to repay.

While the government can be faulted for many things, the financial services sector must blame its own role in pushing the government to lift the lid on corporate investment in NSS. The big failure of the banking sector has been a lack of vision in its leadership.

The sector turned into a self-praise club where the sole consideration for mutual admiration was higher profit. Observers had warned the sector about the consequences of its single-minded quest for profit at the expense of every other value.

Some commentators suggest that ‘refusal’ of the banking sector to squeeze its enormous profits by offering higher returns to depositors prompted the government to allow institutional investment in NSS. That would imply support for SBP advice to the banking sector on this very subject.

Nothing could be better but a more plausible explanation is that the move facilitates accumulating un-funded debt, which is dangerous.

Since 2004, commentators of every bent of mind have wondered why both fiscal deficit and development are being financed through short-term borrowing. Government’s intention to use the NSS instead of issuing PIBs will weaken the chances of the much-needed private-public participation in infrastructure financing, and would form a valid basis for banks not to issue TFCs to mobilize term debt for onward lending to the government. But it can be argued that had banks shown an inclination to do so (which they didn’t) the government would have issued sizeable chunks of PIBs.

Some observers believe that, as primary dealers, banks did not develop a large secondary market for PIBs. Instead, banks held on to PIBs to benefit from them to the exclusion of institutional investors; they are therefore to blame for government’s downgrading of the role of PIBs as a borrowing vehicle.

The argument doesn’t hold water because most private sector corporations hold huge PIB stocks but only a few in public sector had the mandate or the inclination to invest in PIBs.

Marketing PIBs to uninitiated finance managers is not an easy proposition. PIB pricing mechanism often proves too complex to comprehend. This is true of managers in smaller firms which, in any case, don’t have large amounts of liquid funds to invest.

But with the recruitment of many business finance graduates in business and industry there was a possibility that PIBs, rather than low-yield bank deposits, could become popular with smaller corporations as well.

The real reasons for non-expansion of PIB market were the absence of PIBs from the market (because government nearly stopped floating them), and the low yields offered on the few that were floated. Infrequent PIB auctions won’t expand the PIB market.

Creating a large debt paper is a two-way street. Government and investors’ perception about future risks and rewards must coincide for this market to develop. Investors expect regular auctions and realistic yields, which the Ministry of Finance does not seem to appreciate.

The government also overlooks the fact that NSS already accounts for 27 percent of the total national savings. Larger investment flow in NSS could increase this ‘convenient’ un-funded debt even more but not without big risks.

Until now, there were few big-ticket investments in NSS because it remained the repository of individual savings. The benefit was that on scrip maturity dates government was not faced with huge fund outflows. With the corporate sector investing in NSS, this could change. Government may have to frequently pay out (and borrow?) huge amounts.

The only encouragement for re-investing in NSS (that offsets outflows on maturity) will be the returns offered on NSS because corporate investors are yield-conscious.

A refusal to align NSS returns with market rate (most likely a rising KIBOR) could pull savings back into the banking sector. The pressure will be intense requiring frequent revision of NSS rates, which brings us back to square one: realism in returns offered on debt raised either through PIBs or NSS, for which the government has yet to show its liking.

Having said that, it is important to note that banks holding huge deposits of public sectors enterprises (most of them earning low returns) are at risk. With almost 80 percent of their deposit bases consisting of current, savings and term-deposits maturing within 90 days, they are vulnerable to liquidity short-falls.

When these banks don’t remain as liquid as they are at present, also at risk would be the banks that are accustomed to surviving on borrowing from these banks rather than mobilizing customer deposits.

The way out would be to devise attractive time-deposit products. Smaller banks facing competition in mobilizing large-ticket deposits had very wisely begun revising upwards the profit rates payable on term-deposits.

On a 5-year deposit, these banks now offer as much as 11 per cent per annum – higher than the rates currently on offer on 10-year DSCs or 3-year SSCs. These banks are less likely to suffer liquidity shortfalls compared to bigger banks holding large public sector deposits, although they profitability will take a slight dip but not very significantly.

Lower profitability may dampen the prospects of foreign bids for Pakistani banks but not to a worrying extent. No prudent foreign bank expects to earn the breathtakingly high returns that Pakistani banks had got used to earning.

Well-managed banks can still earn net returns on investment close to 20 per cent and that should be attractive enough for prudent (not fly-by-night type) foreign banks. The other plus is that banks will learn to earn fair returns, not ones that seem embarrassingly high and therefore unjust.

Mutual funds and asset management companies have a tougher task ahead of them. But since they are not barred from investing in NSS, they shouldn’t find their future under threat. They certainly need to revamp their asset portfolio mixes to keep their returns competitive. This effort will require a great deal of expertise and ingenuity on their part.