The State Bank of Pakistan has embarked upon a policy of cheap credit, which is a complete reversal of interest rate reform as an important element of financial sector reform , financed by the World Bank and initiated in the early nineties.
As a result, there has been a sharp decline in interest rates, falling to the lowest level ever recorded. This has certainly provided a major relief to the federal budget that had been severely burdened by debt servicing.
The cost of servicing domestic debt to the federal government has been reduced from Rs.218.7 billion, or 36.9 percent of current expenditure and 6.9 percent of GDP (MP) in FY 00 to Rs.198 billion, or 23.6 percent of the expenditure and 4.3 percent of the GDP in FY 03, despite the substantial increase from Rs.1,579 billion to Rs.1,854 billion or by 17.4 percent in the stock of debt.
The ratio of the stock to the GDP in 03 was 46.1 percent as against 49.7 percent in 00.What are the implications of this policy for the rest of the economy? Interest or return, to use the Islamic terminology, is cost to the borrower and income of the lender. Between them stands the financial system, particularly banks, performing a crucial function of intermediation.
Borrowing or lending is one form of use of investable funds, the other being equity. Their interaction impacting the choice of the borrower as well as the lender has far reaching implications for the economy through saving and investment. All these aspects need to be analyzed in depth.
It is very significant that in Pakistan, with the introduction of Islamic Modes of Financing, the return charged by banks from the borrower and that given to the depositor are not set independently, as in interest based system, but are inter linked, the return to the depositors depending on the return from the borrower. Thus any reduction in the return on advances is automatically quickly passed on to the depositor.
This adds to significance of the spread between lending and deposit rates. The likely cost is known to the borrower by way of mark-up, but there is no such pre-determined rate for the depositor and he is at the mercy of banks, who announce the return post-facto in the name of Profit & Loss Sharing on a half yearly basis.
There has been a significant change in monetary policy stance. The Bank Rate, which had been raised from 13 percent to 14 percent in June 01 but reverted in the very next month, was gradually lowered to 7.5 percent in November 02. Similarly, the SBP rate charged for the Export Finance Scheme was first raised from 6 percent in September 00 to 11.5 percent in July 01 but gradually reduced to 6 percent in March 02.
It was raised to 6.5 percent in April 02, remaining at that level till November 02. Thereafter, it was gradually reduced to 1.5 percent in August 03. The rate charged for export of locally manufactured machinery (LMM) followed suit, while for its local sales the rate, which had remained constant at 12 percent till March 02 has been reduced to 5 percent in the same month of 03.
In contrast, the SBP rate for ADBP\ZTB has remained unchanged at 10 percent throughout this period. For Punjab Provincial Cooperative Bank, the rate has been reduced from 8.0 percent in April 02 to 1.212 percent with effect from August 03.The lending rates of these two institutions have been 14.0 percent. The easy monetary policy, coupled with excess liquidity generated by the external sector, has led to a sharp reduction in cost of lending by banks.
As a result, the weighted average of lending rates, which stood at 16.09 percent in June 98 and 14.61 percent in June 99 was down to 7.58 percent in June 03 and 5.32 percent in October 03. Banks are allowed to charge 1.5 percent above the SBP rate and now charge 3.0 percent as against 13.0 percent in July 01 for export finance.
Foreign banks have been very active and claim 13.6 percent of bank advances.Their advances to private business on the basis of Islamic Modes of Financing has declined in absolute amount thus reducing their relative share from 1.7 percent in 99 to 1.4 percent in 02. These banks are urban-based with state-of- the-art management and products. They prefer elite clientele, which sets them apart from Pakistani banks.
This gives a dual character to the banking system, which is not only manifested in their asset portfolio, but also in the size of advances and rates of return charged by them. Their lending to individuals, mostly by way of consumer credit, is quite prominent claiming 18.3 percent of their total advances as against 7.1 percent by Pakistani banks.
The average size of their advances in 02 was Rs.53,000 as against Rs.36,000 for Pakistani banks. As is evident from the table, the cost of borrowing from them is generally lower than Pakistani banks and the rate structure is more even. The weighted average of their lending rates was 13.43 percent as compared with 14.86 percent charged by nationalized banks in June 99. By October 03, this had fallen to 3.75 percent while it was 5.77 percent for nationalized banks and 6.61percent for private domestic banks.
In case of Pakistani banks, the bulk of the advances continued to be at 14 percent and above, even though there was some reduction in the higher rates in 02.At Rs.329 billion, they accounted for 67.6 percent of the advances. The share of 14 percent was 27.7 percent of the advances. The distribution between Pakistani and foreign banks for 03 is not yet available. The available overall position is quite instructive.
There was a phenomenal downward shift in the rates and the bulk of advances were made at rates up to 8 percent, which accounted for 36.6 percent of the advances in 03 as compared with 7.1 percent in 02. The most significant increase was at 4 percent, which shot up from Rs.4.6 billion in 02 to Rs.90.5 billion. This was the new rate for export finance effective from April 03.
To allow for the possibility of overlap between the old and new rates, they may be taken together. Their combined advances rose from Rs.34.4 billion to Rs.116.1 billion. This was obviously out of proportion to the increase of Rs.64.3 billion in exports during FY 03.
The ratio of these advances to annual exports witnessed a three-fold increase from 6.1 percent to 18.6 percent. The apparently excessive growth in export finance at very low rates suggests the possibility of misuse of credit. It is interesting that within this group, there are large borrowings at other small rates. Advances at 3 percent shot up from Rs.0.54 billion in 02 to Rs.43.8 billion in 03 while at 5 percent the amount of lending was also Rs.43.9 billion as against Rs.2.0 billion in 02.
Another important development is the increase in advances made at zero-rate from Rs.3.5 billion in 99 to Rs.23.4 billion in 03. One wonders who enjoys credit at zero-rate, whether by agreement or by default. These elements were largely responsible to pull down the overall rate for lending. The advances made at 14 percent and above were worth Rs.239.4 billion in 03 as against Rs.484.4 billion in 02 and Rs.354.3 billion in 99.
Cheaper credit should have encouraged the marginal cases leading to an increase in the number of borrowers, but the change has been in the opposite direction. The number of advances to private business declined from 1.739 million in 99 to 1.712 million in 02, or by 1.6 percent, but the average amount of advance increased from Rs.317,000 to Rs.358,000. In other words, small borrowers were squeezed out during this period.
In 03, the number of advances to private business increased to 1.774 million, or by 3.6 percent. The average amount also increased to Rs.0.401 million. It is quite obvious that cheap credit policy has not given any significant relief to the marginal borrowers who are generally those who are not so well connected. In other words, the privileged have been favored all the more.
Many of them are habitual defaulters with impunity and, as such, the rate is meaningless for them. The amount of NPLs has increased from Rs.212 billion in 99 to Rs.231 billion in September, 03.
As pointed out above, a huge amount of Rs.23 billion carries no cost of borrowing and who benefits is an important question. They also benefited from large loan write-offs amounting to Rs.25 billion since 99. This compared with outstanding advances of Rs.4.5 billion for advances less than Rs.25,000 each and Rs.32.9 billion for those less than Rs.50,000 each, as of June 03.
The average amount of recent write-offs has been Rs 0.6 million. Perhaps what is more important is the fact that cheap credit policy, which could be justified by the need to encourage investment, has been a dismal failure on that count. There has been no improvement in the rate of national investment, which is stagnating at 15-16 percent of GNP.
In Pakistan, productive investment is hamstrung by numerous infrastructure inadequacies and other serious real irritants with a common root cause of corruption. Unless these limitations, which make quite a list, are effectively removed, mere availability of finance, whether raised at home or abroad, would not do.
While cheap credit policy has little to show in terms of investment, it has certainly acted as a disincentive to save by reducing return to savers. Domestic saving is already very low and needs to be encouraged to reduce dependence on external resources, which only add to the already heavy foreign debt burden.
The real return by banks to depositors, down from 6.4 percent in 99 to 1.45 percent in October 03, has become negative by a substantial margin, if allowance is also made for Withholding Tax and Zakat. What is more disturbing is banks discriminating against the small depositor in regard to return. According to the latest declaration of return on deposits by banks for July-December 03,Habib Bank paid 0.10 percent on savings deposits up to Rs.10,000 and 1.25 percent on those above that.
This gives a ratio of 1: 12.5. Similarly, National Bank paid 0.20 percent on saving deposits up to Rs.20,000 and 1.2 percent for above that balance, a ratio of 1:6. Faysal Bank has paid nothing on balances less than Rs.25,000, but paid 0.90 percent on Rs.25,000 and less than Rs.100,000 and 2.25 percent on Rs.100,000 and above.
In addition, a service charge is levied by almost all banks on a balance of less than Rs.5,000. The sharp reduction in return on NSS is to the disadvantage of a very vulnerable group. The tacit belief that this is a group of captive investors is now belied by a net outflow from these schemes starting with the current year.
Excluding Prize Bonds, the outstanding investment in NSS had, despite the introduction of new Pensioners' Benefit and Behbood saving schemes, declined by Rs.2.3 billion during July-September 03. Cheap credit is also creating or adding to many other economic distortions in the economy. Interest arbitrage through NSS and misuse of export finance are too well known to be dilated upon here.
An observation by a former governor of SBP in this regard is worth recalling He had said that cheap and subsidized credit, mostly availed of by the influential rich, had been used for purchase of Pajeros and construction of palatial houses. Landlords and others acting as money-lenders in rural areas, because of their privileged access to institutional credit, has been documented in a PIDE study.
Since the corporate sector is highly leveraged, debt\equity ratio being 70:30 in general, even 80:20 in some cases, this has improved business profitability without any effort. This distracts the entrepreneur from the urgent need to improve productivity to turn out quality products at internationally competitive prices to be able to face the challenge to be posed by full implementation of WTO in January 05.
To the extent the profits of foreign business in Pakistan increase, because of cheap credit, this puts pressure on balance of payments through larger remittance of profit and dividend. This aspect should be taken note of as these payments have been on the increase and are quite sizable now. They had increased from $ 270 million in FY99 to $ 631 million in FY 03, more than doubling from $301 million in the last two years.
In the first quarter of FY 04, they were higher by $ 15 million than the corresponding period last year. The fact that in Pakistan private corporate bodies are a closely held family controlled business, cheap credit only perpetuates this form of corporate culture, retarding the growth of broad based corporate sector which would provide avenue for investment of individual saving. This is evident from the number of public limited companies listed at the stock exchange.
The number of listed companies at KSE has declined from 769 to 706 in June and 700 in October 03, while their paid up capital has increased from Rs.215 billion in 99 to Rs.301 billion in June and Rs.305 in October 03. In June 03, this was only 7 percent of GNP and 31 percent of outstanding scheduled bank advances. During this period (up to October, 03), 13 new companies were listed at KSE with paid up capital of Rs.13.7 billion.
The priorities built into the policy are quite strange and against the basic requirements of the economy. It is agreed on all hands that what is needed for economic revival and poverty alleviation is to boost agriculture, but this is accorded priority much lower than exports, which, as a matter of fact, depend heavily on agriculture.
The SBP provides refinance at 1.5 percent requiring banks to lend at 3 percent to exporters. In sharp contrast, it lends to ZTB at 10 percent and the farmer is charged 14 percent, or almost 5 times the exporter. The rate for short-term loans for Kharif 03 was reduced to 9 percent. Even that is 3 times the rate for export financing.
It is not only the rate, but also actual availability of credit, particularly to the small farmer. This is not a happy situation. In case of agriculture, forestry and fishing the number of advances declined from 1.471 million in 99 to 1.394 million in 02, or by 5.2 percent, whereas the average amount of advance increased from Rs.62,000 to Rs.73,000. In 02 the number of advances to those engaged in crops and orchards were 1.325 million, the average size of advance being Rs.69,000. According to the 1990 Agricultural Census, there were 5.07 million farms in the country.
Rural areas have been in the clutches of those who are simply bloodsuckers, even though they do not go as traditional professional moneylenders. Development of banking was expected to reduce rural dependence on non-institutional credit, but unfortunately there has been no appreciable change. According to PIDE, "An inter-temporal comparison of borrowing based on various surveys is suggestive of a decline in the share of informal sector in total borrowing of rural households during 1973-85 period.
Since 1985 the trend appears to have been reversed." The share of institutional sources, which had increased from 9.8 percent in 1973 to 58.8 percent in 1985, declined to 22.0 percent in 1996.
Another important finding is, "Around one-third of the credit extended by informal lenders is provided by formal institutions, like banks. Processing units, landlords and other influential persons borrow from banks for onward lending through informal channels." (The Structure of Informal Credit Market in Pakistan, Sept. 1998)
The main reliance of credit to agriculture has been through ADBP\ZTB. As of June 03, of the total outstanding banks advances, ZTB accounted for Rs.111.4 billion as compared with Rs.19.5 billion by commercial banks. This has thrown up the problem of NPLs as far more serious in case of ADBP\ZTB than other financial institutions.
The ratio of NPLs to total loans in that case has been more than twice the overall ratio for all banks. In FY 00, this was 50.9 percent as compared with the overall rate of 25.1 percent.
Interestingly enough 1,551 branches of commercial banks, or 40 percent of total branches in cities with population of less than 10,000, most of them in rural areas, have been closed since 99, as they were believed to be loss making. They were loss making not because of any operational inefficiency or default by borrowers but due to income for not lending there as a matter of policy.
If they lend there, they would make better profit than the urban branches, as they would not be deviled by NPLs. It is a fact that small farmers rarely default, as they cannot afford to do so The PIDE study puts this at less than 6 percent.
In terms of coverage, Khushali Bank and Micro Finance institutions cannot make up the loss of banking facilities in rural areas. Commercial banks must be involved in rural finance in which the availability of institutional credit counts more than its cost, which, in any case, would be much lower than non- institutional sources.
The PIDE study observes, "Lenders who lend money to farmers charge 40 to 50 percent interest for the duration of 8 to 10 months." Apart from other things, private commercial banks need to be reminded of their social responsibility to promote economic activity in neglected areas and sectors.
No significant progress in rural areas can be expected without financial institutions not waiting for the small farmer to come to them, but making credible effort to reach him. The availability of institutional credit to the genuine small farmer should be taken as an essential element of efforts for poverty alleviation in rural areas.