Rising level of NPLs

The revelation by the State Bank of Pakistan on 19th August that the level of non-performing loans (NPLs) of banks and DFIs has touched a historic level of Rs 594.5 billion at the end of June, 2011 could only be a source of great discomfort to the monetary authorities of the country.
According to the data made available, NPLs continued to grow and registered an increase of Rs 5.5 billion during the quarter ended June, 2011 as compared to the rise of Rs 22 billion in the preceding quarter. With a surge of Rs 5.6 billion, banks were solely responsible for the increase in NPLs while NPLs of DFIs registered a small decline of Rs 131 million.
Within banks, NPLs of specialised banks and local private banks rose by Rs 3.9 billion and Rs 5.2 billion to Rs 35.3 billion and Rs 370.2 billion, respectively, while foreign banks and public sector banks reduced their NPLs by Rs 88 million and Rs 3.4 billion to Rs 6.7 billion and Rs 166.9 billion respectively. Although, there was some divergence in trends within the financial sector industry, the overall level of NPLs has, nonetheless, shown almost a consistent increase over the past few years.
A number of factors could have contributed to the rise in NPLs of the financial system in the country. Most of the analysts believe that economic slowdown, particularly dampening industrial and business activity in the country, high interest rates, worsening law and order situation, acute energy shortages, rupee devaluation, high inflation and political uncertainty are some of the major adverse developments resulting in low recoveries and increase in NPLs.
However, neither any study has been made to isolate the precise impact of these factors nor their relevance has been proven analytically to justify the relationship. The available data adds to the confusion further because whatever the conditions on the ground, the level of NPLs has generally shown an upward trend over the years.
For instance, the level of banks' NPLs which was only Rs 173.2 billion in CY06 rose uninterruptedly to Rs 460 billion by CY10 and soared to Rs 594 billion by June, 2011. This suggests that some other factors like the overall culture in society to equate the non-payment of banks' loans with the level of prestige and power of the borrowers, frequent announcements of write-offs by the authorities at the helm to earn popularity, banks' own inefficiencies, and an ineffective mechanism to punish defaulters may also be at work to increase the level of NPLs of the financial sector.
Whatever the reasons, the deteriorating asset quality and the rising incidence of NPLs has emerged as one of the main challenges confronting the banking industry in recent years. This is despite the fact that the SBP has been quite vigilant about the situation and insisting upon higher provisioning requirements against infected portfolios in order to ensure solvency of the system.
The argument of high interest rates and tight monetary policy followed by the State Bank often advanced by the business community for the rising trend in NPLs, however, is not relevant to the situation as the net interest rates in Pakistan (adjusted for inflation) are very much comparable with other countries and the central banks all over the world are always constrained to adopt a tight monetary stance to contain demand pressures in an inflationary environment.
Needless to say, the rising level of NPLs would have a negative impact in certain important areas of the economy. For instance, high provisioning necessitated by higher level of NPLs would erode the profitability of banks, reduce deposit rates and adversely affect the saving rate in the economy. In a situation where foreign investment is declining fast and domestic savings are already low, the consequences of such an unhealthy trend are not hard to visualise.
Another negative outcome is the desire of financial institutions to invest their resources in government paper and desist from private sector credit in order to keep themselves liquid and secure their financial position in a period of rising NPLs. All these tendencies tend to retard the growth rate of economy and increase unemployment and poverty in the country.
In our view, the State Bank and other financial institutions need to devise a proper policy strategy without losing more time in order to ensure that the rising trend of NPLs is reversed before it becomes a threat to the solvency of the system and emerges as a constraint to the growth prospects of country's economy.