Lately, the SBP has been pushing banks to enhance financing extended to SMEs. But banks are not ready to take risk without adequate risk coverage. Global experiences suggest that a first loss guarantee mechanism is required for financial institutions to delve into new areas – be it SME or housing. Once the banks have adequate exposure and learning experience, they can work without guarantees.
In this regard, SBP set up a credit guarantee scheme for SMEs in 2010 and ran it with some success, helped by innovative mindedness. It was recognized both by the SBP and the scheme’s sponsor, UK’s Foreign and Commonwealth Development Office (FCDO) formerly known as DFID that the scheme needs to be run by a specialized outfit managed and majority owned by the private sector.
There are two problems in managing the scheme under public domain. One, is that SBP Act does not allow any unfunded contingent liability. At an estimated loss of 20 percent, a guarantee fund can finance five times of the financing. But SBP can only finance at one-to-one ratio, resulting in opportunity loss. The country needs that leverage as this is how SME finance is being pushed in other developing economies.
If a special purpose vehicle (SPV) is formed, the much-needed leverage can take place. Such SPV can be formed under the ownership of SBP or the government. But past experience of state (or SBP) owned financial entities does not inspire confidence. These entities are inflicted with bad loans and are operating on clutches. For example, the Gross Non-performing loans (NPLs) of SME bank (94% ownership of GoP) was 74 percent in 2019. The story of other SBP owned entities – HBFC (90% owned by SBP) and ZTBL (76% owned by SBP) is no different with toxic assets ratio of around 30 percent for each.
The fundamental point is that state does not have the discipline and capacity to manage development finance institutions. In fact, the story of non-financial state-owned intuitions is no different. Every successive government is running a privatization agenda. Seeing that, having a credit guarantee scheme managed by government is not a good idea.
The guarantees business is very specialized and essentially non-profit. Banks avail the guarantees and pay fees only to develop comfort with a product or specific client segment. It forces guarantee institution to continuously innovate and look for even riskier segments allowing its partners to take risk on unbanked segments and in unchartered territories. The guarantee institution can therefore make some profits initially or on some products, but its business model would almost never allow it to make returns beyond operational sustainability. Thus, guarantees business cannot be purely run by private hands or on commercial basis.
The ideal case is to be run by a development institution conceived as not for profit. Not to mention management and board strength is imperative for the success. Seeing all this, a decision to setup Pakistan Credit Guarantee Company was taken. It was decided to give management lead to an institution such as Karandaaz, a not-for-profit implementation partner of FCDO, with a very-strong independent board comprising of two former Governors of SBP, a Chairman of SECP, and other reputed industry experts.
The story was going smooth and based on logic. Then a debate started on how can a grant move to private hands. This was signed between two sovereign nations, and there were certain conditions stipulated with this grant. Any unspent financial asset upon expiry of the contract were to either revert to FCDO or FCDO’s Enterprise and Asset Growth Programme (EAGR).
Thus, the amount must be used for said purpose or be returned. In Pakistan’s best interest, it should remain in the country and should be served where it has better efficacy. That is why an arrangement is structured by all relevant parties to keep funds invested in Pakistan for continued use to enhance SMEs access to finance. Once these funds are invested, UK will have no claim on its funds, returns or divestment proceeds.
The arrangement proposed is bilateral (G to G) and in line with the provision already stipulated in FIP’s contractual agreements between UK and Pakistan as Karandaaz, a not-for-profit entity, has the responsibility of implementation of UK’s EAGR. One cannot expect a foreign development agency to leave funds in Pakistan which can contractually take it back and yet not care about governance of those when the evidence strongly suggests making it a top priority. All such development agencies are, as they should be, accountable to their taxpayers, audit, and accountability paraphernalia.
The company under question, PCGC, was created in 2019 in response to the recommendation of the FIP. All its setup and operational costs have been funded by FIP’s Credit Guarantee Scheme which is approximately 90 percent FCDO and 10 percent MoF funded. It was created in advance to prepare it for capitalization by FIP on exit. It has a share capital of mere Rs300 and has no operational income or income generating assets.
The company would not have existed without operational grants from FIP and no other funds are available to capitalize it. It is not correct to say that government plans to sell stakes of such a company. New shares are being issued to inject fresh capital. Right now, Rs3.7 billion as a grant from FDCO and Rs0.3 billion by MoF. In new shareholding structure, grant principal amount is proposed to be shareholding of Karandaaz while the interest earned on grant money would be under SBP ownership, and rest to be owned by MoF. In a nutshell, Karandaaz will own 51 percent while rest by SBP and MoF.
Some are worried that the conversion of unspent grant into equity would create a wrong precedent. That is not correct. It is better to utilize it in right way. Otherwise, the money would go back or be parked in a state-owned entity. How can one expect a new entity to do different from what is happening for decades? Even nowadays operationalization of government owned entities takes a painfully long time – Exim Bank being a latest example. And if it does happen eventually, there will soon be talks of its privatization. There are perhaps lessons to be learnt from the proposed PCGC structuring which can be applied to existing state-owned entities.