Kardar banking on government reforms

An interview with Shahid Hafiz Kardar, Governor, State Bank of Pakistan
Ali Khizar & Haider Nawab. In his first detailed interview to a Pakistani publication, after becoming the governor, Kardar talks candidly about how the government's failure to reform is raising obstacles in the country's path to economic growth.
He also sheds light on the culture of lazy banking in Pakistan, while sharing his view on the interest rate outlook and the private sector credit off-take. Below are the edited transcripts.
BR Research: DFIs are supposed to be for long term projects including infrastructure financing, but lately these institutions have simply died down. How would you formulate strategy to revive the much-needed long-term project financing?
Shahid Kardar: There are two issues involved here. The only institutions available after the death of DFIs are the commercial banks. This is because commercial banks were functioning and had been privatised by the time DFIs were wound up or became dysfunctional. They were more aggressive in offering the financing being sought.
However, commercial banks, by definition, have an asset liability maturity mismatch. If you look at the deposit side of commercial banks, 85 percent of them have a maturity of less than one year, whereas they have to have an asset profile which is not completely out of sync with the maturity profile of liabilities.
The other issue is that all projects with a long gestation periods require three things; first, a stable political and economic environment; second the continuity and predictability of government policies. I think this is an area that is beginning to become more entrenched.
The third area is concerned with the development and functioning of capital markets, which is linked to the predictability of policies, the government's financial management strategy and its efforts to create a yield curve for its own instruments.
BRR: Can you elaborate on the development of the yield curve?
SK: For a variety of reasons, the government has not been able to create a proper yield curve for its PIBs; 76 percent of government domestic debt is short term, partly because offer rates for PIBs in recent auctions were being rejected. So when there is no benchmark available for sovereign debt, it hinders the development of a market for long-term financing in the shape of a corporate bond.
BRR: What is being done about it?
SK: We have created certain institutional grounds, and now the government has to pass certain tests. The government has passed one test recently. For example, it has raised money from Sukuk, where out of the Rs 80 billion target, Rs 52 billion have already been mobilized.
There is a much greater degree of engagement and discussion between SBP and the government. We are hoping this will bear fruit. We have transferred the rights to accept offers in auctions to the Ministry of Finance, which is the right approach in my view.
They are the borrowers and hence should adopt their own debt management strategy and decide the quantity of debt or the rate at which they are willing to raise debt. We believe, the Ministry of Finance is adequately equipped to take this decision.
BRR: Does heavy government borrowing hinder the long term infrastructural financing?
SK: Yes, if the role of government was to recede then you would see a variety of developments that would facilitate the creation of a market for corporate debt. If the government is taken out of commodity financing, and if the government reduces its reliance on bank borrowing and prohibits institutional investors and pension funds to invest in the NSS, new opportunities would be created.
This will help develop a body of corporate investors, seeking financing through corporate debt markets. For example, the government has raised commodity financing in excess of Rs390 billion from scheduled banks. And more importantly, if the sovereign is borrowing for such operations at just under 16 percent, naturally the private sector will only be able to borrow at a premium.
Also, the pace of growth of the economy is good, which would facilitate the creation of a market for corporate debt. On the other hand, non-performing loans are on the rise, having reached Rs500 billion. With this kind of risk profile amid heavy government borrowing from banking sources, not only are banks risk-averse, but also there is little appetite for long-term financing. Under such circumstances it is going to be an uphill task, at least in the foreseeable future, unless the situation changes dramatically.
BRR: What can change things dramatically?
SK: The major changes that we are hoping for are: a) the amendments in the State Bank Act; once they're in place, we will be adequately empowered legally to check government borrowings; b) a significant reduction in the government's fiscal deficit, through an effective implementation of RGST which will enable the government to reduce its borrowing, and c) a pick-up in economic activities.
To summarize, the government's heavy borrowing is not helping the creation of a market for the corporate sector to raise long term financing.
BRR: Have you incorporated RGST in your monetary policy model?
SK: Yes we are hoping that RGST will be implemented; we have also weaved its impact in our recent Monetary Policy Statement.
BRR: Do you think that reducing the fiscal gap to 4.7 percent is too optimistic?
SK: I agree it looks somewhat ambitious at this stage. But I do not lack confidence in the government. It has indicated its intention and has given a commitment to change the tax regime and mobilize additional resources and I hope that it will be able to deliver on this front.
Part of the reason for the slippage in the fiscal deficit is additional expenditure on security and flood related rehabilitation. What needs to be seen is the extent to which the Federal and Provincial Governments will be able to adjust the deficit under such challenging circumstances. We expect that as we move forward, the demand of funds by the government from banks will begin to decelerate.
BRR: With the amendments in SBP Act in place, government borrowing from central bank would have to come down to 10 percent of government revenues. How much will the government have to repay?
SK: Under the Act, the Government of Pakistan needs to offload the stock of SBP's lending in five years, from the date of passage of the Act. Just to give you an example, the stock of MRTBs on the date the Act was passed by the National Assembly, was Rs1,355 billion. So by the time it will be passed by the National Assembly after its approval by the Senate, the stock may touch Rs1.5 trillion. That will place a huge demand on the financial system and managing it will be a challenging task.
BRR: If Rs250 billion per annum is offloaded on average, the government will have to go more to the commercial banks, hence, more crowding out of private sector. Doesn't that add to the woes?
SK: Yes. When the Act's amendments were actually drafted, the borrowings were lower. Now that the Act is about to be passed, the stock has piled up. So, today it won't be that easy. We will have to manage liquidity without seriously crowding out the private sector, a formidable challenge.
BRR: When would you think Act will be effective?
SK: Full credit must go to the Finance Minister and his team who are piloting it through the Parliament. We hope that by mid-January, we will be ready to start implementing it.
BRR: In the last six months government borrowing has increased by more than Rs200 billion, whereas external flows have remained lacklustre. How will the government manage it?
SK: External flows are not what had been predicted. Greater clarity is required on potential flows, for instance, on the revenue likely to be raised to the tune of Rs50 billion through the issuance of 3G licences.
BRR: 3G licenses! Really? We are half way to the year and there is no development in it?
SK: The government insists that it will be able to raise this amount. We must incorporate it in our model. We cannot challenge them on this when they argue that their initial discussions have been rather promising and that they are well placed to mobilize the amount projected in the budget.
BRR: What other avenues the government is eyeing on?
SK: The reimbursements under the Coalition Support Fund is one area. Claims of $2.5 billion are being processed by the US, out of which US$110 million have arrived and an additional amount of US$700 million is expected by the end of December, The government is confident that it will try to get more from the CSF during the second half of the fiscal year.
BRR: Is there a lack of coordination between the State Bank and MoF?
SK: In some cases yes. For instance, we mentioned in our last monetary policy statement that since the government raised less money than the target under the announced auction despite higher participation in a previous T-Bills auction, it added unnecessary pressure on its borrowings from us. Our view is that you cannot fix both quantity and price simultaneously. Now they are accepting our argument and have raised more than the target in the most recent T-Bills auction.
The Finance Minister, the Deputy Chairman, Planning Commission and I are on the same wavelength. We have similar mindsets and views. We also know each other socially and there is a high level of trust and comfort amongst us. It may be a sheer coincidence, but it is a great opportunity that will go a long way in building trust and coordination at the institutional level. Even at the bureaucratic and administrative levels, there is good coordination, partly also because I have known the key players over the years both professionally and socially.
This is a huge window of opportunity for improving co-ordinations at all levels. My plan is not to create linkages at a personal level but try to institutionalize the processes. We have cleared the first test of our institutional understanding with the government meeting its T-bills target in the recent auction. We have four more tests just in December including a PIB and a Sukuk auction.
BRR: Do you think that the RGST has been unnecessarily delayed?
SK: Yes, it has taken much longer than had been envisaged. But look at the positive side. The legislation has been passed by Senate and there is an agreement amongst the provinces on 99 percent of the issues, a minor matter remains to be resolved and that shouldn't take long. All that is required is the processing time for it to be passed by the National Assembly. I believe that the government has taken 1.5-2 years in implementing RGST because they were preparing themselves; as it is not that simple to get all the stakeholders on board.
BRR: How can we increase the presence of venture capital, private equity and investment banks? Their role was envisaged in the five year road maps of your forerunners. What is your take on it?
SK: If the role of government recedes, we can probably get venture capital firms rolling in. Much of it also has to do with greater political stability, improved law and order conditions and the predictability of government policies, lack of which naturally forces economic actors to think in the short term. The lead has to be taken by the government by giving a long-term sustainable direction.
BRR: The gap between demand and supply of low cost housing for middle class is increasing. Under high interest rates scenario, how would you work in this area?
SK: There is no denying that at these interest rates, it's difficult to create a market for housing finance. But there are other issues as well. For example, the provincial or local governments are required to ensure a decent system for title veracity, provide primary infrastructure to enable development of land for housing, in which neither the Federal Government nor the State Bank has any role.
Then there is the question of the structure of taxation; stamp duties, property taxes, charges for commercial development, rent control laws, foreclosure, etc. Investors will not develop a property for rental purposes if they cannot get a tenant to vacate.
On the issue of foreclosure, it's just not the legal aspect but also the behaviour of the courts. And, last but not the least, there is the question of building and zoning regulations, considering that there is a need for flats for middle and lower income households.
BRR: What is being done about it?
SK: One, we are working with the International Finance Corporation (IFC) on a mortgage refinance facility. Second, we are trying to learn from the Indian model. One of our teams visited India and now we are inviting the Indian HBFC team. We are working with Indians because they have similar issues as us, other than the issue of interest rates. We hope to learn from them on how to manage such hurdles.
Third, I met an investor group that has set up a mortgage refinancing facility with the IFC in Saudi Arabia. So, instead of reinventing the wheel, we will try to learn from their experiences. We lost the opportunity to develop a housing finance industry when interest rates and inflation were low.
BRR: Bank lending to big corporate has been crowding out the small and medium enterprises. What can be done to turn the situation around?
SK: We feel that the most neglected part of SMEs is the 'M' part. A part of the 'S' is being catered by microfinance or other similar concessional lending. But we think greatest potential lies in the 'M' part and that's a niche that we will target in future policies and initiatives.
We are in discussions with the IFC to provide credit lines to commercial banks. We are also in negotiations with the USAID on development of incentive packages and instruments for mid-sized enterprises that banks would find attractive to market more aggressively. We have also invited the Asian Development Bank for discussions on this subject.
BRR: How do you plan to go about?
SK: Our aim is to devise an incentive structure for the banks that would entice them to target the SMEs. The flood affected areas have provided us an opportunity to test our strategy. Our NPLs in flood-affected areas are at 22-23 percent, but just to make these areas functional again, we have frozen the NPLs in those areas with relaxed provisioning requirements for overdue amounts.
Since the banks were reluctant to lend in the flood hit areas, we have asked the banks to continue doing so, on the promise that we will provide them 30 percent guarantee on first loss. So initially, the scheme will over-compensate the banks, but with a very clear strategy that as we move forward this over-compensation will be phased out in a year and a half or two, and help us develop other incentives packages and instruments. Having learnt this from our experiences in flood-affected areas we can refine the packages and roll out models for the rest of the country to cover areas other than the flood-affected areas.
Moreover, we are looking at the whole business of Export Refinance Schemes for SMEs. The modalities and the allocations have not been decided yet on how to support SMEs as they are more likely to be exporting non-traditional items.
BRR: But EFS has traditionally been misused for example buying a property in Dubai?
SK: It is less likely to be misused by SMEs for the simple reason that they don't have access to other funding. Those with deep pockets and access to other funding are better placed to abuse this facility since money is fungible. The stakes for SMEs not to run foul of the scheme rules will be much higher.
BRR: How would you incentivise commercial banks to finance SMEs?
SK: We are giving first loss guarantee and arranging funding from DFID and, hopefully, USAID. We have to change the mindset. I am hoping that with these incentive structures, we will be able to change the way the banks view SMEs. Commercial banks argue that transaction costs are high for them to deal with SMEs. This is lazy banking, as today banks are not even looking at corporate clients, all they are doing is filling the appetite of government. And once the economy revives, banks will have to revert again to the private corporate sector.
BRR: Do you think there is some responsibility on the part of corporate sector as well to take an initiative and go to the public themselves, like Engro has ventured with Rupiya?
SK: I agree. The Engro management comprises of dynamic individuals. It's a great idea; I am a great supporter of it. Interestingly, Engro is borrowing from the public at a cheaper rate than the government is borrowing for commodity finance from the commercial banks. You may well ask if this is good evidence that they are better and more creditworthy borrowers than the government. This leaves one wondering if these are the early signs of whether the appetite is weakening for lending to government.
What we need to do in coordination with the SECP is to try and build a corporate debt market. We need to urge the corporate sector to raise capital from the market in a variety of ways.
BRR: Since some of the small banks are yet to meet the MCR requirement, there is likely case of more mergers and acquisitions. How are you facilitating that?
SK: There are ten banks in Pakistan, apart from three public sector banks, which are falling short of capital. Two of them are merged and three are in the process of mergers. We are closely monitoring them and are conscious of it. The most difficult case is of public sector banks.
We need to find out what is making it difficult for them to comply with the MCR while realising that the current environment for raising capital is not favourable. So we are looking at them on a case by case basis as most of the banks have already met the MCR requirement. Some have even complied with the future requirement.
BRR: Does SBP plan to slash the MCR requirement further?
SK: We will revisit it only if necessary. At this point in time, I don't think it is necessary.
BRR: Do you think CAR is a better measure than the MCR, especially after Basel III?
SK: After the global financial crisis, the view is changing worldwide. I am of the view that we need both CAR and MCR. Nonetheless, at the moment, we believe that MCR as a measure is imperative to ensure good quality capital, although we can discuss the definition of what should constitute capital.
That's because for small banks to be able to survive and generate profits on a sustainable basis, they require to invest in IT, risk-management, human resources and a branch network; there is a need for a minimum size to operate. For that particular reason, for us, MCR is important.
Most jurisdictions work with MCR, though some might place more and some might have less emphasis on it. Also, small banks, with limited capital, face difficulties in withstanding the risk of major borrowers defaulting or a large depositor withdrawing unexpectedly. We have seen repeated pressures on small banks both from the asset and liabilities sides.
BRR: Shouldn't small banks be finding their own niche?
SK: They should, but they haven't done so. There is a culture of lazy banking in Pakistan.
BRR: There is problem of high currency-in-circulation. It has remained historically high in Pakistan and it has increased significantly in the past two years; what is the solution?
SK: One reason is the fact that most part of the agri-sector is undocumented. But there are other reasons as well, for instance, 0.3 percent tax on cash transactions is a deterrent, as is the high level of government borrowing from SBP. Increasing documentation is a solution and RGST will go a long way to address this issue. The second solution is for banks to set up more branches in rural areas, because the farm sector is now booming. The third solution is branchless and mobile banking which, to me, is the future.
Finally, tightening of monetary policy will also bring Currency in Circulation (CIC) back to the system if we pack it up with administrative measures. Banks' deposit rates will also have to respond to it. That would mean people holding cash would see a decent return and revert to the banking system.
BRR: There is a lot of potential in lending to agriculture sector. How are you looking to tap it?
SK: The trouble is that although Zarai Taraqiati Bank is prominent in rural areas, it doesn't have the financial wherewithal to provide adequate credit. We need to work in certain areas. We are looking at the whole issue of crop insurance plus the concept of warehouse receipts. In case of warehouse receipts, the root of all problems can be traced to the government policy to fix the issue price of wheat for the entire season. Fixation of prices kills the incentive for the private sector to build storage. So we are pursuing the government to get out of the price fixation mode. The other aspect is the establishment of the commodity exchange.
We are also providing first loss guarantee for agricultural lending in flood- affected areas. We are hoping to incentivize banks to develop some products. As of today, branchless banking is confined to the liability side including remittances, utility bills payment, etc. With time, as this industry grows, financial services will also increase.
BRR: Continuous monetary tightening is aimed at curtailing inflation through demand management. But critics argue that inflation in Pakistan is primarily due to high powered money creation and cost push factors. Can monetary policy be used to address these issues, as government may continue borrowing despite the increase in rates? SBP's mandate is to control prices while spurring growth. How do you address this dichotomy?
SK: Let's look at three indicators. Although private investments may have fallen, I don't think we know enough about private consumption demand. Private sector credit has grown in the last month or so, partially due to the sharp increase in the price of cotton.
Private sector demand is strong in some areas. Although, so far this year, industrial sector growth has been weak, some sub-sectors are exhibiting handsome growth due to the boom in rural areas following the increase in prices received by the farming community for their rice, cotton and sugar cane. The retail sector has also been showing decent growth. We need to be careful in analyzing this decline sector by sector.
Industrial growth is not taking place at the pace private consumption is growing. That gap is worrying us and could put a strain on the current account, which will have to be financed. Had we not adjusted the interest rates, the need to finance the gap would have added some stress.
Private demand, which is perhaps not fully serviced by the domestic sector, may have spilled over on the external account, increasing the gap between imports and exports. Although it's being narrowed down by higher cotton prices that are boosting exports, we are watching these developments closely.
The government's heavy borrowing is not helping the creation of a market for the corporate sector to raise long term financing.
We are also providing first loss guarantee for agricultural lending in flood- affected areas. We are hoping to incentivise banks to develop some products.
We are hoping that RGST will be implemented; we have also weaved its impact in our recent Monetary Policy Statement.
We hope that by mid-January, we will be ready to start implementing the amended SBP Act.
We are looking to launch Export Refinance Schemes specifically for SMEs, though the modalities and the allocations have not been decided yet.
External flows are not what had been predicted. Greater clarity is required on potential flows.
We are working with the International Finance Corporation (IFC) on a mortgage refinance facility.
Kardar had served at various ministerial positions in the government, including finance, excise and taxation, before his recent appointment as the 16th Governor of State Bank of Pakistan.
A chartered accountant, and a graduate from the University of Oxford in politics, philosophy and economics, has also authored three books on Pakistan's economic and political environment. Kardar was also a member of various commissions and government committees and task forces set up by the Federal and Punjab governments at various points in time since the mid 1980s.
Added to his diverse experience are consultancy services for multilateral and bilateral donors like the World Bank, the Asian Development Bank, and the Department for International Development (DFID), UK. He has also led several projects and studies on key socio-economic issues facing the country.