Pakistan: Banking system: negative outlook

In a new report released on 22nd July, 2013, Moody's Investors Service has reiterated that the outlook for Pakistan's banking system remains negative, reflecting banks' large and increasing holdings of government bonds, which render their balance sheets vulnerable to sovereign credit risk and the challenging domestic operating environment which will continue to pressure asset quality. These negative pressures are only partly mitigated by banks' low cost and stable deposit-funded profiles. According to Moody's estimates, Pakistani banks' exposure to government securities and loans to public sector companies increased to 674 percent of Tier I capital as of March, 2013 (or 46 percent of total assets), up from 382 percent as of December, 2010. As for the future, banks' high and increasing exposure to Pakistani government debt will remain a major source of credit risk, as the government will continue to run large deficits over the outlook period, which will be financed in a large part by domestic banking sector. Operating conditions will also remain challenging due to low growth rate, significant fiscal imbalances, low foreign exchange reserves, fragile political environment and structural problems, particularly in the energy sector where power outages have depressed manufacturing activities and led to a fall in private investment. This will suppress demand for credit and lead to increases in NPLs which stood at 14.7 percent as of March, 2013. Also, reported NPL figures understate the full extent of asset-quality deterioration in the banking system due to high level of problematic government guaranteed loans that are not classified as NPLs. We feel that what the Moody's has said makes ample sense and needs to be considered seriously for reversing the course. Large and increasing holdings of government bonds have of course made the banking system highly vulnerable to sovereign credit risk and challenging domestic operating environment has pressurised its asset quality. In fact, banks are no more functioning as intermediaries between savers and investors but investing most of their resources in government bonds and government guaranteed securities. This suits the banks because they get adequate profits without any risk but the private sector which is supposed to be the engine of growth is deprived of the badly needed credit. Moody's is also not optimistic about the future. It believes that major issues of the economy like low growth, fiscal imbalances, and other structural problems would continue to induce banks to invest in government securities and follow the same pattern. NPLs were under-reported and they did not reflect the full extent of asset quality deterioration. Fortunately, negative pressures were partly neutralised by stable and low cost deposits. Implicit in the observations of the Moody's is the advice that Pakistan should revert back to the old practice through which most of the bank credit is disbursed to the private sector, borrowings by the government for budgetary support are contained within reasonable limits and banks perform their normal intermediary functions between savers and investors. In the context of Pakistan, it is only possible if budget deficit is reduced sharply and most of the deficit is financed either from foreign sources or through non-bank domestic sources. However, while analysing the situation, Moody's seems to have ignored some of the latest developments. For instance, concerted efforts by the new government to raise higher levels of revenues and a fresh programme with the IMF could serve to reduce the budget deficit to manageable levels and lower the budgetary borrowings from the banking system. Political environment is also no longer fragile after the induction of the new government. Therefore, there is a chance that banking system may have a positive rather than a negative outlook after few months.