Dynamics of macroeconomic stability and financial stability Dr. Shamshad Akhtar Governor State Bank of Pakistan

1. Dynamics of macroeconomic stability and financial stability Dr. Shamshad Akhtar Governor State Bank of Pakistan January 14, 2008

2. Outline • Conceptual Macroeconomic Framework and its Interrelationships • Trends in Growth, Money and Prices • Financial Trends and Stability

3. Saving-Investment Gap and CAB

4. How Saving-Investment gap is financed? • Private sector can finance through • Net foreign borrowing • Loans from domestic banking system • Net foreign direct investment • Government can finance the deficit by • Borrowing from domestic banking system • Selling bonds/bills • Obtaining net foreign borrowings

5. CAB and Money supply M2 = NFA + NDA So DM2 = DNFA [BoP] + D credit to government [Fiscal] + D credit to non-govt [Real] + D OIN

6. Interrelationships Among Macroeconomic Accounts CENTRAL GOVERNMENT REAL SECTOR RevenuesGrantsExpenditures Current CapitalOverall balanceFinancing Domestic financing (net) Banking system Nonbanking sector External financing (net) National Accounts Private consumptionGeneral government consumptionPrivate investmentGeneral government investmentExports of goods and nonfactor servicesImports of goods and nonfactor services MONETARY SECTOR EXTERNAL SECTOR Monetary Authorities Balance of PaymentsCURRENT ACCOUNTExports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official PrivateCAPITAL ACCOUNTDirect investment Medium/long-term capital (net) Short-term capital (net) Overall balanceChange in net foreign assets Net foreign assetsNet domestic assets: Net credit to central govt.. Credit to banks Other items (net)Reserve money Deposit Money Banks Net foreign assetsBanks' reservesNet domestic assets: Net credit to central govt. Credit to private sector Other items (net)Liabilities to monetary authoritiesPrivate sector deposits Accounting identities Strong accounting relationships

7. II. Growth, Monetary Policy and Inflation Dynamics

8. Long Term Trends in Inflation and GDP Growth Note: the trends are for 10-year moving averages.

9. After a loose monetary policy stance from FY02-FY04… SBP had to enter into monetary tightening phase Loose Monetary Stance Tight Monetary Stance

10. Monetary stimulus played a significant role in growth revival…

11. Growth picked-up – however, with money supply growth outpacing nominal GDP growth CPI rose from 3.5% in FY02 to 9.3% in FY05

12. Food prices are still a major source of volatility and recent price hike; tight monetary policy helped in arresting demand driven inflation as reflected in core inflation

13. Several Monetary Policy measures have been taken to contain inflation since FY05 • Changes in policy rate (i.e. SBP 3-day REPO rate): • from 7.5% to 9.0% in April 2005; • from 9.0% to 9.5% in July 2006; • from 9.5% to 10.0% in July 2007. • Changes in CRR and SLR • Current CRR are: 7% for demand & time liabilities of less than one year; • Earlier CRR were 3% for time liabilities above 6 month maturity and 7% for demand and less than 6 months time liabilities; • Aggressive liquidity management through OMOs

14. Monetary tightening partly diluted due to SBP re-financing schemes and high government borrowings; both issues addressed in FY08…

15. Rising international food and oil prices remain key risk for FY08… While monetary policy is ready to contain demand pull inflationary pressures, cost push factors may pose threat to price stability in FY08. Among others, the key problems are: Rising global commodity prices, in particular steep uptrend in international oil prices. Domestic agriculture crops outcome (particularly wheat, sugarcane & gram) during FY07 was good. However poor demand-supply management has led to crisis situation in the country. Rising per capita incomes, but shortages emerged because of fluctuations in productive sectors or problems with distribution of commodities.

16. Measures to further arrest inflationary trends… • Besides increase in SBP policy rate, SBP recommended the government to retire SBP debt in FY08 (by Rs 62.7 billion) to ease reserve money growth • Introduced policy to reduce commercial banks’ reliance on refinance facilities (envisaged a 30 percent reduction in outstanding refinance at end June 2007 during FY08 without affecting the overall availability of credit to the exporters). • Stepping forward towards a more market based credit allocation mechanism the age old credit planning exercise has been abandoned completely. • SBP has been encouraging long term paper issuance with regular frequency to transfer government reliance from SBP to private financing sources

17. Growing macroeconomic Imbalances are now posing renewed challenges • July-November data reveals that both fiscal and external account deficit will be higher than original projections. • Borrowing from central bank to finance budget is significant and such borrowing is likely to augment inflationary pressures since output will be impacted by the recent disruptions. • The central bank will have to take appropriate measures to further contain demand pressures augmented by fiscal and external deficits. • Extent of monetary tightening would depend on fiscal restraints.

18. FINANCIAL SECTOR STABILITY

19. Financial Sector is bank dominated… Composition of Financial Sector Assets

20. At present the banking sector is predominantly owned by private sector… Ownership Structure of the Banking Sector

21. Foreign stake is rising in Pakistan’s banking sector…

22. Banking sector assets are growing rapidly… Assets of the Banking System

23. Encouragingly rapid growth is accompanied with improvement in asset quality… Banks’ Non-Performing Loans

24. Increased capital requirement, with improved asset quality, has enhanced soundness of financial sector… Indicators of Capital Adequacy

25. Banks are well capitalized… Net NPL to Capital Ratio

26. Banks’ profitability has reached an all time high… After Tax Return on Assets

27. The 2.1 percent ROA during CY06 is significantly higher than the international norms of around 1.0 percent….

28. Financial Soundness Index (FSI) witnessed that the performance of the banking system has improved substantially over the last five years….

29. Mutual funds are the fastest growing sub-groups within NBFIs… Composition of NBFIs’ Assets

30. Insurance penetration is increasing in a steadfast manner… Asset Structure of Insurance and Reinsurance Sectors

31. By now market capitalization has surged to 48.5% of GDP… Market Capitalization of Karachi Stock Exchange

32. Banking Sector Growth complements KSE growth… Banks have played a major role in the growth of the KSE-100 index by contributing more than 30 percent in KSE market capitalization

33. Foreign participation in KSE is rising… Foreign participation in KSE market capitalization has increased to 7 percent

34. Future Agenda • Continued effective monetary policy conduct and management • Macroeconomic stability prerequisite for financial sector growth • Consolidation and growth in banking sector • Introduction of Basel II along with strengthening of risk management • Continued strengthening and improvement in governance structure of regulators • Broaden and deepen financial sector reforms • Diversification of financial sector • Augmenting robustness of banking sector • Enhancing financial services penetration • Islamic banking • Microfinance

35. Concluded

36. Some extra slides… Maturity Mismatches & SBP motive The maturity mismatched aspect has increased for banks operation in Pakistan during recent years. However, SBP has introduced tiered cash reserves requirements for demand and time liabilities to encourage banks to mobilize long term deposits.

37. Proactive liquidity management has reduced volatility in short-term interest rates…

38. Responsiveness of private sector credit to lending rates has increased…

39. FX Reserve Adequacy