Financial Sector Reforms in Pakistan

It is well established that a vibrant and balanced financial system plays key role in promoting economic efficiency, achieving higher economic growth and stabilizing the economy. An efficient financial system not only reduces uncertainty and transactions costs, but also provides a more investor-friendly environment and promotes a better allocation of resources for investment. In contrast, regulated financial systems lead to underdeveloped and uncompetitive markets.

A weak and inefficient financial system is more vulnerable to contagion, less able to cope with volatile capital flows and exchange market pressures, and likely to propagate and magnify the effects of financial crisis. Moreover, a financial sector dominated by government-owned financial institutions imposes constraints on economic growth. Financial sector reforms are an example of measures designed to address Pakistan’s structural weaknesses.

The financial sector reforms did not take place in isolation but were part of the structural adjustment programs implemented within the framework of the International Monetary Fund and the World Bank since the late 1980s. The political setting played an important role in the reform process and is therefore examined here. There is then a discussion of the impact of the reforms and structural adjustment measures, implemented to correct the internal and external imbalances. Based on the discussion, conclusions and policy recommendations are drawn to reform the financial system.

Reform program The growth record of Pakistan in its first 60 years of existence was impressive and comparable to any high-performing developing economy. The growth rate of gross domestic product (GDP) averaged about 6 per cent a year until the late 1980s, and poverty was reduced from 46 per cent to 18 per cent. The rate of inflation remained low during the period and per capita income almost doubled, despite high population growth. But this performance of the economy and high growth can best be described as borrowed growth.

The easy availability of funds from both domestic and foreign sources lured policy makers to frame expansionary policies with large fiscal deficits. This resulted in faster growth in government expenditure than revenue over the years. Because of the lavish spending, the budget deficit reached an unsustainable 9. 4 per cent of GDP in the late 1980s. The current account deficit also rose, reaching 3. 1 per cent of GDP by 1987-88. Domestic debt doubled to 43 per cent of GDP while external debt rose from 31 to 42 per cent of GDP over the short period from 1980-81 to 1987-88.

These imbalances in the macroeconomic indicators, mainly due to the structural rigidities and distortions in the economy, caused an economic crisis in 1988 and compelled the country to reform its economy. The Pakistani government has negotiated 13 stabilization and structural adjustment programs with international financial institutions since that time (see Table). The main objective of these programs was to remove weaknesses and rigidities in the economic structure and distortions in the incentive system, in order to stabilize the economy and restore macroeconomic balance.

However, the motivation that prompted successive governments to implement these programs was the short-term need to secure foreign liquidity infusions from the International Monetary Fund and the World Bank. [Table about here] The first reform program was signed in 1988 and led to implementation of medium-term structural adjustment measures with the help of the International Monetary Fund and the World Bank. Subsequent policy reforms were a combination of short-term stabilization measures and long-term structural adjustment measures.

The short-run stabilization measures included tight monetary policy and fiscal discipline while the longer-term adjustment measures included tariff rationalization, removal of non-tariff barriers, price decontrols and removal of exchange rate distortions. The fiscal measures were aimed at resource mobilization through the restructuring of the income tax system, the removal of exemptions from customs duties on imports, introduction of a General Sales Tax, and the removal of price subsidies on public utilities.

For the revival of the industrial sector and to attract foreign direct investment, measures were introduced to reduce state controls on foreign investment, encourage investment through incentive schemes and promote competition. The prices of oil products, gas and power were also rationalized to promote efficiency, resource mobilization and energy conservation. The agriculture sector reforms included the aligning of agricultural input and output prices and the gradual removal of subsidies.

Although a number of reform initiatives were taken by successive governments to correct the imbalances and distortions in the economy, many of these could not be implemented properly because of political imperatives and a lack of commitment by the leadership. The lack of political commitment arose from the frequent changes in government, especially during the period of economic reforms. Since 1988 there have been nine governments — four elected governments, four caretakers and one military government.

In the early period of reforms (1988-90) in particular, the democratically elected government compromised on many of its stands to keep the army at bay. General Zia-ul Haq had given the presidency the constitutional power to dismiss parliament and the prime minister, and this made subsequent elected governments live in fear. They were right to do so because under this provision, three elected governments were dismissed by the president prematurely and without completion of their tenure between 1990 and 1996.

Because efforts have been half-hearted, the expected outcomes of the economic reforms such as rapid economic expansion, export-led growth, higher incomes for all groups, expanded health and education benefits, better housing, and building of a ‘social safety net’ have yet to be realized. Financial sector reforms were a part of the major adjustment and reform program. Compared to other types of reforms, however, the financial sector reforms launched in the early 1990s were a success story that not only promoted efficiency in the sector but also set higher standards of service quality.

A number of measures were introduced, such as privatization of state-owned banks, the setting of market-based lending rates, and the phasing out of concessional interest and direct credit schemes. Some of the reasons for the success of these reforms are explained below. Prior to 1990, the financial sector was heavily controlled. Interest rates were administratively set and were usually negative in real terms. Monetary policy was conducted primarily through direct allocation of credit. The money market was under-developed, and bond and equity markets were virtually non-existent.

Commercial banks often had to lend to priority sectors with little concern for the borrowing firm’s profitability. Before the opening of the non-bank financial sector for private investment in the mid-1980s, state-owned financial institutions held almost 94 per cent of the assets of the entire financial sector. Moreover, financial institutions were in a precarious state because of high intermediation costs resulting from overstaffing, large numbers of loss-incurring branches, poor governance with low quality banking services, accumulation of non-performing loans and inadequate market capitalization.

In brief, the financial sector was weak on governance, accounting standards, market discipline, prudential regulation and legal infrastructure. These problems increased the exposure of financial institutions to a variety of external threats, including a decline in asset values, market contagion, speculative attacks, exchange rate devaluation and reversal of capital flows. Capital flight and disrupted credit allocation further worsened the efficiency of banking sector.

These inefficiencies and distortions in turn caused severe macroeconomic difficulties and distorted economic growth. The financial sector reforms and restructuring measures were undertaken with a view to bringing back financial discipline and improving the operational efficiency of the financial sector. The reforms were aimed at establishing a market-based system of financial intermediation and government financing, conducting monetary policy more efficiently through greater reliance on indirect instruments and contributing to the rapid development of the stock market.

The reforms were also designed to correct the distortions implicit in the administered structure of returns on various financial instruments, to abolish the directed and subsidized credit schemes, to allow free entry of private banks in the financial sector in order to enhance the competition and efficiency in the financial sector and to strengthen the supervisory role of State Bank of Pakistan.

The financial sector reforms included: * liberalization of interest rates by switching from administered interest rate setting to market-based interest rate determination; * reduction of controls on credit by gradually eliminating directed and subsidized credit schemes; * creation and encouragement of the development of a secondary market for government securities; * strengthening of competition in the banking system by recapitalizing and restructuring the nationalized ommercial banks and increasing their autonomy and accountability; * improving the prudential regulation and supervision of all financial institutions; and * allowing the free entry of private banks into the financial markets. Financial restructuring and privatization have changed the landscape of the financial industry in Pakistan. In response to financial restructuring measures, financial discipline and operational efficiency showed a significant improvement compared to the pre-1990 period.

The secondary market is relatively thin and as such, the supply of corporate securities remains small, but the change in banking is more fundamental. In the following section, the developments in the financial sector are discussed in detail. The chapter also examines the political economy of the reforms to shed some light on the reform process and how these have impacted the financial sector. The Reform Process Pakistan inherited a weak financial sector at the time of independence in 1947. Banking services were very badly affected by the division of British India.

On 30 June 1948, there were only 81 branches of scheduled banks in the territories of present Pakistan. However, by the end of 1973, there were 14 scheduled commercial banks with 3,323 offices in the present Pakistan and 74 offices in foreign countries. There were no development finance institutions at the time of independence to support different sectors of the economy. Therefore, the Pakistan Industrial Development Corporation was established in 1950 with the mandate to establish industries only in those areas where the private sector was not investing.

Such industries had to be ultimately transferred to the private sector. Similarly the House Building Finance Corporation was established in 1952 with the mandate to facilitate construction of houses. The Agricultural Development Finance Corporation was set up in 1951 and the Agriculture Development Bank of Pakistan was set up in 1957 to develop the agricultural sector. The specific purpose of the bank was to offer credit facilities to farmers. The National Investment Trust was established in 1962 as a joint stock company.

Its main objective was to mobilize domestic savings through the sale of its units and to invest the funds so raised in shares and debentures of sound and productive enterprises in the interests of unit holders. Another institution, the Investment Corporation of Pakistan, was setup in 1966 to broaden the base of investments and to develop the capital market. In May 1970, the Equity Participation Fund was established to accelerate the growth of small and medium sized industrial units in the private sector in the less developed areas of the country.

There were 77 insurance companies at the time of independence; seven were local while 70 were foreign companies. There was neither reinsurance nor a public sector company till 1952. In 1952, the Government of Pakistan established the Pakistan Insurance Corporation as a reinsurance company and in order to give it a strong base, asked all the insurance companies to cede 10 per cent of all their business compulsorily to it. Consequently 40 of these foreign companies left Pakistan. The National Co-Insurance Scheme was formed by the government in 1955. Initially it was run by Pakistan Insurance Corporation.

It provided insurance services only to the public sector. The adoption of liberal policies in the 1960s led to high economic growth. However, there was a general perception that economic power was concentrated in a few hands and the rest of the population was at the mercy of these capitalists. The skewed income distribution gave a good opportunity for Zulfqar Ali Bhutto and his Pakistan People’s Party (PPP) to capitalize on the situation. He promised to launch nationalization of major industries and finance companies and to ensure an equitable distribution of income.

The people of the then West Pakistan (now Pakistan) voted for his party in general elections in 1970 and Bhutto fulfilled his promise of nationalization after assuming power. Thirty-two basic industrial units and 31 life insurance companies were nationalized in January 1972 and March 1972, respectively. Moreover, in January 1974, all the commercial banks including the Industrial Development Bank of Pakistan were nationalized to increase the credit availability to the agricultural sector and small borrowers (Nasim 1992).

The nationalization of banks in 1974 did not achieve the objective of equitable distribution of credit to the agricultural sector and to small borrowers. On the contrary, the nationalized commercial banks were used extensively as instruments of political patronage. As a result, the nationalized units became overcrowded with political appointees and started losing money. Consequently the quality of their services to the public deteriorated sharply.

In order to further gain the sympathies of workers, the government allowed the unionization of all state-owned enterprises, including banks and other financial nstitutions. The management of the nationalized institutions was from the bureaucracy and lacked practical experience of the businesses in which they were placed. These factors contributed negatively to the overall running of these institutions and to their losses. Loans were disbursed to the powerful political elite. Union leaders became so powerful that they started influencing management in their decision making, sometimes forcing them to take steps that were not in the institution’s interests.

Service delivery deteriorated substantially and nationalized institutions failed miserably to achieve the objective of their existence. The need was felt to re-evaluate the nationalization policy and to reform the system using policy options prevalent in more advanced economies. In July 1977, General Zia-ul Haq toppled the elected government of Zulfqar Ali Bhutto and imposed martial law. The martial law government made only a few structural changes to the economy in its first two years.

The major goals of these efforts, particularly in response to the second oil price shock, were the recovery of economic growth and stability of macroeconomic indicators. The significant policy change was initiated in 1979-80, when the military government introduced a program of Islamization of the economy. A three-year plan for the implementation of an Islamic economic system was announced in February 1980. The two major ingredients of this program were the institutionalization of ‘zakat and ushr’ and interest-free banking and commerce.

Both of these measures were controversial and hotly contested until the government accommodated the demands of the Shia community to be exempted from the levy of zakat and ushr, and the system was then introduced in 1982-83. In the sphere of interest-free banking and commerce, the government introduced profit and loss accounts, Participation Term Certificates, ‘modaraba’ and ‘musharika’ in 1981-82. The major structural adjustment reforms were started in 1982-83 and were intended to improve the long-term efficiency of the economy by expanding the role of the private sector in the production and distribution of goods and services.