Dynamics of macroeconomic stability and financial stability

Dr. Shamshad Akhtar Governor

State Bank of Pakistan

January 14, 2008

Outline

2

I. Conceptual Macroeconomic Framework and its Interrelationships

II. Trends in Growth, Money and Prices

III. Financial Trends and Stability

1. GDP = C + I + X – M 2. GDPNI = C + I + [X - M + YF + TRF]

3. GDPNIP + GDPNIG = CP + CG + IP + IG + CAB 4. GDPNIP - CP - IP + GDPNIG - CG - IG = CAB

5. [SP - IP] + [SG - IG] = CAB (or -SF)

CAB

SP SG

Saving-Investment Gap and CAB

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

CAB and Money supply

M2 = NFA + NDA

So

DM2 = DNFA [BoP]

+ D credit to government [Fiscal]

+ D credit to non-govt [Real]

+ D OIN

CENTRAL GOVERNMENT

Interrelationships Among Macroeconomic Accounts

Accounting identities Strong accounting relationships

REAL SECTOR

Private consumptionGeneral government consumption

Private investmentGeneral government investment

Exports of goods and nonfactor servicesImports of goods and nonfactor services

National Accounts

EXTERNAL SECTOR

Balance of Payments

CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official PrivateCAPITAL ACCOUNT Direct investment Medium/long-term capital (net) Short-term capital (net)

Overall balanceChange in net foreign assets

RevenuesGrants

Expenditures Current Capital

Overall balanceFinancing Domestic financing (net) Banking system Nonbanking sector External financing (net)

Net foreign assets

Net domestic assets: Net credit to central govt.. Credit to banks Other items (net)

Reserve money

Net foreign assets

Banks' reserves

Net domestic assets: Net credit to central govt. Credit to private sector Other items (net)

Liabilities to monetary authoritiesPrivate sector deposits

Monetary Authorities

Deposit Money Banks

MONETARY SECTOR

II. Growth, Monetary Policy and Inflation Dynamics

8

Long Term Trends in Inflation and GDP Growth

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

FY56

FY59

FY62

FY65

FY68

FY71

FY74

FY77

FY80

FY83

FY86

FY89

FY92

FY95

FY98

FY01

FY04

FY07

GDP Inflation

Low Growth

High Inflation

Note: the trends are for 10-year moving averages.

0

4

8

12

16

20

24

Sep

-96

Jun

-97

Mar-

98

Dec

-98

Sep

-99

Jun

-00

Mar-

01

Dec

-01

Sep

-02

Jun

-03

Mar-

04

Dec

-04

Sep

-05

Jun

-06

Mar-

07

Dec

-07

per

cent

SBP 3-Day Repo Rate

After a loose monetary policy stance from FY02-FY04… SBP had to enter into monetary tightening phase

9

Loose Monetary Stance

Tight Monetary Stance

10

Monetary stimulus played a significant role in growth revival…

0.01.02.03.04.05.06.07.08.09.0

10.0

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

perc

ent

Real GDP GrowthReal GDP growth 5-years average

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

11

-3.0

-1.0

1.0

3.0

5.0

7.0

9.0

11.0

13.0

15.0

-3.0

-1.0

1.0

3.0

5.0

7.0

9.0

FY9

4

FY9

5

FY9

6

FY9

7

FY9

8

FY9

9

FY0

0

FY0

1

FY0

2

FY0

3

FY0

4

FY0

5

FY

06

FY0

7

perc

en

t

Monetary overhang Inflation (rhs)

Inflation & Monetarty overhang

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

12

2

4

6

8

10

12

14

16

Jan-

05

Ma

r-05

Ma

y-05

Jul-0

5

Sep-

05

No

v-0

5

Jan-

06

Ma

r-06

Ma

y-06

Jul-0

6

Sep-

06

No

v-0

6

Jan-

07

Ma

r-07

Ma

y-07

Jul-0

7

Sep-

07

No

v-0

7

perc

en

t

Core (Non Food & Non Energy) Core (20% trim) Food

Trends in Inflation (YoY)

13

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

Several Monetary Policy measures have been taken to contain inflation since FY05

-50

0

50

100

150

200

250

Jul

Au

g

Sep Oct

No

v

Dec Jan

Feb

Mar

Ap

r

May Jun

bil

lio

n R

up

ees

SBP NFA Reserve money SBP NDA

Reserve Money Flows (cumulative) during FY07Rise in NFA due to receipt of external financing by the government, though substantially sterilized

Rise in RM due to subsidized financing

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

14

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:

1. Rising global commodity prices, in particular steep uptrend in international oil prices.

2. 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.

3. Rising per capita incomes, but shortages emerged because of fluctuations in productive sectors or problems with distribution of commodities. 15

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

16

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.

FINANCIAL SECTOR STABILITY

Financial Sector is bank dominated…

20

30

40

50

60

70

80

CY00 CY01 CY02 CY03 CY04 CY05 CY06

Perc

ent s

hare

in A

sset

s

Banks Others

19

Composition of Financial Sector Assets

Ownership Structure of the Banking Sector

10

20

30

40

50

60

70

80

90C

Y00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

H1-

CY

07

perc

ent of to

tal ass

ets

PSCBs LPBs

20

At present the banking sector is predominantly owned by private sector…

Foreign stake is rising in Pakistan’s banking sector…

21

0

10

20

30

40

50

60

70

80

CY04 CY05 CY06

per

cent

Pakistani Foreign

Position ofShareholding

Assets of the Banking System

40

42

44

46

48

50

52

54

56

58C

Y00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

H1-

CY

07

per

cent

of G

DP

22

Banking sector assets are growing rapidly…

Banks’ Non-Performing Loans

0

5

10

15

20

25C

Y00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

H1-

CY

07

per

cent

Net NPLs to Net Advances NPLs to Advances

23

Encouragingly rapid growth is accompanied with improvement in asset quality…

Indicators of Capital Adequacy

24

Increased capital requirement, with improved asset quality, has enhanced soundness of financial sector…

2

4

6

8

10

12

14

16C

Y00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

H1

-CY

07

per

cent

CAR Tier 1 capital to RWA

Net NPL to Capital Ratio

25

Banks are well capitalized…

0

40

80

120

160C

Y00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

H1

-C

Y07

per

cent

After Tax Return on Assets

26

Banks’ profitability has reached an all time high…

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5C

Y00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

H1-

CY

07

per

cent

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

27

percent

CY01 CY02 CY03 CY04 CY05 CY06

Pakistan -0.5 0.1 1 1.2 1.9 2.1

Bagladesh 0.7 0.5 0.5 0.7 0.8 N.A.

India* 0.5 0.8 1 1.2 0.9 N.A.

Korea 0.7 0.6 0.2 0.9 1.2 1.3

Singapore 1 0.8 1.1 1.3 1.2 1.2

Thailand 1.5 0.2 0.7 1.3 1.5 1.5

SriLanka 0.7 1.1 1.4 1.4 1.3 N.A.

source: Global Financial Stability Rports, IMF

*ROA before tax

Table: Return on Assets

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

28

-1.2

-0.8

-0.4

0.0

0.4

0.8

1.2

CY9

7

CY9

8

CY9

9

CY0

0

CY01

CY0

2

CY03

CY0

4

CY0

5

CY06

H1-

CY0

7

Financial Soundness Index

Mutual funds are the fastest growing sub-groups within NBFIs…

29

Composition of NBFIs’ Assets

0

10

20

30

40

50

60

FY02 FY03 FY04 FY05 FY06

perc

ent

Mutual Funds DFIs Others

other includes Discounting, Housing finance, Investment Finance, Leasing, Modaraba and Venture Capital

Insurance penetration is increasing in a steadfast manner…

30

Asset Structure of Insurance and Reinsurance Sectors

0

50

100

150

200

250

300

2003 2004 2005 2006

Reinsurance Life Non Life

billio

n r

up

ees

By now market capitalization has surged to 48.5% of GDP…

31

Market Capitalization of Karachi Stock Exchange

0

5

10

15

20

25

30

35

40

45

50

FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07

per

cent

of G

DP

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

32

05

101520253035

Bank

s

Oil

& G

as

Mar

ketin

g

Oil

& G

as

Exp

lora

tion

Cem

ent

Tech

& C

omm

Perc

ent o

f mar

ket c

apit

aliz

atio

n

June-06 March-07 June-07

Foreign participation in KSE is rising…

Foreign participation in KSE market capitalization has increased to 7 percent

33

2

3

4

5

6

7

8

Oct

-05

Dec

-05

Feb-

06

Apr

-06

Jun-

06

Aug

-06

Oct

-06

Dec

-06

Feb-

07

Apr

-07

Jun-

07

Aug

-07

Oct

-07

Dec

-07

perc

ent o

f mar

ket

capi

taliz

ation

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 reformsoDiversification of financial sectoroAugmenting robustness of banking sectoroEnhancing financial services penetration

•Islamic banking•Microfinance

Concluded

35

Maturity Mismatches & SBP motive

36

24

26

28

30

32

34

Q2-

CY0

2

Q4-

CY0

2

Q2-

CY0

3

Q4-

CY0

3

Q2-

CY0

4

Q4-

CY0

4

Q2-

CY0

5

Q4-

CY0

5

Q2-

CY0

6

Q4-

CY0

6

Q2-

CY0

7

per

cent

Asset Maturing After One Year

(9.0

)

12.0

7.6

0.6

-10

-5

0

5

10

15

20

Up

to 3

-m

3-m

to 1

-yr

1 to

5 y

rs

5 to

10

yrs

per

cent

of A

sset

s

GAP Analysis -End June 2007

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.

Some extra slides…

0

2

4

6

8

10

12

FY02 FY03 FY04 FY05 FY06 FY07 FY08*

per

cen

t

SBP Policy rate Average O/N rate Coefficient of variation

SBP Policy rate and Overnight Repo rate in Interbank Market

*: up to January 10, 2008

37

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

38

Responsiveness of private sector credit to lending rates has increased…

-5

0

5

10

15

20

25

30

35

40

FY76

FY77

FY78

FY79

FY80

FY81

FY82

FY83

FY84

FY85

FY86

FY87

FY88

FY89

FY90

FY91

FY92

FY93

FY94

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

Regulated interest rates Market based interest rates

per

cent

Growth in Private Sector credit Real lending rate

Real Lending Rates and Private Sector Credit

FX Reserve Adequacy

39

 FX

Reserves* Import Coverage

Reserves to Short Term Liabilities

FY00 1973.6 10.7 1FY01 3231.6 16.5 1FY02 6435.2 35.5 3.3FY03 10769 49.3 7.6FY04 12389 47.2 10.1FY05 12598 35 8.6FY06 13122 27.8 9.4FY07 15634 30.2 7.88-Jan-08 15334.5 28.8 n.a *: Gross FX reserves including SBP and Scheduled banks Reserves