THE federal government’s dependence on borrowings from commercial banks has remained strong amid widening fiscal deficit because of inadequate tax revenue and sliding inflows of external financing.

While the tax-to-GDP ratio is at a low of 9.4 per cent, the steadily diminishing share of external funds in deficit financing stood at nine per cent in 2011 compared to over 50 per cent during FY01-07 period.

Commercial banks have emerged as a major source of deficit financing as government shifted away from the central bank, to keep its borrowings within limits agreed with the SBP.

However, budget deficit is likely to worsen as the return on government securities is now being earned by commercial banks instead of the central bank. As a consequence, the banks’ appetite for investment in government papers remains unabated, pushing the share of banks’ net investments in total bank assets to 34 per cent, highest in a decade.

Unsurprisingly, the share of net advances has experienced a drop, sliding down to 43.9 per cent by June 2011 from 47.6 per cent in June 2010.

With rise of 22.4 per cent in investments outpacing the growth of 1.04 per cent of advances by a wide margin, advances to deposits ratio (ADR) of the banking system has dropped from 61.4 per cent to 56.7 per cent during first half of 2011.

Steadily declining ADR captures some important banking trends. First, it indicates availability of ample loanable funds or improved liquidity. It underscores banks’ growing risk aversion towards private sector credit which becomes less attractive when risk-free investments offer a decent return. Finally, it highlights banks’ receding role as financial intermediaries, when viewed in terms of socially and economically desirable allocation of credit.

While these trends heighten the concern about crowding out of the private sector, poor credit off-take has other reasons as well. With severe energy crisis, poor law and order situation, and a challenging economic environment, demand for private sector credit is subdued.

Admittedly, with government receiving a growing portion of the credit at rates quite attractive to the banks, the cost of borrowings for private sector remains high, prompting firms to confine their borrowings to immediate working capital needs.

Despite some easing in weighted average lending rate following the policy rate cut in October, 2011, credit expansion to the private sector decelerated to 6.4 per cent during July-March FY2012 compared to 7.6 per cent last year.

Within private sector credit, loans to private businesses increased by only 1.8 per cent which is the lowest growth in the past 10 years.

The segment–wise breakup of loans indicate that the deceleration was concentrated in working capital and trade loans, while fixed investment loans staged a recovery in July-Mar FY12.

Loans to manufacturing sector decelerated sharply in July-Mar FY 12 over the corresponding period last year. The slowdown was broad-based as all the major industries including textile, sugar, rice, cement, machinery and equipment were impacted.

In the textile sector substantial requirement of past loans, lower cotton prices and subdued export performance, contributed to the slowdown in loan demand. In the cement sector, a sharp rise in retail prices augmented revenues of cement sector which reduced demand for working capital loans.

During July-March FY12, the government actively intervened in the fertilier and sugar sectors, which have affected the credit flow to these sectors.

In case of sugar, the seasonal flows of working capital during Dec-March FY12 was Rs51.6 billion, against Rs83.5 billion during the same period last year. Since sugar mills were not willing to offload their stocks in the market due to a drop in domestic sugar prices, this constrained their ability to borrow this year.

Of all risks that banks have to confront with, credit risk remains the most significant as 79.3 per cent of banks’ risk weighted assets can be ascribed to credit risk alone. The non-performing loans (NPLs) continue unabated despite the slack in demand of private sector credit.

During first half of 2011 banks added another Rs31.4 billion to infected assets compared to rise of Rs27.8 billion during the same period last year, pushing the non-performing loan ratio (NPLR) from 14.7 to 15.3 per cent.

Bank-wise breakup reveals that two groups are particularly vulnerable to mounting credit risk: mid-sized private banks (LPBs) and state-owned commercial banks (PSCBs).

While slack economic growth and attendant rise in credit risk is understandable and indeed relevant for all banks, mid-sized LPBs and PSCBs have infection ratio of 25.6 and 21.5 per cent respectively, far higher than industry average of 15.3 per cent.

The explanation lies, in case of LPBs, primarily in the choice, if they have any,of borrowers.

The bulk of the quality borrowers are served by big banks, mid-sized banks are compelled to choose relatively riskier borrowers, because they have to earn enough to compensate for their much higher cost of deposits than of top five banks. In case of PSCBs, their credit standards explain partially above average infection ratios.