The State Bank of Pakistan — File Photo

It would sound incredible if someone told you that the government is ‘subsidising’ banks. But it’s a fact that government is making banks rich by grabbing most credit, holding interest rate very high and paying a substantially big interest spread even on its guaranteed loans.

The government’s domestic debt rose sharply to Rs8.12 trillion at the end of the first quarter of the current fiscal to September from Rs6.22tr a year earlier and from Rs4.65tr at the end of 2009-10 with its commodity loans standing at Rs894bn (including the guaranteed loans of over Rs4tr).

In spite of reduction of 400bps in the SBP’s key policy rate to 10 per cent in last 16 months, the banks are charging government spread of up to 300bps above the benchmark Kibor on its guaranteed commodity loans it obtains for power sector or for wheat procurement. Punjab, for example, has paid over Rs80 billion as interest on its commodity loans during last four years. Its officials say the province pays between 225-250bps spread on Kibor on its commodity loans.

“It is the government’s huge borrowing at a formidably high cost that is helping banks, especially the Big 6, make massive profits at the expense of private investment and jobs,” says an economist who refused to give his name for personal reasons.

The combined net profits after tax of 22 listed banks grew by 24 per cent to Rs93bn during the first three quarters of CY2012 to September
from Rs75.5bn a year earlier, says a report prepared by Raza Jafry, a senior investment analyst at AKD Securities. The profit of Rs75bn of the six big banks is up by 17 per cent and accounts for 80 per cent of the industry’s total profits.

In CY2011, the banks’ profits rose by 27 per cent. Bankers have their own point to make. “There’s no doubt that the banks prefer to lend to the government and love to secure investment in government papers. But it’s not their fault. They have liquidity which has to be invested and the private sector doesn’t have any appetite for funds due to a growing energy supply gap in the country. Besides, the banks have become risk-averse on account of a high rate of loan infection on the back of slowing domestic economy. The banks need to invest the deposits, and who should they lend this money to, if not the government?,” argues a senior executive of MCB Bank in Lahore who is not authorised to make public statements.

The banks’ tilt towards the government means that they are no longer playing their intermediary role of providing funds to the private sector as pointed out by the central bank in its previous monetary policy. Consequently, the year-on-year growth in loans to private sector businesses has declined from 22.4 per cent in 2008 to 0.7 per cent by the end of last fiscal. The bank is hopeful that a “declining interest rate environment should lead to a rethink of this strategy.”

To a question, the MCB Bank executive admits that the banks are charging between 225bps to 300bps spread on Kibor on commercial loans to the government and its entities against just 100bps they charge from their good private sector customers.

“There’re different reasons for high spread on government loans despite reduction in credit cost. The risk of lending to the government and its entities has increased substantially due to mounting debt, and questions are being raised as to its ability to pay back the loans. As if it wasn’t enough, the government defaulted on its sovereign commitment to independent power producers (IPPs) in July over payments of their outstanding dues on account of electricity purchased from them. Such factors have conspired to keep interest spread on government loans higher than credit for the private sector ,” he elaborates.

The anonymous economist, however, is of the view that the government borrowings and its willingness to pay a higher cost on loans to ward off competition for funds from the private sector is keeping interest spread, the key determinant of the banks’ earnings, to come down rapidly in spite of reduction in the rate.

Weighted average interest spread was 7.11 per cent in the first 10 months of the current calendar year to October, down only by 54bps from 7.65 per cent the previous year. “Interest spread is dropping, although sluggishly,” asserts Raza. “It dipped below seven per cent to 6.95 per cent in August for the first time in four years and shrank to 6.77 per cent in October. The drop in October spread corresponds with the flat net interest income, which came off three per cent in first three quarters this fiscal year-on-year, for the listed banks and indicates the loan re-pricing is taking place,” he says.

Raza believes the net interest income of banks is headed for a dip going forward (due to rate cut).

“The downward trend is sluggish due to six per cent floor on savings deposits. Also, loan re-pricing takes time to settle and force spreads to come down. In the next six months we will see spread fall at a quicker pace as loan re-pricing takes place,” he argues.

A higher spread hurts both depositors and borrowers. While depositors get a low return on their savings, the borrowers are forced to pay a higher rate for banking credit if spread is as high as it is for some years now.

The dip in the spread rate preceded by 75bps reduction in the banks’ average lending rate during the first 10 months of the year, which stood at 12.91 per cent against 13.7 per cent the previous year.

Analysts admit growth momentum is picking up on ‘accommodative’ monetary policy, record government spending and rising remittances. The speed of increase in banks’ non performing loans (NPLs) portfolio have declined by 37 per cent in the first three quarters of this year, reducing the cost of provisioning. They, nevertheless, fear inflation may return in the mid 2013 as forecast by an IMF staff review on falling rupee and weakening government finances.

The increase in domestic debt has substantially raised the cost of its services. The government paid Rs299bn or about 1.3 per cent of GDP (slightly more than budget deficit of 1.2 per cent) as interest on domestic debt during the first quarter of this fiscal – up from Rs177bn paid year earlier, according to the finance ministry’s report on the government’s fiscal operations during July-September 2012-14.

Going forward, analysts expect the interest payments on domestic debt to shoot to a minimum of Rs1.2tr in line with the previous years’ trend. In last fiscal, interest payments on domestic debt grew to Rs846bn from Rs772bn in the preceding year.

Gohar Ejaz, a top business leader who has lobbied extensively to convince Preident Asif Ali Zardari and SBP Governor Anwar Yasin for bringing credit cost down for giving growth a chance just before the central bank resumed monetary easing in August, has some interesting numbers to crunch.

“The financial burden because of keeping interest rate at 14 per cent has cost the economy Rs1.2tr or almost $12bn a year in debt servicing. This size of servicing should have been enough to pay for a debt of $400bn, or almost twice the size of the $200billion GDP (gross domestic product) at the present international servicing cost of three per cent.

Thus (theoretically though), the government is servicing a debt equivalent to 200 per cent of GDP (gross domestic product), which is unsustainable,” he argues. He wonders as to why the country’s finance managers are letting bankers fleece the exchequer by charging abnormally high spread on sovereign loans. “The spread on these loans shouldn’t be above 100bps,” he asserts.

“The government could save Rs600bn provided interest rate is brought down to seven per cent, at par with the regional average. This should provide fiscal space to the government for development and stimulate private investment, triggering growth and job creation. The results of the last two cuts in rate disprove the theory that high credit price could bring cost pushed inflation down or dent the government’s inelastic demand for funds (to finance its budget). It is reduction in the rate that is pulling inflation down and triggering economic
activity,” Gohar says. Indeed, a strong argument for further easing of monetary policy.