KARACHI: As 2010 draws to a close, reverberations of Global Financial Crisis (GFC) which started in 2007 continue to be felt in various parts of Eurozone, most recently in form of sovereign debt crisis in Greece, Portugal and Ireland. Emerging economies like Pakistan remained largely insulated from a direct impact of GFC, given low level of integration with global financial system, and consequently, virtually negligible exposure to toxic assets responsible for contagion impact.

These economies were, however, indirectly impacted once financial crisis gave way to a recession in advanced economies, given trade linkages and drying up of capital flows. Process of global economic recovery, which had started earlier than expected, is now starting to wane and is propelled forward by growth potential in emerging economies, State Bank's Financial Stability Review 2009-10 released on Tuesday said.

Notably, expansionary fiscal policies driven by large financial rescue programmes, and need for providing necessary stimulus to ailing economies during GFC, essentially led to a situation where fiscal position of major advanced economies deteriorated dramatically, to levels not seen since Second World War.

The extent and pace of deterioration (government debt to GDP ratio exceeding 100% and even higher in some cases) has been such that stringent austerity measures are now being frantically adopted and implemented to bring down budget deficits to more sustainable levels. This is in recognition of the fact that high levels of public debt raised to finance these deficits, serve to increase these economies' vulnerabilities to adverse shocks, reduce their long-run growth potential and endanger prospects of monetary stability.

Pakistan, on other hand, was suffering from rising fiscal deficit and public debt burden even before onslaught of GFC. Structural weaknesses in process of revenue generation, significant rigidities in government spending and necessity of spending sizable sums to counter acts of terrorism, led to increase in fiscal deficit to 6.3% of GDP in FY10, from 5.2% in FY09. Expansion in quasi-fiscal operations (which includes lending to public sector agencies and financing government's commodity operations), together with a weak cash management system, added to fiscal burden which is increasingly financed from financial system.

An attempt to assess financial stability in prevalent circumstances presents a conundrum of sorts. Notably, stability of financial system is largely derived from predominant position of banking sector, as other components of financial system continue to grow at a more gradual pace. Size of domestic financial sector increased to Rs. 8.8 trillion by end-CY09, with a YoY growth of 15%, almost double the growth in CY08.

With such heavy reliance on banking system for meeting financing needs of economy, continued presence of the government with an insatiable appetite for banking system resources, is key risk factor in: (1) achieving basic objective of financial system in Pakistan i.e. enhancing financial sector development and penetration, (2) meeting financing needs of private sector and thus jeopardizes prospects of long term growth and investment. Both these factors have serious implications for monetary and financial stability.

Government in Pakistan has had a historically traditional recourse to central bank borrowing for financing budget deficit, with consequent challenges for monetary management. For one, borrowing from central bank is akin to printing money, feeds directly into inflationary pressures and tends to increase currency in circulation.

In effect, such monetization of fiscal deficit dilutes monetary policy stance, as has been case in Pakistan where impact of monetary tightening in controlling inflation has only been partially successful given government's heavy reliance on borrowing from SBP. Such financing thus jeopardizes monetary stability. Empirical evidence suggests that persistently high inflation has a negative correlation with economic growth.

A study on reasons for rise in NPLs in banking system, conducted for FSR 2008-09, concluded that cyclical patterns in economy have an inverse relationship with non-performing loans, major indicator of quality of advances of banking sector. Rising NPLs in a recessionary period,as seen most recently in CY08 and CY09, have a detrimental impact on banks' financial health, and hence on financial stability, Report said.

In recognition of negative consequences of borrowing from central bank for both monetary and financial stability, and given need for compliance with IMF-SBA's structural performance criteria which limits  net quarterly borrowing from central bank to zero, government then looks to meet its funding needs from commercial banks through T-Bills and PIBs auctions and borrowing for commodity operations, in addition to quasi-fiscal borrowing by Public Sector Enterprises (PSEs). Such borrowing carries implications for banks' incentives.