Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 30847 - PK

INTERNATIONAL DEVELOPMENT ASSOCIATION

AND

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR

A PROPOSED CREDIT

IN THE AMOUNT OF SDR 65.3 MILLION (US$lOO MILLION EQUIVALENT)

AND

A PROPOSED LOAN

IN THE AMOUNT OF US$200 MILLION

TO

THE ISLAMIC REPUBLIC OF PAKISTAN

FOR A

BANKING SECTOR DEVELOPMENT PROGRAM

December 13,2004

Finance and Private Sector Development South Asia Region

a restricted distribution and may be used by recipients only in the performance o f their off icial duties. I t s contents may no t otherwise b e disclosed without W o r l d Bank authorization.

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ABL ADB B C P B S A L B S D BSRPP

C A S CB C D C CIRC

C P I DFI EO1 FB FSAP FSDIP

GDP HBFC HBL ICP IDA I D B P IDF IMF I P O I S E K S E L D P LPB L S E MCB

CURRENCY EQUIVALENTS (Exchange Rate Effective November 30,2004)

Currency Unit = Pakistan Rupee (PRs) PRs59.60 = U S $ l US$0.016 = PRs 1

GOVERNMENT’S FISCAL YEAR July 1 - June 30

ABBREVIATIONS AND ACRONYMS

A l l i e d Bank o f Pakistan Asian Development Bank Basle Core Principle Banking Sector Adjustment Loan Banking Supervision Department Banking Sector Restructuring and Privatization Project Country Assistance Strategy Commercial Bank Central Depository System Corporate And Industrial restructuring Corporation Consumer Price Index Development Finance Institutions Expression o f Interest Foreign Bank Financial Sector Assessment Program Financial Sector Deepening and Intermediation Project Gross Domestic Product House Building Finance Cooperation Habib Bank L imi ted Investment Corporation o f Pakistan Intemational Development Association Industrial Development Bank o f Pakistan Institutional Development Fund Intemational Moni tory Fund In i t ia l Public Offering Islamabad Stock Exchange Karachi Stock Exchange Letter o f Development Pol icy Local Private Bank Lahore Stock Exchange Muslim Commercial Bank

N B P NCB NCSS

NDFC

NIM NIT(L) N P L NSS PPP PRs PRSC PRSP PSCB S A A R C

SB SBP SECP

S L R S M E S M E B SOE TFCs UAE UBL U N D P

V R S WBI ZTBL

National Bank o f Pakistan Nationalized Commercial Bank National Clearing & Settlement Systems National Development Finance Cooperation Net Interest Marg in National Investment Trust (Ltd. ) Non-Performing Loans National Saving Scheme Purchase Price Parity Pakistani Rupee Poverty Reduction Strategy Credit Poverty Reduction Strategy Paper Public Sector Commercial Bank South Asia Association for Regional Cooperation Specialized Bank State Bank o f Pakistan Securities and Exchange Commission o f Pakistan Statutory Liquidity Requirement Small M e d i u m Enterprise Small M e d i u m Enterprise Bank State Owned Enterprise Te rm Finance Certificates Uni ted Arab Emirates United Bank o f Pakistan Uni ted Nations Development Program Voluntary Retirement Scheme Wor ld Bank Institute Zarai Taraqiati Bank L im i ted

Vice President: Country Director:

Sector Director: Sector Manager:

Task Manager: Mudassir Khan, SASFP

Praful C. Patel, SARVP John W. Wall, SACPK Joseph D e l M a r Pemia, SASFP Simon C. Bell, SASFP

FOR OIFFPCIAL USE ONLY PAKISTAN: BANKING SECTOR DEVELOPMENT POLICY CREDIT AND LOAN

PROGRAM SUMMARY

Borrower:

Amount:

Terms:

Description:

The Islamic Republic o f Pakistan

IDA SDR 65.3 mi l l ion (US$ 100 mi l l ion equivalent) and IBRD U S $ 200 mill ion.

Standard IDA terms: 35-year maturity including 1 O-year grace period IBRD terms: Fixed Spread U S Dollar Loan with 20-year maturity including 8-year grace period with commitment l inked level repayment and automatic rate f ix ing feature.

Pakistan has achieved significant progress in reforming i t s banking sector since the launch o f i t s ‘home grown’ reform program in 1997. Overall assessment o f the recently concluded FSAP was quite positive and the findings highlighted that the banking sector reforms undertaken have been effectively implemented in the context o f broader macroeconomic stabilization, providing an essential foundation to financial sector recovery.

The proposed credit and loan support the Government o f Pakistan towards improving sector govemance through privatization o f UBL, HBL and resolution o f ABL, further strengthening the regulatory and supervisory environment for banking, improving transparency and disclosure, and preventing possible use o f the banking system for money laundering. Bo th CAS & PRSP recognize the importance o f financial sector reforms for accelerating economic growth and reducing poverty.

Benefits: Financial sector reforms have significantly improved the soundness and efficiency o f the financial system by reducing state intervention and improving the environment for banlung. The divestiture o f state ownership o f banks has substantially changed the structure o f the banking sector and nearly 80 percent o f sector assets are n o w controlled by private banks as compared with 34 percent in 1999, and just 8 percent in 1990. A s a result, access to finance has improved and credit to private sector has witnessed significant growth during the past three years. Last year alone private sector credit showed an increase o f over 30 percent. A large part o f the success o f the reforms stems f rom the improved legal and regulatory framework and enhanced corporate governance as a result of reduced role o f the govemment. Profitability and liquidity indicators for the commercial banks have shown a marked improvement. The banking sector has also become considerably more competitive and responsive. BSDPC would support further strengthening o f banking sector competitiveness and i t s outreach to areas/population with l i t t le or n o access to banking services.

Th is document has a restr icted d is t r ibut ion and may be used by recipients only in the performance o f their of f ic ia l duties. I t s contents may n o t be otherwise disclosed w i thout World Bank authorization.

Risks and Mitigation The risk o f the program credit and loan i s l o w since pr ior actions are Strategy: already completed. However, there i s a risk o f policy reversal in the

medium term, if access to financial services does not expand to the rural areas and other traditionally underserved sectors. The significant growth in credit to the consumer markets poses a risk and requires strengthening o f credit appraisal systems and risk management by the banks as well as strong monitoring by the regulator. SBP has already issued risk management guidelines and increased the provisioning requirements o f banks for consumer lending. There have also been initiatives to promote and expand credit information services in the private sector, enhancing governance and transparency, as wel l as improved legal and judicial processes for insolvencyhankruptcy.

Disbursement: The credit in an amount o f US$ lOO mi l l ion equivalent and a loan o f US$ 200 mi l l ion wi l l be disbursed in one tranche upon effectiveness.

Project ID Number: PO83079

.* 11

TABLE OF CONTENTS

I . INTRODUCTION 1

11 . POLITICAL AND ECONOMIC CONTEXT 1

A . B .

Recent Political Developments ............................................................................... 2 Macroeconomic Developments and Growth Performance ........................................ 2

11 I. FINANCIAL SECTOR OVER VIEW 4 The Financial Sector .............................................................................................. 4 The Banking Sector ................................................................................................ 5

A . B .

I K PAKISTAN’S BANKING SECTOR REFORMS 8

A . Background ........................................................................................................... 8 B . C . Phase II - Reforms Supported by Banking Sector Restructuring and Privatization Project .......................................................................................................................... 9 D . Phase III - Reforms Supported by the Proposed Credit ........................................... 11 E . Cost of Banking Reforms [I 997 - 20041 ................................................................ 12 F . Governments’ Medium Term Reform Strategy ....................................................... 12

K THE PROPOSED CREDIT 14 Prior Actions ....................................................................................................... 15 Bank Groups’ CAS and the Government’s PRSP ................................................... 18 Partnerships with other Donors and Agencies ....................................................... 19 Financial Accountability and Fiduciary Environment ............................................ 20 Credit Administration .......................................................................................... 21

VI . BENEFITS AND RISKS 22 Benefits and Risks ........................................................................................................ 22

Phase I - Reforms Supported by Banking Sector Adjustment Loan ............................ 8

A . B . C . D . E .

ANNEXES

Government’s Letter of Development Policy ................................................................ 25 Pakistan: Asset Structure of the Financial Sector. 2000-03 ..................................................... 35 International Comparison of Financial Indicators ............................................................. 36 Structure of the Banking Sector ........................................................................................ 37 Financial Sector Soundness Indicators ......................................... .......................... 40 Key Banking Sector Recommendations (of FSAP) .............................................................. 41 Banking Sector Adjustment Loan (BSAL) (Ln . 4257) ....................................... Banking Sector Restructuring and Privatization Project (BSRPP) (Cr . 3571) Financial Sector Medium Term Outcomes Matrix .... Key Macro Economic Indicators .... Public Information Notice (IMF)

............................ 47 .............................................................................. 48 .............................................................................. 49 ...

TABLES

Table 1: Pakistan: Selected Indicators. 1999/00 to 2004/05 ................................... 4 Table 2: Cost o f Restructuring and Privatization ............................................................ 12 Table 3: Net Credit Expansion (Billion Rs.) ............................................................ 37 Table 4: Changes in Selected Banking Sector Indicators ................................................. 38

CHARTS

Chart 1: Cash Recovery Against N P L s ......................................................................... 10 Chart 2: N e t N P L s o f Banks ....................................................................... 10 Chart 3: Staff and Branch Reductions ............................................................................ 11 Chart 4: Cost Income Ratio ............................................................................................. 11 Chart 5: Outstanding Credit to PS ................................................................................ 22 Chart 6: E Banking Infrastructure ................................................................................... 23 Chart 7: Herfindahl Index for Industry ............................................................................ 23 Chart 8: Bank Composition ......................................................................................... 37 Chart 9: Profitability Indicators ...................................................................................... 37

......................................................................... 38 Chart 10: Deposits o f Banking System

Map 28419

Task Team

Task Team Leader: Mudassir K h a n (Senior Financial Sector Specialist. SASFP) . Team: Kiatchai Sophastienphong (Senior Financial Sector Specialist. SASFP); Christopher Juan Costain (Lead Financial Sector Specialist. SASFP). Zahid Hasnain (Economist. SASPR); Isfandyar Zaman (Research Analyst. SASFP). Rubina Quamber and Kadi ja Jama (Program Assistants. SASFP). Simon C . B e l l (Sector Manager. SASFP) and Joseph D e l M a r Pernia. (Sector Director. SASFP) . Peer Reviewers: Manuela Ferro (Lead Economist. SASPR); S . K . Wajid. (Deputy Head IMFIMED); Ann C . Rennie (Lead Financial Sector Specialist AFR); Kha l i d Siraj (Consultant) .

PROGRAM DOCUMENT FOR THE PROPOSED BANKING SECTOR DEVELOPMENT

POLICY CREDIT AND LOAN TO THE ISLAMIC REPUBLIC OF PAKISTAN

I. INTRODUCTION

1. Pakistan has implemented far-reaching reforms in the financial sector during the last decade with the help o f the Bank. The banking sector has undergone fundamental changes through a three phased reform program. The f irst phase o f reforms initiated in 1997, was supported by the Banking Sector Adjustment Loan (BSAL). The reforms managed to address the root cause o f sector’s problems and achieved a complete turnaround in the environment for banking in the country. The reforms involved controlling abuse o f the public sector banks by vested interests through changes in laws and governance; strengthening the regulatory framework and institutions; rationalization o f interest rates through reforms in the National Savings Scheme (NSS), improving the environment for enforcement o f financial contracts, bringing greater transparency and disclosure o f information, and operational restructuring o f public sector banks. Whi le these reforms managed to improve the environment, the sector remained government dominated and privatization efforts stalled. Realizing the need, the Government initiated a second phase o f reforms with further restructuring. These reforms were supported by the Banking Sector Restructuring and Privatization Support Project (BSRPP) in 200 1. Under this program public sector, banks further downsized their workforce and rationalized their branch networks, reducing their overall cost structure and improving profitability. The program also managed to liberalize bank branching, and rationalized the tax structure. Together, these reforms paved the way for third phase o f reforms which covered privatization o f two out o f the three largest commercial banks Le., UBL and HBL and the sale o f 75 percent shares o f Al l ied Bank Limited to local investors. With the privatization o f two o f the three NCBs which accounted for nearly 25 percent o f the system and sale o f A l l ied Bank L imi ted (ABL), nearly 80 percent o f country’s banking sector assets are now in private hands. This has also brought the f i rst generation reforms commenced in the late 1980s to near a conclusion. Concurrently, the Government and SBP also initiated second-generation reforms which aimed to further develop the financial markets infrastructure by improving the pol icy and regulatory environment and expanding access to financial services for al l segments o f the society and sectors o f the economy. These reforms are fully aligned with the results o f the Financial Sector Assessment and are an important pil lar of the Government’s medium term Poverty Reduction Strategy. These are outlined in the Government’s Letter o f Development Policy attached as Annex 1.

2. The proposed Banking Sector Development Policy Credit (BSDPC) supports the completion o f the third phase and helps with financing the costs incurred by the government in re- capitalizing these banks pr ior t o privatization.

11. POLITICAL AND ECONOMIC CONTEXT

3, Pakistan’s per capita growth averaged 3 percent in the 1980s, but only 1.2 percent in the 1990s. The slow growth o f the 1990s, exacerbated by drought and poor agricultural performance in the second ha l f o f the decade, l ed to an increase in the incidence o f poverty over the 1990s. Successive govemments in the 1990s attempted to respond but for the most part reforms were only partially implemented and results were generally disappointing. The mi l i tary government

1

which came to power in 1999 sought to reverse this situation and build upon the efforts o f i t s predecessors. I t launched a comprehensive reform program that sought to attack the interlinked problems o f slow growth, poor social indicators, and the heavy debt burden. Over the past four years, the government has made substantial progress in implementing reforms and macroeconomic performance has strengthened considerably.

A. Recent Political Developments

4. The present government took office after elections in October 2002 and i s marked by continuity o f policy and personnel in key economic management positions, including Finance Minister and the Governor State Bank. It has continued the banking reform program launched under the Nawaz Sharif government in the context o f a wide-ranging and ambitious reform program initiated by the military government. Recently there has been a change o f leadership in the ruling party leading to the swearing in o f a new Cabinet under Prime Minister Shaukat Aziz, who also retains the portfolio o f the Finance Minister. The new government has announced i t s commitment to continuity o f reforms which would be helped by the continuity o f key Cabinet members.

5. Relations between India and Pakistan have continued to improve as the “composite dialogue” to address the full range o f issues between two countries has proceeded. The new government in India has further invigorated the dialogue, and expressed i t s full commitment to continue to further the peace process. A further round o f talks was held in late November 2004. The January 2004 SAARC summit resulted in a landmark free-trade agreement under which SAARC members wil l reduce their intra-regional tariffs to 5% or less during the next decade while eliminating informal trade barriers.

Regional tensions have subsided over the past year.

6. Internal security challenges persist. Pakistan’s cooperation in the war o n terrorism has been extremely unpopular among extremist elements o f the society. Recently, the Government initiated military action in the tribal areas bordering Afghanistan to remove Taliban remnants and to respond positively to Afghanistan’s concems regarding anti-government forces taking refuge in Pakistani territory. Additionally, in the province o f Balochistan there have been incidents o f terrorist attacks o n key government installations. In the last few months there has been escalation o f sectarian violence in the coastal c i ty o f Karachi.

B. Macroeconomic Developments and Growth Performance

7. Continuity o f reforms has largely been successful and helped transform the country f rom a highly regulated to a more open market economy. As a result, macroeconomic performance continued to improve, with increased growth, greater extemal financial inflows, and improved fiscal performance (Table 1). Real GDP (at factor cost) increased by 5.1% in 2002/03 and 6.4% in 2003/04. This acceleration was led primarily by the manufacturing sector, which grew by 13.4% in 2003/04, as well as by robust performance o f the services sector, which increased by 5.2%. Gross capital formation rose f rom 16.7 percent o f GDP in 2002/03 to 18.1 percent in 2003104, and i s projected to increase to 19.4 percent in 2004/05. ‘Inflation as measured by changes in the Consumer Price Index (CPI) remained l o w at 4.6% during 2003/04. However,

’ Pakistan’s Federal Bureau o f Statistics completed in May 2004 a comprehensive revision o f the national accounts statistics. The base year was moved from 1980/81 to 1999/00 and several new sectors o f economic activity were included. T h e results o f this revision are a nominal GDP for 1999100 and subsequent years that are about 20% higher than previously estimated levels. T h i s document uses the ‘hew” GDP series.

2

strong domestic demand, increased food prices, and relatively loose monetary policy, have put pressure o n prices in recent months, and inflation i s projected to increase to 7% in 2004/05.

8. Extemal balances also continued to improve. Due to high levels o f remittances, strong exports and sizeable extemal support, the current account and overall balance o f payments improved. Over the past two years the current account tumed in a surplus. Debt re-profiling, made possible by the current l o w interest rate regime, availability o f grants and concessional finance, debt forgiveness and fiscal prudence, resulted in significant reduction o f the debt burden. As a result, progress in reducing Pakistan’s debt burden was substantial with government debt as a share o f GDP declining sharply fi-om 89% in 2000-01, to 69% in 2003-04. Against the backdrop o f improved macroeconomic prospects and declining debt burden, Standard and Poor’s credit-rating agency upgraded Pakistan’s long-term foreign currency debt rating to “B“ with a positive outlook. These developments bode well for Pakistan’s future economic and social development.

9. Fiscal outcomes continued to improve in FY03 and FY04. The fiscal deficit fe l l f rom 5.5 percent o f GDP in FY02 to 3.7 percent o f GDP in FY03, and to 2.4 percent in FY04. Whi le tax revenue collections, one o f Pakistan’s key macroeconomic weaknesses, increased by 16% and 10% in nominal terms respectively in FY03 and FY04, the tax to GDP ratio remained low, rising from 10.9% in FY02 to 11.2% o f GDP in FY04.

10. Aggregate expenditures have remained in check, with increased allocations provided to PRSP expenditures, lower than projected interest payments, and higher defense expenditures resulting f rom military activity on the Afghan border. Monetary aggregates grew rapidly in the first nine months o f 2003/04, reflecting the strong economic recovery, l o w interest rates, and ample liquidity in the banks.

11. The easy monetary stance o f SBP during the last few years started yielding results in FY04, k i ck starting the economy. SBP has been successful in inducing an increase in aggregate demand leading to increased capacity utilization especially in the manufacturing sector which helped realize a real GDP growth o f over 6 percent and a record growth in net private sector credit, Albeit, this also contributed to a rise in inflationary pressures. Thus, FY04 witnessed a gradual shift in monetary policy, as rising inflation became a source o f concern. Whi le SBP signaled bottoming out o f Rupee interest rates as early as August 2003, it started moving interest rates gradually upwards only during the last six months when both inflation and exchange rate pressures started to surge. On aggregate, SBP used monetary pol icy to stimulate economic activity in the country, and it i s l ikely to continue balancing between the objectives o f sustaining the growth momentum, managing the pressures on the exchange rate and containing inflation through FY05. This i s impl ic i t in SBP’s FY05 (July - Dec.) monetary pol icy statement.

12. IMF’s ninth and f inal review o f the PRGF recently completed (October 2004)* concluded that Pakistan’s economic performance was much stronger than at any time during the past decade. Tighter macroeconomic policies and structural reforms have resulted in a stronger external position, a lower public debt burden, renewed access to intemational capital markets, and a revival in growth, albeit accompanied lately by some increase in inflation. The strong macroeconomic performance i s expected to continue at least in the short term.

Staff Report for the 2004 Article I V Consultation, the Ninth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, October 2004.

Table 1. Pakistan: Selected Indicators, 2000/2001 to 2004/2005

2000101 2001102 2002103 2003104 2004105

Output and prices Real GDP fc Gross National Savings ("? of GDP) Real per capita GDP Consumer prices

Public finances Revenue (including grants) Expenditure Consolidated govemment budget balance (in % of GDP)

Excluding grants Including grants

Excluding grants Including grants

Consolidated govemment primary balance (in % of GDP)

Investment Gross capital formation

Govemment Non-govemment

1.8 15.6 -0.2 4.4

14.3 17.6

-4.3 -3.3

2.3

17.2 2.2 15.0

Total govemment debt (in % of GDP) 88.8 43.2 45.6 27.8

Total domestic debt (in % of GDP) Total extemal debt (in % of GDP)

Extemal public and publicly guaranteed debt service (in % o f exports of goods and s

Exports (12-months percentage changes, in US dollars)

Gross reserves (in millions of U.S. dollars) Current account balance excluding official transfers (in % o f GDP) -2.7

1,679

3.1 19.0 1.2 2.5

16.1 19.7

-5.5 -3.6

2.0

16.8 2.9 13.9

79.7 39.9 39.8 33.8

2.3 0.1

4,330

5.1 21.8 3.1 3.1

17.3 18.7

-3.7 -1.4

3.0

16.7 2.7 14.1

74.3 39.3 35.0 26.3

19.1 3.8

9,521

6.4 20.1 4.0 4.6

15.1 16.9

-2.4 -1.8

1.8

18.1 2.9 15.1

68.7 36.8 31.9 29.8

13.8 1.4

11,657

6.5 18.9 4.6 7.0

14.7 17.0

-3.2 -2.3

1.1

19.4 3

16.3

63.6 34.1 29.5 20.4

8.0 -0.9

10,984

Source: IMF.

111. FINANCIAL SECTOR OVERVIEW

A. The Financial Sector

13. For a low-income country, Pakistan has a well-developed, diverse, and sophisticated financial market. The sector i s dominated by commercial banks which account for nearly 73 percent o f the financial system's assets - see Annex 2 for financial sector's asset structure. The State L i f e Insurance Company, with Rs.86 b i l l ion ($1.5 bil l ion) in assets as o f December 2002 i s among the few non-bank institutions in Pakistan that comes close to the scale o f the major public and private banks. The equity market, however, i s one o f the largest relative to GDP amongst the peer group, exceeding Sri Lanka - the highest per capital income country in the region, (although falling short o f the standard set by India). International comparison o f financial sector indicators i s provided in Annex 3. Equity market capitalization reached US$24.4 b i l l ion as o f end June 2004, equivalent to about 36 percent o f GDP. In addition, there are a large number o f mutual funds, a nascent corporate debt market, and a developing contractual savings sector.

14. Pakistan's capital markets have grown but remain relatively narrow and small. SECP has adopted a number o f measures to reinforce market integrity while more systematic efforts are planned to curb market abuse. There are three stock exchanges Karachi Stock Exchange (KSE),

4

Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE). The K S E i s the most active and includes almost al l L S E & ISE listed companies. In recent years, Pakistan has been one o f the world’s best performing equity markets with KSE-100 index up 21% in the f i rst ha l f o f 2004, more than 65% over 2003 and 112% in 2002. There has been a revival o f new listings in 2004, comprising both privatization and private sector offerings, with 12 listings by end o f August 2004 versus 6 in 2003, the highest number in seven years.

15. There i s also a growing futures market, with 15 one-month single stock futures contracts traded o n the KSE. The SECP has approved regulations for an over-the-counter market but this i s not yet operational. There i s a National Clearing and Settlement System (NCSS) and a Central Depositary Company (CDC) through which virtually al l the actively traded securities are settled.

16. The corporate bond market remains small but shows significant potential for growth. There are 57 listed corporate bonds (known as Term Finance Certificates, or TFCs) with a total face value o f Rs.31 b i l l ion or about $530 mi l l ion (less than 1 percent o f GDP). Until recently, development o f the bond market was hampered by distortions caused by high yields on NSS instruments, which effectively served as a benchmark for the corporate bond market. The prohibit ion on institutional investment in the NSS resulted in a significant increase in corporate debt issuance in 2002-2003. N e w activity has since slowed, as excess liquidity in the banking system has resulted in increased availability o f relatively inexpensive loans from commercial banks. There are two registered rating agencies and a l l corporate debt issues have to be rated.

17. The mutual fund industry i s growing in line with the development o f the capital markets. There are eleven open ended and fifteen closed end mutual funds, managing assets worth over Rs.48 b i l l ion ($820 million); the vast bulk o f investment being f rom institutional sources. The industry, which dates back to the 1960’s, was dominated by two public sector fund managers, ICP and NITL. The management rights for 26 ICP funds have now been sold to private investors and the government i s in the process o f restructuring and privatizing NIT the largest open-end mutual fund in Pakistan.

18. The leasing sector continues to grow in assets, increasing by 16% to Rs.52.3 b i l l ion or about US$900 mi l l ion but remains highly concentrated with more than ha l f o f sector assets held by 3 o f the 29 active leasing companies. Although recent regulatory changes and increased capital requirements have led to consolidation within the financial sector and are l ikely to increase competition for the leasing industry.

19. Contractual savings remain underdeveloped. Bo th insurance and pensions are relatively small and have traditionally invested in government securities. Insurance penetration i s very l o w relative to other countries at Pakistan’s income level, reflecting a history o f nationalization and instability, weak consumer protection and awareness. Recent growth rates have demonstrated the scope for substantial development within an appropriate regulatory framework. The Government intends to improve the law and strengthen regulatory powers as wel l as capacity o f the SECP. In addition there are plans to introduce a private pension system in order to protect pension savings o f individuals.

B. The Banking Sector

20. The Pakistani banking sector consists o f the State Bank o f Pakistan (SBP) - the central bank, and one large and one small state owned commercial bank (National Bank o f Pakistan and First Women Bank), 4 privatized banks - Habib, United, Muslim and Allied, 17 private domestic banks, and 13 foreign commercial bank branches. In addition, there are 3 small state owned

5

specialized banks and 2 small provincial banks. Domestic banks dominate the share o f total assets and liabilities o f the banking system. Their performance in terms o f mobilization o f deposits and extension o f credit has further increased whi le the market share o f foreign banks has declined in recent years. This was basically due to the shifting o f Foreign Currency Deposits (FCDs) into local currency with the restriction on withdrawals in foreign currency, increased competitiveness o f the local banks and the decision o f several foreign banks to discontinue operations in Pakistan mainly as a result o f their global strategy. Details o f the sector’s structure are provided in Annex 4.

2 1. Prior to 2000 Pakistan had an extensive network o f Government-owned commercial and various specialized banks as wel l as development finance institutions. All were characterized by corruption, mis-management, and inefficiency resulting in high N P L s and negative net worth. Under the Government’s reform program, some o f the large commercial banks were privatized, a number o f Development Finance Institutions (DFIs) have been closed or merged, and others are being restructured. The remaining state-owned development finance institutions - SMEB, HDFC, and ZTBL are mandated to provide funding to the areas underserved but at the same time are being restructured to operate on commercial basis.

22. A challenge faced by the sector in recent years was the decision o f the Supreme Court o f Pakistan in December 1999 and extended for one year in 2000, required transforming the financial system to operate in accordance with the Shariah. The precise nature o f this requirement was challenged and s t i l l remains under legal review, leaving ambiguity regarding the status of Islamic banking. However, the Government’s declared pol icy i s to let the market determine the relative sizes o f traditional and Islamic banking. T o promote Islamic banking in response to market demand, SBP has since been pursuing a three pronged strategy, which included: (i) licensing o f full fledged Islamic banks that transact only in Shariah compliant products and services; (ii) allowing conventional banks to carry out Islamic banking through separate dedicated subsidiaries; and, (iii) permitting existing commercial banks to set up dedicated branches for Islamic banking. In April 2004 the Shariah Board o f the SBP also approved Islamic modes o f financing to ensure compliance with minimum Sharia standards by banks conducting Islamic banking. Once fully approved, the guidelines wil l function as prudential regulations for Islamic banks. As o f June 2004 one bank (Meezan Bank) was operating with 10 branches in 5 cities as a full-fledged Islamic bank. In addition, 5 local and foreign banks have been issued licenses to operate 12 dedicated Islamic Banking Branches o f which 10 branches were already operational. SBP has also given in principle approval for opening 12 additional Islamic banking branches during 2004. Some o f the banks are also offering Islamic banking products through their existing conventional branches.

23. At the Country’s request, a jo in t Bank-Fund Financial Sector Assessment Program (FSAP) was recently conducted (April 2004). Overall assessment o f the FSAP was quite positive and the findings highlighted the banking sector reforms undertaken to have been effectively implemented in the context o f broader macroeconomic stabilization, providing an essential foundation to financial sector recovery.

24. The FSAP highlighted the transformation o f a predominantly state-owned and weak banking system into a healthier, market-based system, owned pr imari ly by the private sector, noting that the efficiency o f the banking system has been enhanced substantially by restructuring o f major banks. The Assessment found the results o f the reform efforts in the banking sector manifested in improving financial soundness indicators, greater resiliency to credit, market and liquidity risks, and good compliance with international supervisory standards - see Annex 5 for financial soundness indicators. The study went o n to observe that the strengthened financial

6

position o f banks, coupled with increased liquidity in the sector form a strong balance o f payments. The release o f institutional funds f rom the National Savings Scheme, have led to a sharp increase in credit to the private sector, both in aggregate terms and to a wider range o f smaller borrowers. The expansion o f credit to previously underserved markets has led to strong gains in consumer, housing, SME, and agricultural finance over the previous two years. Credit to these market segments, once the quasi-exclusive domain o f public DFIs and specialized banks, i s n o w being provided by a broad range o f financial institutions. Progress was made on improving financial market infrastructure and practices.

25. The reforms, however, did not equally advance across al l segments o f the financial sector. Insurance penetration remains very l o w relative to other countries at Pakistan’s income level which can be improved through further consolidation and liberalization o f the industry as we l l as more market/solvency-based regulatory structure.

26. discussed below:

The key FSAP recommendations on the banking sector (Annex 6) and their status i s

(a) Revise the SBP Act and the Banking Companies Ordinance to address the concerns noted in the Basel Core Principles assessment, especially ensuring legal authority of the SBP to conduct consolidated supervision. This i s being pursed by the Banking L a w Review Commission set by the Government with help from the Bank under the Banking Sector TA Project.

(b) Continued supervisory vigilance and efforts to further strengthen the system. This i s being supported under the Banking Sector TA.

(c) To broaden access to financial services in a sustainable and cost-eflcient manner to the previously underserved markets wi l l require some adaptation of relevant regulations. SBP has issued revisednew regulations for corporate/commercial consumer and SME financing supported through this operation.

(d) Adopt market risk-related capital charges and consider tightening speciJic provisioning requirements. SBP has introduced market risk-related capital charges in line with Basel 2 requirements. On provisioning requirements, SBP has required the banks to make general provisions o f 5% for unsecured and 1.5% for secured loans - this i s in addition to specific provision already in place.

(e) Develop a strategy to privatize NBP and continue divestiture from the capital of other banks. NBP has been restructured by the government, has sold twenty three percent shares through the stock market, and plans to complete i t s privatization by 2010. The remaining government shares in other banks will also be o f f loaded gradually either v ia stock market andor sale o f shares. The specialized banks are being restructured under the Asian Development Bank (ADB) program and are planned to be privatized over the medium term.

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IV. PAKISTAN'S BANKING SECTOR REFORMS

A. Background

27. The banking system was o n the verge o f crisis in the mid nineties. By the end o f 1996, non-performing loans had reached alarming proportions. Liquidity problems had begun to emerge as dis-intermediation spreads and banking losses mounted. Most cases o f loan defaults remained unresolved in an ineffective court system. These were manifestations o f deep-seated problems rooted in a failure o f governance and lack o f financial discipline. Political interference had vitiated the financial intermediation function o f the banking system and borrowers expected not to repay loans, especially f rom the Nationalized Commercial Banks (NCBs) and DFIs. NCBs and DFIs were major sources o f bad loans, accounting for 90 percent o f the bad loans in the entire system and were the main loss-makers. Overstaffing and over-branching and undue interference by labor unions in bank, personnel and operations resulted in large operating losses. Poor disclosure standards abetted corruption by window-dressing the true picture o f banks. The authorities realized that, while these deep-rooted problems would take time to resolve, immediate measures were needed to arrest the deterioration and prevent a banking crisis, especially since the country was facing a diff icult external position. In early 1997, the State Bank o f Pakistan and the Ministry o f Finance designed and started to implement a "home-grown" banking reform program.

28. Over the three phases as discussed earlier, the first generation reforms were based around four pillars and aimed to strengthen the sources o f governance and financial discipline for the banking sector, namely bank regulators, markets, the courts and bank owners by enhancing the authority and the ability of the central bank to supervise banks and enforce regulations. The program sought to promote market discipline, improve the legal and judic ia l processes for enforcement of financial contracts and initiated corporate governance reforms in the NCBs and DFIs.

B. Phase I - Reforms Supported by Banking Sector Adjustment Loan

29. The 1997 B S A L supported implementation o f major short-term measures designed to arrest the f low of bad loans, curtail loss-making, and conserve the assets o f the NCBs and DFIs. Prudential regulations and financial disclosure standards were brought to international levels increasing transparency. Market distortions were reduced to increase the efficiency o f financial intermediation. Legal and judicial processes were strengthened to enable a more effective enforcement o f financial contracts. Management and boards o f the NCBs and DFIs were replaced and the law was amended to insulate the appointment process f rom polit ical interference. Improvement in corporate governance was to be sustained through a well-structured privatization program. The NCBs and DFIs were to be sold to reputable strategic investors with integrity, capital, banking expertise, management and technology to run these institutions prudently and efficiently. These reform measures were not only critically needed to stop the hemorrhage o f the banking sector, they were also needed to lay the basis for the implementation o f a medium-term program that would deal with the stock o f bad loans, strengthen banking supervision, and build the capacity o f the legal and judic ia l system for loan recovery.

30. The program helped the Government realize these objectives and by the end o f 1999, the banking sector had improved by most benchmarks compared with the situation in 1996. In the three-year period, cash recoveries against non-performing loans totaled Rs.70 bil l ion, or a third o f the stock o f loan defaults. The NCBs stemmed operating losses through staff rationalization - nearly 30 percent of the workforce and closing 500 loss-making branches. The new banking

8

court system processed 22,000 out o f 52,000 loan default cases at an unprecedented rate. The level o f non-performing loans started to stabilize due to better lending practices and intensified loan recovery, work-out o f problem loans as wel l as take over o f large NPLs by the Corporate and Industrial Restructuring Corporation - setup by the Government as an instrument to deal with the stock problem and to clean up the balance sheets o f NCBs and DFIs. These measures helped the banking system achieve improvements in capital adequacy, asset quality, efficiency, and profitability. These improvements were despite more stringent disclosure standards in 1998 and 1999 than those of 1996- improved disclosure being part and parcel o f the reform program itself . See Annex 7 for BSAL policy reforms matrix- the specijk measures implemented and their outcomes.

31. Whi le B S A L was successful in supporting the pol icy reforms and first level o f operational restructuring, the reform program was far f rom complete. As the crisis eased and financial institutions started to recover, the reform process slowed down. Interference in the banking system restarted by mid o f 1999, through new centrally mandated credit programs. Loan recovery slowed, except for the dramatic gains as a result o f the accountability campaign initiated by the new mi l i tary Government that took over in October 1999. Loan collateral foreclosure and bankruptcy procedures were not strengthened as planned. Market reforms to reduce segmentation were not completed. Most importantly, bank privatization did not materialize as planned due to weak market conditions, the country's deteriorating foreign investment climate, faltering resolve and also because o f the distressed conditions o f NCBs - high cost structures and depleted balance sheets, which did not attract quality buyers.

32. As i t was believed that privatization was the only sustainable solution to the country's banking sector problems, there was need to ascertain what was required to attract suitable investors and complete privatization. Market feedback at the time highlighted that quality acquirers were reluctant to dedicate substantial management time, as well as assume polit ical and social risks, o f further restructuring necessary to bring the operating structure o f the NCBs closer to international norms. Moreover, the significant cost o f these restructurings, especially when added to the cost of required balance sheet restructuring, was beyond the capacity o f any domestic financial institution. To assist the Government with further operational restructuring o f the NCBs and strengthening o f the policy environment the Bank in 2001 prepared BSRPP as an investment operation.

C. Phase I1 - Reforms Supported by Banking Sector Restructuring and Privatization Project

33. The BSRPP was planned to help the Government with second level o f operational restructuring o f the NCBs in preparation o f their privatization as wel l as for improving corporate governance o f the partially privatized banks by divesting the remaining government shareholding and allowing complete control of the private sector owners. In addition, the project sought to address the problems o f the specialized financial institutions by reducing their number to three (catering to small industry, housing finance and small agriculture), and amalgamating the largest DFI - NDFC, into the National Bank o f Pakistan. Details o f the pol icy and institutional reforms carried out are discussed below. See Annex 8 for specijk reform measures implemented under BSRPP and their outcomes.

34. Policy Reforms: The first generation pol icy reforms implemented under the B S A L were short term in nature and were able to stabilize the financial sector by addressing some o f the core issues and thereby create a platform for longer term reforms. These second-generation reforms were aimed at achieving a permanent resolution through genuine privatization and improving the

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overall banking environment. The latter required tackling the N S S that were the cause o f significant dis-intermediation, rationalizing the taxation structure, resolving the problems o f enforcement of financial contracts and improving the environment for bank operations.

80 -

35. Institutional investment in N S S was banned, tax advantages were removed, and the rates lowered and linked with comparable market rates. Removing these distortions enabled the banks to realize considerable growth in deposits. Liberalization o f bank branching led the private banks to expand their networks while the NCBs rationalized theirs. There was also major expansion in ATMs improving access to banking services. Reduction in tax rates from 58 percent to 47 percent in 2003 improved margins and profitability o f the sector. Further reductions were approved which would bring down these rates to 35% by 2007. Additionally, income tax law was improved and past tax disputes o f the bankmg sector were resolved. The reforms had a positive impact in improving the market structure, reducing the cost o f financial intermediation, and deepening the market.

36. The improvements in the regulatory and legal environment along with the passage o f Financial Recoveries Ordinance 2001 had a significant impact on reducing the overall level o f N P L s and improving recoveries. Cash recoveries o f the NCBs increased by 32 percent in a single year (from 2000 to 2001). The total recoveries by the NCBs during the last three years reached Rs.69 bi l l ion and were about Rs.89 bi l l ion including al l private and public sector banks and DFIs (chart 1) The FRO also provided the banks with powers to foreclose without court interference. This provision, however, was recently challenged in the high court on constitutional grounds. If the provision i s upheld, the usage and deterrence value o f the law would increase significantly. In addition, the Corporate and Industrial restructuring Corporation (CIRC) helped restructure the balance sheets o f NCBs and DFIs by taking up their non-performing loans o f over Rs.10 million. With special legal powers, CIRC was more successful in liquidating and disposing o f assets than the banks. However, to avoid premature re-capitalization o f the NCBs and DFIs, the CIRC law provided for replacement o f loans only at the time o f privatization or after a period o f three years.

37. Since 2001 the flow o f new N P L s has reduced and i s comparable to international benchmarks. Chart 2 shows the trend o f reduction in the net N P L s o f al l categories o f banks over a period o f four years.

Chart- 2: Net NPLs of Banks loo 1

PSCBs LP0S F0s CBs SBs

38. Operational Restructuring: The NCBs underwent extensive operational restructuring and with the start o f the BSRPP program in 2001, a total o f 11,000 staff were separated through

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voluntary separation programs (see chart 3). Staff rationalization, de-layering coupled with branch rationalization where 800 branches (majority urban) were closed, reduced the high cost structure o f NCBs, and brought their costhcome ratios (chart 4) closer to the international benchmark o f 0.50.

Chart - 3: Staff and Branch Reductions

40000 7 1- employees ~ O O 30000

20000

10000

0 HBL UBL NBP HBL UBL NBP HBL UBL NBP 1995 2000 2003

Chart-4: Cost Income Ratios

0 0.2 0.4 0.6 0.8 1

The cost reduction brought about by staff and branch rationalization enabled the banks to invest more and faster in technology, increasing staff productivity and improving work culture.

39. Preparing. NCBs for Privatization and Disinvesting. Government Shareholding. in Partially Privatized Banks: Finally and most importantly, the ultimate goal o f reforms implemented under BSRPP was to bring a permanent change in corporate governance. With the experience o f MCB and ABL (sold in 1991), the Government adopted a different approach for the privatization o f UBL and HBL. The policy reforms and operational restructuring carried out under BSRPP led to earlier than expected privatization o f both the institutions. UBL was successfully sold to a consortium o f foreign and local investors in October o f 2002 followed by HBL which was sold to the Agha Khan Fund for Economic Development in January 2004. As the cost o f operational restructuring was less than expected, BSRPP was recently modified to al low it to partially support the cost o f balance sheet restructuring carried out at the time o f privatization. However, as the available funds were insufficient, the proposed credit and loan would augment Bank’s support towards the required balance sheet restructuring.

40. The Government successfully divested i t s shareholding in M C B and off-loaded 23 percent o f i t s shares in N B P through the stock market. This strategy achieved the objective o f market deepening and improved disclosure, and has provided some measure o f market discipline for NBP. In addition, the State Bank managed to bring a change in management and ownership in ABL through sale o f additional shares in the bank.

D. Phase I11 - Reforms Supported by the Proposed Credit and Loan

41. The proposed BSDPC supports phase I11 o f the f i r s t generation reforms that are fully aligned with FSAP recommendations and the Government’s PRSP and include: (i) improving o f sector governance through privatization o f UBL, HBL and resolution o f ABL; (ii) developing effective regulatory and supervisory capacity at SBP through changes in banking regulations; (iii) enhancing transparency though greater public disclosure; and (iv) preventing possible use o f the banking system for money laundering. With implementation o f phase 111, the Government has reached a near conclusion o f the f i rs t generation reforms and has concurrently embarked o n the second-generation reforms discussed in sub section ‘F’ o f this Section under the Government’s medium term reform strategy. Phase I11 reforms are discussed in detail in Section ‘V’ o f the Proposed Credit and Loan.

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E. Cost of Banking Reforms [1997 - 20041

42. The banking reforms that were initiated in 1997 have cost the Government about US$2 billion, nearly 2.8% o f GDP. The costs include capital injections, voluntary separation programs for downsizing and bringing the cost structure o f public sector banks in l ine with intemational norms and other outstanding claims o f the banks on account o f state owned enterprises and tax settlements. The costs o f operational restructuring o f the banks were partially supported by the Bank under B S A L and BSRPP. However, the operational restructuring cost incurred under BSRPP was less than expected and the project was modif ied recently to allow it to support the cost o f balance sheet restructuring. The proposed credit and loan supplement Bank’s support towards balance sheet restructuring - details o f the costs incurred for the reforms carried out since 1997 are provided in the table below.

Table 2: Cost of Restructuring & Privatization (US$ in millions)

Tax Total Cost of Settlements Restructuring

SOEKIRC VRS Recognition

Bonds

Capital Injection

COSTS

UBL 530 105 90 91 816 HBL 275 160 60* 172 667

-- 60 NDFC 50 l o -- NBP -- 415 -- 82 497 Total 855 690 150 345 2,040

FINANCING GoP: 940

**Sale 590

Budget 350 Bank: 850

BSAL - 250 250 BSRPP 100 200 300

***BSDPC 300 3 00 OECF - 250 250

Total 2,040

Proceeds

* HBL figures include $39 mil l ion SOE Recognition Bonds. * * Proceeds from the sale o f UBL, HBL and NBP’s 23 percent shares. *** The proposed Credit and Loan to finance balance sheet restructuring.

F. Governments’ Medium Term Reform Strategy3

43. Government’s medium term strategy covers the second-generation reforms to consolidate the gains realized thus far and to build on the strengths o f the financial system for expanding access to financial services. The strategy i s aligned with the recommendations o f the FSAP and i s also discussed in the Government’s LDP. Specific outcomes are provided in Medium Term Outcomes Matr ix attached as Annex 9. Bank support for these second-generation reforms would be through several instruments including the PRSCs, the ongoing Baking Sector Technical

ADB i s also supporting financial sector reforms through their programs for capital markets, specialized banks and DFIs as well as SME development.

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Assistance Project, IDF for SECP, the Second Poverty Alleviation Fund Project, technical assistance for housing finance, pensions and debt market reforms as wel l as a possible TA for capital markets development in partnership with other donors particularly ADB.

44. Improving the environment for financial intermediation and completing the process of restructuring and privatization o f the remaining state owned financial institutions. The Government in the budget FY05 announced restructuring o f NSS, transforming it into a corporation to operate on commercial lines. The corporation would offer mutual funds managed by professional asset management companies and would assist in increasing coverage and availability o f resources for investment. This area was also highlighted in the FSAP and the Bank assistance o n debt management strategy, reorganization and risk management i s underway. The Government has gradually been reducing the taxation on banking and aligning it with the corporate sector as stated pol icy for providing a level playing field. I t i s also moving to rationalize the tax structure for private companies to encourage registration and to avoid listing o f companies purely for tax advantages. In addition, to reap the benefits o f an efficient and effective private banking system, the Government and SBP would continue their efforts for disinvesting state ownership in the remaining public sector banks, DFIs and non-bank financial companies. The Government has already disinvested 23 percent o f i t s shareholding in NBP, the only remaining NCB, through stock market and i s in process o f amending the Nationalization Act, 1974 to al low voting rights to minority shareholders and to continue further dis-investment. The plans include complete privatization o f NBP by 2010. The Government has initiated operational restructuring of the ZTBL, SMEB and H B F C and plans to privatize these institutions once private sectors credit i s largely able to meet the demand o f these sector that have traditionally remained underserved. IDBP and NIT - the largest open-end mutual fund, are being restructured for privatization. There are also plans to restructure and privatize the state owned insurance companies over the medium term. Restructuring and privatization o f DFIs, NBFCs, and insurance companies has support f rom ADB.

45. Improving the legal framework and judicial process for enforcement of financial contracts. The Government has already initiated the work for review and consolidation o f the banking laws through the Banking L a w Review Commission. This would include review o f the SBP Ac t for purposes o f strengthening SBP’s autonomy as wel l as o f the banking laws for implementation o f Real Time Gross Settlement System and for sharing o f credit information to facilitate private sector credit bureaus. In addition, there are plans to review and improve the Public Debt Act, Insurance Ordinance, as wel l as laws pertaining to insider trading and take over o f companies in l ine with best practices. Draf t laws for bankruptcy/insolvency, and AML/CFT have already been prepared and are currently in their f inal stages before being presented to the Parliament for approval. SBP has also organized training o f banking court judges and i s raising awareness amongst stakeholders for improving implementation o f FRO 200 1.

46. Strengthening and further deepening capital markets. SECP has made reasonable progress during the last few years with the support o f ADB, however, a number o f areas remain weak and were highlighted in the FSAP. The Government and SECP have already started to take these up and plan to address them over the medium term for the capital markets to p lay their due role in development. The main focus areas include: (i) development o f a legal and regulatory framework for private pensions; (ii) rethinking the role and devising a strategy o n that basis for state owned insurance companies; (iii) development o f rules and gradually introducing margin financing to replace COT; (iv) training o f adequate level o f resources for supervision and on-site inspection o f entities regulated by SECP; (v) sk i l l development and capacity building o f SECP and the exchanges; (vi) putting in place adequate systems and resources for market surveillance

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and supervision o f market intermediaries; and (vii) strengthening investor protection and taking additional measures for expanding services and improving investor education.

47. Improving financial markets infrastructure and access to financial services. The Government and the SBP have taken concrete steps to improve the legal and regulatory framework for improving access to finance for the micro, SMEs, and consumers and new prudential regulations for these sectors have been introduced. As a result, private sector credit through the banking system has considerably increased. In the last year alone, private sector credit witnessed a growth o f more than 30 percent. In addition, the Government has initiated operational restructuring o f the ZTBL, SMEB, and H B F C to improve service delivery to small farmers, consumers, homeowners, and small businesses. There i s already sizeable rise in the share o f agriculture financing by private commercial banks f rom the year before. Performance o f H B F C has improved and along with that there are 19 other institutions engaged at some level in providing loans for housing, thereby increasing the outstanding o f this segment to Rs.22 b i l l ion (Dec 2003). Along with these positive developments, SBP and SECP are placing emphasis on: (i) encouraging businesses to improve record keeping and transparency in operations; (ii) promoting expansion o f private sector credit information services; (iii) equipping financial institutions with necessary tools for a risk based environment; (iv) innovatiodproduct development for borrowers as wel l as savers; and (v) focus o n technology.

V. THE PROPOSED CREDIT AND LOAN

48. During the course o f reforms it was recognized that the NCBs would require substantial balance sheet restructuring to attract quality investors and provide the basis for genuine privatization. Details o f these reforms supported by B S A L (1997) - Phase I and BSRPP (2001) - Phase 11, are discussed in section N.

49. Rationale: Bank privatization supported by the proposed Credit and Loan has been undertaken in the context o f Government’s overall banking reform strategy as spelled out in their Letter o f Development Policy. Earlier operations have supported operational restructuring in order to facilitate privatization, however, the Bank had linked any re-capitalization support to successful privatization. With the completion o f privatization o f UBL, HBL and resolution o f ABL, IDA Credit o f US$lOO mi l l ion equivalent and IBRD o f US$200 m i l l i on are proposed to support the program.

50. Rationale for Prior Actions: Reform o f corporate governance was considered the most critical for sustainability of the complete reform program and to ensure i t s irreversibility. Other actions were included with a v iew to improving the overall environment for banking. The Government has already completed the required actions for corporate governance and handed over the three banks to qualified foreign and local investors. In addition, the Government has taken steps to further strengthen the regulatory and supervisory framework for banking, improving transparency and disclosure and preventing the possible use o f the banking system for money laundering. The Government i s also committed to continue with the second-generation financial sector reforms as part o f i t s economic growth and poverty reduction strategy and i t s objectives and strategy are explained in the LDP.

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A. Prior Actions

5 1. Privatization o f HBL. The Government carried out extensive operational restructuring o f HBL since 1997 with support under B S A L and BSRPP. T o enable i t s sale, government also had to address the bank’s negative capital position. These efforts paid o f f when HBL was successfully privatized in January 2004. A strategic equity stake o f 5 1 percent was sold to the Aga Khan Fund for Economic Development for a total bid price o f Rs.22.40 b i l l ion (US$390 mill ion) and the hand over o f bank’s management was completed in Feb. 2004.

52. In 1998, the Government agreed to re-capitalize the bank and injected Rs.9.7 b i l l ion which was followed by another injection o f Rs.8 b i l l ion (a total o f about $275 mill ion) init ially given as an advance against rights issue in 2000. The amount o f Rs.9.8 b i l l ion ($172 million) was also provided in the form o f bonds in 2003 in recognition o f previously unrecognized expense. Another Rs.2.2 b i l l ion ($39 mill ion) were given in bonds against the bad debts dating back to 1992/3 and Rs. 1.2 b i l l ion ($20 mill ion) transferred to the CIRC.

53. The process o f HBL’s balance sheet restructuring has cost the Government an amount o f Rs.30 b i l l ion (excluding the costs o f VRSs) or approximately US$500 mi l l ion. The total cost o f restructuring comes to US$270 mi l l ion after taking into account the sale proceeds o f 5 1 percent shares. Privatization will, however, result in additional revenues for the Government once it disinvests the remaining 49 percent shares sometime in the future.

54. Privatization o f UBL. The Government also initiated restructuring UBL for i t s ultimate privatization f rom 1997. Despite facing a more challenged financial situation at the outset, the restructuring o f UBL proceeded at a faster pace (in part due to the unquestionable need to take drastic measures at the very outset o f the rehabilitation exercise). As a consequence o f the rigorous approach which was adopted with regards to UBL, in October 2002 the Government was able to sell a 5 1% shareholding in the bank to a consortium o f a UAE bank (which already had a Pakistan presence) and a reputable UK businessperson o f Pakistani origin. However, the proceeds o f $177 m i l l i on received for the 51% stake do not come close to covering the costs incurred by Government in the restructuring process. Similar measures were applied to those that were later used for HBL, including a total o f almost Rs.26 b i l l ion ($530 mill ion) in capital injections (commencing with Rs.21 b i l l ion re-capitalization in M a y 1998), tax refunds o f Rs.5.4 b i l l ion ($9 1 million), transfer o f NF’Ls and other operational restructuring actions. With UBL’s sale in October 2002, the total cost to the Government o f UBL was about $630 mi l l ion.

Shareholding of NCBs and ABL

Other Private Sector Name of Majority Shareholder Holding and Shareholding Name o f Bank Public Sector

Institutions Al l i ed Bank o f 12% 88% Ibrahim Leasing & Ibrahim Group- Pakistan 79%; National Bank o f 77% 23% GOP-2% Pakistan Habib Bank Ltd. 74% 26% Agha K h a n Foundation o f

SBP-75% - o n behalf o f GOP

Economic Development-26% * Uni ted Bank o f 49% 51% A1 Nahayan & Bestway G r o u p Pakistan 51%

GOP/SBP-73%

*AKFED has yet to pay and legally transfer the remaining 25% bought as part o f the privatization transaction.

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55. For the last few years, the Government and SBP were making efforts to resolve the complex legal and transactional issues which had been a challenge from the time o f SBP intervention. The transaction was not a typical privatization exercise. I t required creative structuring to resolve the situation for handover o f A B L ’ s management and ownership to a strong and credible private owner.

Change o f Ownership and Management in ABL.

56. Considering A B L ’ s precarious financial position with a negative equity o f Rs.3.97 billion, SBP structured sale o f additional shares o f 75.35 percent o f the aggregate paid up capital through a l imited public call for offers.

57. T o realize the sale, SBP invited offers f rom seven private sector parties that had indicated interest in acquiring the institution through submission o f Expression o f Interests (EOIs). Five investor groups were pre-qualified for bidding which was held on July 23, 2004. ABL was sold to the highest bidder at a price o f Rs.14.2 b i l l ion ($240 mill ion) which included a per share premium o f Rs.33.7 over par value. The Government issued i t s notification authorizing the sale o f additional shares to the Group o n July 24, 2004. With the payment in full, ABL was handed over to the consortium o f M/s Ibrahim Group/Leasing.

58. With these recent successes in privatization nearly eighty percent o f banking sector assets i s in private hands - the table below provides the distribution o f assets, deposits and equity between state, private domestic, specialized and foreign banks.

Post-privatization structure of the Banking Sector (March 2004)

Banks No. Assets Deposits Equity

Amount Share Amount Share (Rs. (Rs. (%)

Share Amount (Rs.

Billions) (%) billions) (”/I billions) State-owned’ 4 518.8 18.6 379.3 20.1 22.5 17.2

Domestic 20 1840.3 66.0 1292.3 68.5 92.8 70.9 private

Foreign 13 278.4 10.0 198.0 10.5 26.7 20.4

Specialized’ 3 149.8 5.4 16.0 0.9 -11.1 -8.5

Total 40 2787.2 100.0 1885.6 100 130.9 100

Source: Banking Supervision Department, State Bank o f Pakistan ’National Bank o f Pakistan, First Women Bank, the Bank o f Punjab, and the Bank o f Khyber. *Zari Tarqiati Bank Ltd, Industrial Development Bank of Pakistan, and Punjab Provincial Co- operative Bank Limited

59. Developing effective regulatory and supervisory capacity at SBP. The SBP has introduced a new system o f monitoring, surveillance, and supervision, institutional Risk Assessment Framework (IRAF). This i s aimed at ensuring a cohesive and proactive monitoring through preparation o f risk profiles o f individual institutions and taking prompt corrective action as and when called for. In addition, separate sets o f regulations have been introduced for corporate finance, S M E finance, consumer finance, micro-finance, NBFCs, and insurance companies. The aim i s to bring about a more systematic and risk-focused supervision and regulation o f financial institutions. Finally, the SBP has issued guidelines on risk management for banks/DFIs in order to ensure a more effective system o f risk identification, assessment, measurement, monitoring, and mitigating/controlling al l r isks inherent in the business o f banking.

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60. Promoting transparency and disclosure. The SBP has taken a number o f steps to promote transparency and disclose through issuance o f a master circular containing consolidated instructions on financial disclosure. Banks have been asked to publish financial statements every quarter. N e w formats for reporting o f financial information have also been circulated and enforced. The formats are based on I A S to avoid miscommunication and bring standardization. These guidelines have brought about improved disclosure and full compliance with prudential regulations.

61. Prevention o f the possible use of the banking system for money laundering, financing for terrorism, and transfer of illegalhll-gotten money. The SBP has taken steps to prevent the use o f banking channels for the purpose o f money laundering. The measures include the establishment o f AML Unit, and issuance o f prudential regulations, The Unit i s entrusted with the responsibility o f bringing rules and regulations in l ine with international best practices and developing an effective regulatory system that minimizes the possibility o f money laundering and financing o f terrorism. The SBP has also issued minimum guidelines to be followed by banks while opening and dealing with accounts o f the customers. The SBP has issued prudential regulations on K n o w Your Customer, Record Keeping, and Reporting o f Suspicious Transactions.

Prior Action Matrix

Objectives 1. Improving sector governance through privatization.

2. Develop effective regulatory and supervisory capacity at SBP.

Prior Action (a) Privatization and hand over o f UBL.

(b) Privatization and hand over o f HBL.

(c) Mergerhale and handing over o f ABL to a qualif ied private sector group.

(d) Qualified bankers appointed to board and management o f NBP.

(e) Issuance o f detailed guidelines under “Fit and Proper Tests (FPT)” for the appointment o f Board o f Directors, Chief Executive Officers and Senior Management o f the banks.

Introduction o f a new system o f monitoring, surveillance and supervision, Institutional

Outcome Indicator UBL i s privately owned and managed and i s adequately capitalized compliant with SBP regulations;

HBL i s privately owned and managed and i s adequately capitalized compliant with SBP regulations.

ABL governance issues are resolved with the bank re- privatized and i s adequately capitalized.

Autonomy and professionalism assured.

Corporate governance enhanced through hiring o f bank managers with professionalism and integrity.

A cohesive and proactive monitoring through preparation o f risk Drofiles o f individual

Status LJBL i s successfully privatized.

HBL is successfully privatized.

ABL transferred to private sector.

N B P i s professionally managed.

Banks have fo l lowed these FPT guidelines since for appointment o f key executives since April 2003.

The IRAF has been put in place since early 2004.

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3bjectives

3. Promote transparency and disclosure.

4. Prevent the possible use o f the banking system for money laundering, financing for terrorism, and transfer o f i l legali i l l- gotten money.

?rior Action Cisk Assessment 7ramework IRAF).

[ntroduction o f separate jets o f regulations have 3een introduced for :orporate, SME, :onsumer finance, micro- Finance, NBFCs and insurance companies.

[ssuance o f guidelines on risk management for banksiDFIs.

Issuance o f master circular containing consolidated instructions o n financial disclosure.

Issuance o f guidelines for openingidealing with the accounts o f customers.

Outcome Indicator institutions and taking prompt corrective action as and when needed. Financial Soundness indicators for the system show an upward trend.

More systematic and risk- focused supervision and regulation o f financial institutions. General reserves o f 25% introduced for unsecured and 5% for secured consumer lending.

A more effective system o f risk identification, assessment, measurement, monitoring, and mitigating/controll ing a l l r i sks inherent in the business o f banking has helped ensure that banks are adequately capitalized to assume these risks.

Improved transparency and full compliance with prudential regulations as BanksiDFIs have increased public disclosure.

Money laundering, f inancing for terrorism, and transfer o f i l l-gotten wealth through banks wil l become increasingly dif f icult .

Status

Separate guidelines have been introduced in 2003.

Banks have started implementing an effective risk management strategy based o n these guidelines since August 2003.

The consolidated instructions o n financial disclosure have been put in place since January 2004.

Banks have implemented a know-customer po l icy based o n these guidelines since March 2003.

B. Bank Groups’ CAS and the Government’s PRSP

62. Based on the Government’s strong progress in implementing reforms, Pakistan CAS fully recognizes and supports the banking sector reforms and i s aligned with the Government’s Poverty Reduction Strategy. The Government regards the financial sector reforms as central to i t s poverty reduction and growth strategy and the PRSP clearly states the Government’s medium term strategy on the financial sector. The vision being o f a financial sector that intermediates effectively and caters to a l l segments o f the society thereby contributing to increased growth and reduced poverty in the long run.

63. The broad PRSP objective for the financial sector i s to improve governance through restructuring, privatization, and strengthening banking supervision. Specific areas o f importance

18

within the sector include: integration o f N S S rates with rates o f comparable market instruments; rationalization o f taxation on banking; privatization o f NBP; bringing the three restructured DFIs to the point o f sale or closure; restructuring o f S M E Bank and ZTBL; implementing Anti Money Laundering legislation and preparing bankruptcy legislation, further developing the pension and insurance systems and improving the overall framework for contractual savings. The Poverty Reduction Structural Credit (PRSC) which supports the PRSP was recently approved by the Board.

64. In l ine with CAS and PRSP, the Bank has continued i t s support to Pakistan's financial sector reforms through FSDIP, BSAL, and BSRPP. The Banking Sector Technical Assistance Project, approved in July 2002, supports further strengthening o f the SBP and the SECP. The recently approved 2"d Poverty Alleviation Project also aims to enhance access to finance for the poor. Future assistance will focus on consolidation of , existing reforms and further deepening o f the financial sector.

65. The size o f the proposed credit i s in l ine with the 2002 Country Assistance Strategy and reflects Pakistan's growing need for external financing support. The CAS Progress Report indicated that the Banking Sector Development Policy Credit (BSDPC) would total $175 mi l l ion in IDA with the Government of Pakistan assuming a larger share of the total costs o f balance sheet restructuring. However, this size was recently reduced to $100 m i l l i on because o f lack o f availability in IDA resources. In addition, since the summer, the current account and federal budget have experienced pressure from the rise in international o i l prices. Whi le the Government i s considering a number o f measures to address this issue- including adjusting prices to avoid pressures o n the budget - i t expressed i t s desire to reduce the share o f total bank re-capitalization costs financed fi-om the budget. Therefore, during negotiations i t has requested additional support f rom the Bank, i.e. $200 mi l l ion in IBRD financing, to be added to the $100 m i l l i on IDA. Even with this additional support from the Bank, the Government o f Pakistan i s bearing the majority o f the costs o f bank restructuring and privatization, which overall have cost the Government about $2 bi l l ion since the reform program was initiated in 1997. This level o f IBRD financing i s consistent with the original CAS high-case lending program which foresaw IBRD adjustment lending o f $600 mi l l ion over FY04-05 - total IBRD borrowing over this period i s n o w expected to reach $400 mi l l ion ($50 m i l l i on in FY04 and $350 mi l l ion in FY05).

66. accelerating economic growth and reducing poverty.

Both the PRSP and CAS recognize the importance o f financial sector reforms for

C. Partnerships with other Donors and Agencies

67. The Bank has worked closely with ADB and the Fund in pol icy dialogue and reforms o f the financial sector. The ADB has focused o n strengthening o f capital markets and has an ongoing Financial (Non-Bank) Markets and Governance Program. In addition, the ADB, Bank, and the Swiss Development Corporation have supported development o f the regulatory framework for micro-finance. The EU in coordination with the Bank has provided budgetary assistance for the Financial Sector Services Reform Program for efficient regulatory framework and improved financial services to rural areas. U N D P has also supported capacity building initiatives o f SECP and SBP. In addition, the Bank and the Fund have worked and recently concluded a country Financial Sector Assessment Program. In preparation o f BSDPC there have been regular coordination meetings with other donors and in particular the IMF due to the budgetary support nature o f the program.

19

D. Financial Accountability and Fiduciary Environment

68. Quite apart f rom the significant reforms already being registered in the area o f corporate governance and specifically in the regulation and enforcement mechanisms in the Banking sector, Pakistan has achieved some considerable improvement milestones in the public financial management and accountability reform agenda. The CFAA, delivered in December 2003 highlighted a series o f required actions by the government to further improve on the accountability framework in the public sector. The report dilated on the specific weaknesses in the budget formulation and execution, accounting, internal control and financial reporting, external audit, and legislative oversight at a l l levels o f government. It however concluded that, notwithstanding the ongoing reforms and a series o f other actions required to further improve the accountability framework in Pakistan, the fiduciary risk to Bank funds and other donor funds managed through mainstream government systems i s minimal. I t cited improvements in expenditure tracking and concluded that adjustment loans disbursed and managed through reliance on government-own financial management systems have shown satisfactory outcomes. The report however highlighted the need to register incremental progress in building institutional and personnel capacity in order to engender increased comfort and support the transition to full reliance on government systems, controls and reporting.

69. Integrating the financial accountability and management reforms in the PRSC reform actions engendered positive outcomes. The government introduced new reforms and consolidated and entrenched ongoing reforms in financial management and procurement areas with a v iew to enhancing the effectiveness, transparency, and accountability in the management o f public finances.

70. Specifically, the initiative to launch a review o f obsolete government treasury ru les and design and implement a comprehensive reconciliation o f accounts framework, with the earlier expectation o f completion in FY 2005 shall n o w be completed in FY 2006; the PIFRA project which i s in i t s last year o f the f i rst phase has produced, so far, 16 budgeting and accounting sites, a l l operating o n the new chart o f accounts using the new accounting model; as a result o f the progress n o w being achieved in the implementation o f PIFRA, the federal and N W F P governments have prepared their budgets solely on the basis o f the new chart o f accounts and are executing their budgets on that basis. The Sindh and Punjab governments however prepared their respective budgets on a parallel basis (both new and o ld charts) but have presented to their assemblies only o n the o ld chart o f classification. The Balochistan government prepared i t s budget only o n the o ld chart o f classification. As o f FY 2006 however, the whole federation i s geared to preparing their budgets solely on the basis o f the new chart o f accounts. This would indeed be a formidable achievement and a basis point towards preparation o f the federation’s accounts consistent with international standards.

71. Hitherto, the lack o f timeliness in rendering annual accounts for audit has been a factor that hindered the timeliness o f audit and presentation o f those accounts to the legislature. At present, the Controller General o f Accounts complete the preparation of the federal government accounts within 6 months o f the end o f the fiscal year and presents the accounts to the Auditor General for audit. I t is, currently, only the provincial accounts which suffer some delay o f up to an additional period o f 2 months before they are presented for audit. Dialogue with the Office o f the Controller General to ensure timely completion o f a l l accounts o f the federation i s signaling some positive outcomes.

20

72. The f i r s t phase o f PIFRA, designed to cover core transactions o f central, non- departmentalized accounts, strengthen the bifurcation o f the accounting and auditing functions and introduce a new model o f accounting using a new chart o f accounts, i s expected to be succeeded by a follow-on project (PIFRA 11). The preparation o f PIFRA I1 i s currently being finalized. I t i s designed to extend PIFRA I sites to the remaining 75 district accounts offices, 140 l ine ministries, departmentalized accounting agencies, and provide a comprehensive computerized budgeting, financial accounting and reporting environment in the government o f Pakistan. By these means, the reliability, comprehensiveness, timeliness, and accuracy o f financial and fiscal data for the whole o f the government o f Pakistan will be assured upon the completion o f the program.

73. External auditing conducted by the Auditor General o f Pakistan covers the entire federation. The timeliness o f audit has been a factor that impaired the financial reporting outcome. However, pursuant to the reform actions identified in the C F A A as wel l as the measures supported by PRSCI (amplified in the proposed PRSC II), the capacity o f the Auditor General’s Office i s being enhanced under the PIFRA initiative to improve o n the quality and timeliness o f audit through improvements in audit methodology and introduction o f modem approaches to regularity audit, performance audit, and value for money audit. A major component in the proposed PIFRA I1 project i s directed to these issues which encompass the systematic training o f auditors in the use o f computerized auditing and audit management modules.

74. Progress has been achieved, since’PRSC I, in the establishment and improved functioning of Public Accounts Committees (PACs). All provinces and the federal government have established PACs. Although there are mixed results in the progress o f individual P A C deliberations, the federal government, Punjab, N W F P and Sindh governments are making tremendous progress in dealing with reviews o f audited accounts and audit reports despite significant backlogs since the Ad Hoc PACs (established after the change o f government but n o w defunct). With the approval o f an IDF Grant to support the strengthening o f the federal PAC, the effectiveness o f the federal PAC will be enhanced when the project becomes effective. This will be a source o f inspiration to other provincial PACs to improve on their legislative oversight functions.

75. In general, the PRSC i s used as the vehicle for initiating financial management action triggers for advancing on this sector development pol icy lending. The government’s commitment to improving on the achievements in the area o f financial management i s more or else resounding. PIFRA constitutes the core thrust o f the financial management agenda in Pakistan. The government’s ownership o f the project as wel l as i t s pursuit for a follow-on project to complete fundamental reforms initiated and implemented during the f i rs t project i s a solid pointer that reforms are indeed working and, overtime, Pakistan could become proud o f a system that can pass the test o f time.

E. Credit and Loan Administration

76. The Government o f Pakistan shall establish a Special Deposit Account with the State Bank o f Pakistan (SBP) into which the proceeds o f the Credit and Loan will be disbursed o n a single tranche basis. The Rupees equivalent o f the funds in the Account will, within two working days, be transferred into the Consolidated Fund o f the Government o f Pakistan (Account No. 1) held with the SBP. Disbursements f rom the Consolidated Fund for activities to be financed under the Program by the Government o f Palustan shall not be l inked to any specific purchases, and n o special procurement requirement shall be needed. The proceeds o f the Credit and Loan shall,

21

however, not be applied to finance expenditures in the negative l i s t as defined in Schedule 1 o f the legal agreements. If any portion o f the Credit and Loan i s used to finance ineligible expenditures as so defined in the D C A , the Bank shall require the Government to reimburse the amount to the Special Deposit Account to finance eligible expenditures or refund the amount to the Bank. The SBP, on behalf o f the Government, shall maintain an appropriate accounting system in accordance with generally acceptable accounting principles. The Bank may request an audit to be carried out, with a v iew to providing a ‘special opinion’ as to the receipt o f funds into the special deposit account and the eventual transfer o f the local currency equivalent o f such funds into the Consolidated Fund Account o f the Government o f Pakistan.

soundness and efficiency o f the financial system by reducing state intervention and improving the environment for banking. The divestiture o f state ownership o f banks has substantially changed the structure o f the banking sector and nearly 80 percent o f sector assets are now controlled by private banks as compared with 34 percent in 1999, and jus t 8 percent in 1990. As a result access to finance has improved and credit to private sector has witnessed significant growth during the past three years. Last year alone private sector credit showed an increase o f over

77. disbursement in a single tranche upon effectiveness.

Since al l prior actions have been completed, the Credit and Loan wil l be available for

Chart-5: Outstanding Credit to PS

1.000.000 -

8oo,ooo. I

8

5 600,000

400,000

200,000 -

.-

0 , , , , , ~ , . , , , , , , , , F q s 6 2 2 2 y 2 2 - 8 $ q 8 8 : z g g $ $ $ s g d j $ < s g j

78. policies (OP 401), this structural adjustment i s classified as Category C.

Environmental Assessment Requirements: In accordance with the Bank’s environment

VI. BENEFITS AND R I S K S

Benefits and Risks

80. Profitability and liquidity indicators for the commercial banks have shown a marked improvement. The returns for the sector also improved despite the decline in the interest rate environment and reduction in interest margins. Profitability was helped by cost reduction measures o f the banks as wel l as improved economic activity and growth. Liquidity increase was a result o f higher remittances and additional flows due to N S S reforms and has led the banks to diversify their product base. Overall, bank’s lending to SMEs and the consumer sector increased considerably during the last few years - the share o f personal loans (including auto loans), mortgages and credit cards, which were negligible in the mid 1990s, reached about 15 percent o f total bank credit f low as o f June 2004.

22

8 1. The banking sector has also become considerably more competitive and responsive. The Herfindahl index4 reflects the decreased concentration and increased competitiveness, particularly in the f ie ld o f advances, where the index level o f 780 reflects a relatively high degree o f competition. The extensive branch networks and government relationships o f the current and former N C B s has left them with a more dominant position in the market for deposits, hence greater concentration in this field. A further reflection o f the increased freedom to compete allowed to the banking sector i s shown in the rapidly improved use o f automation and information technology in recent years, whereby the number o f online branches increased five- fo ld in just three years and the number o f ATMs almost tripled.

1300 -

1200

1100 -

1000 -

900 -

800 -

Chart -6: E-banking Infrastructure

600 2000 1500 400 1000

200 500 0 0

31-12- 31-12- 31-12- 31-12- 00 01 02 03

No. of ATMs +No. of Online Branches (WS)

Chart -7: Herfindahl Index for Industry

I don - - I

700 600 1 CY96 CY97 CY98 CY99 CY00 CY01 CY02 CY03

+Advances Total Assets -3--Depsits I 82. Risks: The r isks o f the program credit and loan are l o w with the completion o f a l l prior actions. Improvement in financial services and access has contained the polit ical backlash against privatization. However, there i s a risk o f pol icy reversal, in the medium term, i f access to financial services does not expand further to the rural areas and other traditionally underserved sectors. Also, N B P s t i l l remains under majority state ownership and leaves a window for future interference, though under the program the Government has committed to preserving its professional private sector board and management. The Government has listed the bank o n the stock exchange and sold 23 percent o f i t s shares to the general public which has brought greater transparency and also plans to privatize the bank over the medium term. N o w that the financial system that was at the brink o f a crisis in 1996 has been turned around, broader access to finance by society i s the focus o f further reforms. The Government and SBP have taken concrete steps to improve the legal and regulatory framework for improving access to financial services for consumers; micro, small, and medium size businesses. N e w prudential regulations for these sectors have been recently introduced. In addition, the Government has initiated restructuring o f the SMEB, ZTBL and H B F C retained under state-ownership, for improving service delivery and credit f l ow to the underserved sectors. Privatization o f these institutions would be crucial as the share o f private sector credit to these sectors grows.

83. The significant growth in credit to the consumer markets, however, poses a risk and requires strengthening o f credit appraisal systems and risk management by the banks as wel l as strong monitoring by the regulator. SBP has already issued risk management guidelines, restricted financing for purchase o f plots alone unless they are accompanied by construction o f

Herfindahl Index i s defined as sum o f squares o f the market share o f all banks. The maximum value that the index can assume i s 10,000 i.e. only one bank holding 100 percent market share - absolute concentration. T h e index i s used by authoritiesiregulators to measure and control market Concentration. An index value below 1,000 reflects relatively limited concentration and above 1,800 significant Concentration.

23

house to control speculation o f land prices, and increased the provisioning requirements o f banks including 5 percent general reserves for unsecured and 1 percent for secured consumer lending.

84. There have also been initiatives to promote and expand credit information services in the private sector, improving governance and transparency, as wel l as the legal and judicial processes for insolvencyhankruptcy. These initiatives are l ikely to have a positive impact on improving access and mitigating risks. Development o f Islamic financing/Islamic banking can also go a long way in expanding access in particular to the segment o f society that has remained outside the banking system for religious reasons. The Islamic system i s based on prof i t and loss sharing and requires reliable and transparent information o f income and accounts. In the Pakistani context where only one percent o f the population actively files income tax, this caries inherent r isks.

24

Annex 1

Government's Letter of Development Policy

25

26

27

4 o f 10

28

29

30

3 1

32

3 3

34

Annex 2

Pakistan: Asset Structure of the Financial Sector, 2000-03

Financial Institutions 2000 2001 2002 2003

Commercial Banks - olw public - olw private - olw foreign Specialized Banks DFIs Investment Banks Leasing Companies Modarabas Housing Finance Companies Mutual Funds Discount Houses Venture Capital Companies General Insurance Companies L i f e Insurance Companies Pension Funds All Financial Institutions (* estimate as o f June 2003)

Commercial Banks - olw public - olw private - olw foreign Specialized Banks DFIs Investment Banks Leasing Companies Modarabas Housing Finance Companies Mutual Funds Discount Houses Venture Capital Companies Insurance Companies Pension Funds All Financial Institutions

Memorandum Items: Commercial Banks (in percent o f GDP)

1,696 902 5 14 280 112 92 42 39 16 22 26

2 1

n.a. n.a. n.a.

2,046

82.9 44.1 25.1 13.7 5.5 4.5 2.0 1.9 0.8 1.1 1.3 0.1 0.0 n.a. n.a.

100.0

49.5

(in billions o f rupees) 1,835 2,127

945 878 565 969 325 28 1 107 98 61 69 28 23 46 44 16 17 24 22 24 29

1 2 0 0

n.a. 30 84 96

n.a. n.a. 2,165 2,432

(in percent o f total) 84.8 87.5 43.7 36.1 26.1 39.8 15.0 11.5 4.9 4.0 2.8 2.8 1.3 1 .o 2.1 1.8 0.7 0.7 1.1 0.9 1.1 1.2 0.1 0.1 0.0 0.0 1 .o n.a.

n.a. n.a. 100.0 100.0

50.6 52.9 59.7 60.5

2,380 980

1,122 277 n.a. n.a. 25 45 14 21 75

n.a. n.a. n.a. n.a.

150* 2,710

94.8 39.1 44.7 11.0 n.a. n.a. 1 .o 1.8 0.6 0.8 0.5 n.a. n.a. 0.5 n.a.

100.0

54.1 All Financial Institutions (in percent o f GDP) 59.8 57.0

Source: State Bank Pakistan

35

Annex 3 International Comparison of Financial Indicators

Bangla Sri Egypt, Arab Pakistan India desh Malaysia Lanka Philippines Republic

Ratings

S&P B/POS; BB- BB/STA; N/A A-/STA; A+ BB/STA; BB+/NEG; POS BB+/NEG /STA BBB/STA BBB-/NEG

Moody's B2/B2/STA Baa3/Ba2/ST N/A Baa1/A3/ N/A Ba2/Ba2/ Ba1/Baa2/ A(m) POS(m) NEG STA(m)

Private credit to GDP- percent' 27 32 29 145 28 33 61

M2 to GDP-percent 48 58 37 100 37 57 81 Banking Industry

Net interest margin-percent 4.73 3.32 0.94 2.50 4.30 2.45 0.88 Overhead costs/T. A. - percent Bank Concentration (3 banks)

3.19 2.09 1.57 1.40 3.19 2.70 0. 84

65 44 N/A 56 NA 43 62

Capital and Insurance Markets Number of Companies listed 701 5644 247 897 244 234 967

Stock market capitalization to GDP (percent) 17 25 3 130 10 '5 1 29

Stock market total value traded to GDP (percent) 43 38 1 29 2 4 3

Stock market turnover ratio (percent) 436 139, 23 34 35 9 14

Concentration 53 53 N/A 15 48 58 N/A Insurance premiums to GDP-percent 0. 62 3.26 0.46 4.91 1.30 1.48 0.59

Credit information Existence of credit bureau Yes Yes No Yes No Yes Yes Rating Agency Yes Yes Yes Yes Yes Yes N/A

Governance Index -0.84 -0.18 -0.77 0.45 N/A -0.22 -0.37 Development Indicators

GNI per capita (US$) 410 480 360 3,540 840 1020 1,470 GNI per capita (PPP) $ 1,940 2,570 1,720 8,280 3,390 4280 3,710 Percent rural population 66 72 74 41 77 40 57 Population total (millions) 144.90 1,048.28 135.68 24.30 18.97 79.94 66.37

Sources: Current Moody's Ratings in the format "Foreign Currency Long Term/Domestic Currency Long Term Outlook"

Current S&P Ratings in the format "Foreign Currency Long Term/Outlook; Domestic Currency Long Term/Outlook

M2/GDP is obtained from SIMA; data is for 2002 except for Sri Lanka (2001) Credit to Private Sector/GDP is obtained from SIMA; data is for 2002 except for Sri Lanka (2001) NIM (interest income/earning assets): 2002 from Bank scope. Incomplete bank coverage. Overheads/Total Assets is obtained from Bank scope; 2002 data Bank Concentration: Source: WB (2001) Number of Listed Companies is as of end 2003 and obtained from EMDB database. Market Capitalization of Stock Exchange/GDP is as of 2002 and obtained from SIMA. Stock Exchange Turnover Ratio is obtained from the EMDB database; as of end 2003. Concentration: & turnover of the top ten (10) companies in a stock exchange. Source: World Federation of Exchanges, 2002. Insurance Premia/GDP source: SIGMA study produced by Swiss Re; 2002. Existence of Credit Bureaus: World Bank Credit Reporting System Program. Existence of Rating Agencies was verified, where possible, using various web based sources. Governance Index obtained by averaging the six key governance indicators (voice and accountability; political stability; government effectiveness; regulatory quality; rule of law; and control of corruption) provided by WBI. Lowest rating is -2.5 and highest is 2.5; data is as of 2002. GNI per Capita is obtained from SIMA (Atlas method, current USD); data is as of 2002. GNI per Capita (PPP) is obtained from SIMA (current USD); data is as of 2002. Population (in millions) is obtained from SIMA as of 2002. Rural Population (in percent of the total) is obtained from SIMA as of 2002.

Annex 4 Structure o f the Banking Sector

Over the last decade composition o f the sector has changed with privatized banks spurring the growth o f the sector new domestic private banks being formed. Strengthening o f the regulation and introduction o f banking ordinance and financial recovery laws has led to renewed confidence amongst investors.

Disaggregating the net credit by banking groups, i t i s apparent that other than PSCBs and specialized

Chart -8: Bank Composition

0 2003

25

2o

l5

10

5

o

P PJ!, 4 s “IJc %Ft ObJ9 beet

“€OP PP2, 49.& 0% 8“ 94* %.4*

2, “’2) “€e *It2

%* “94* %,+* “€2

Strong deposit growth together with the easy monetary stance o f the SBP contributed to a sharp decline in domestic interest rates with T-bill rates reaching al l time lows in November 2002 matched by lending rates dropping into single digit for the f i rst time in nearly thirty years. The large reduction in interest rates initiated a resurgence o f credit demand, taking the FY03 net credit expansion to an Rs.33.2 billion, over three times higher than the corresponding FY02 figure. Whi le a part o f the higher FY03 credit probably reflects the exploitation of interest rate arbitrage available through NSS instruments, evidence clearly points to a strong contribution o f increased economic activity as wel l as the aggressive marketing o f consumer credit by the banks.

foreign banks 10.5% as compared to 20% in 1996.

C ha rt-9: Profi bil ity Indica tors 100,

Deposits grew by an overall 73% over the period 1997 to 2003. The share o f the Large Private Banks increased dramatically f rom 27% in

lo

0.1

37

1997 to 49% in 2003, reflecting not only the privatization of UBL but also the space provided for growth o f the private sector under the

+Net interest margin

and SME finance. Competitive pressures have led the banking sector to be more responsive to client needs.

21 00

1800

1500

1200

900

600

300

0

Chart-IO: Deposits of Banking System

CY97 CY98 CY99 CY00 CY01 CY02 CY03

/ m P S C B s 0 L P B s BFBS CBs m S B s +All (RHS) 1

Banks continue to make progress in the recovery o f classified loans. Non-performing loans (NPLs) fel l f rom Rs.247 b i l l ion annually to Rs.222.7 b i l l ion (US$3.9 bil l ion) on December 30th 2003. Total cash recovery against N P L s in 2003 amounted to PRs 32.2 bil l ion, or 14.5% o f total N P L s held by banks, according to SBP data. Provisions held by banks rose to 64.3% o f the entire stock o f NPLs, from 60.7 at the end of 2002. Despite l o w interest rates o n bank deposits, they grew by Rs.150 billion, or 9%, between July 2003 and February 2004, to reach Rs.1800 b i l l ion (US$3 1 billion). During this period the average deposit rates at banks fell f rom 1.9% to 1.3%. Of the PRs 150 b i l l ion increase, PRs 25 b i l l ion Deposit mobil ization 112.2 173.5 275.1 consisted o f deposits in the Gross disbursements 105.9 199.3 387.3

N e t credit 66.9 41.7 133.2 form o f foreign exchange. In the eight month period, banks made loans o f Rs. 163 billion, Credit t o private sector 54.3 32.3 167.2

Table 4: Changes in Selected Banking Sector Indicators

2001 2002 2003

raising total advances to PRs 1.23 tri l l ion f rom PRs 1,070 Stock o f NPLs 18.8 14.0 -7.0

b i l l ion previously. During the WA lending rates (basis points) 103 -185 -454

Period the average lending rate WA deposit rates (basis points) -89 -83 -227 fel l f rom 7.6% to 5.3% Total investments made by banks Profi t after tax (B Rs. ) -9.8 2.4 20.9

from Rs’724 to Note: Negative s ign indicates decline over the previous year Rs. 744 billion.

38

Whi le not o f the same scale as the challenges faced by the NCBs, some o f the local private banks have also emerged as problem banks, largely due to financial indiscipline and poor corporate govemance. SBP intervened firmly to address the problems in four private banks, only one o f which now remains as a problem bank. Under the reform program the SBP has introduced a number o f measures to maintain standards in the private sector, these have included “fit and proper” tests for directors and senior management, enhanced disclosure requirements and directives relating to the responsibilities o f directors and risk management guidelines, in addition to enhanced onsite and offsite supervision.

39

Annex 5

Pakistan: Financial Soundness Indicators for the Banking Sector, 1999-2003 (in percent)

Dec-99 Dec-00 Dec-01 Dec-02 Sep-03

Capital Adequacy Regulatory capital to risk-weighted assets Tier I capital to risk-weighted assets Capital to total assets

Asset composition and quality NPLs to gross loans Provisions to NPLs NPLs net o f provisions to capital

Earnings and Profitability ROA (after tax) ROE (after tax) Net interest income to gross income Non-interest expenses to gross income Personnel expenses to non-interest expenses Non-interest income to total income

Liquidity Liquid assets to total assets Liquid assets to total deposits

12.2 10.3 5.0

22.0 46.6

117.4

-0.3 -6.2 54.3 76.9 57.0 17.6

38.7 48.2

11.4 11.3 9.8 9.7 4.9 4.6

19.5 19.6 53.9 53.2 96.7 100.7

0.0 0.0 -0.3 -0.3 61.2 68.9 71.6 62.7 54.3 52.6 16.5 14.5

37.5 39.9 48.0 50.3

12.6 13.1 9.7 10.9 6.1 6.2

18.0 16.1 58.3 63.0 54.5 41.8

0.8 1.4 13.8 22.1 67.4 58.2 57.3 50.4 51.4 50.1 18.1 30.9

47.0 48.6 60.2 59.4

40

Annex 6

Key Banking Sector Recommendations (of FSAP)

Address issues identified in the Basle Core Principal (BCP) assessment, including: revision and strengthening SBP A c t o f autonomy from the Government; clearly define the rules for acquisitions and major investments o f banks; enactment o f market risk-related computations, capital charges and a clear definition o f “connected or related parties”; and provision o f legal authority to SBP to conduct consolidated supervision. Special consideration to tighten provisioning requirements especially in the light o f recent rapid credit expansion.

Government and SBP should develop a strategy to privatize NBP and continue divestiture o f capital f rom other banks.

The authorities should continue phased reduction and alignment o f taxation o f banks and authorize tax deductibility o f mandated provisions for NPLs.

The authorities should address the shortcomings in banking supervision identified by the BCP assessment. In particular, the mission recommends:

i) to amend the SBP A c t to strengthen the autonomy o f the SBP f rom the government (BCP 1(2));

ii) to define rules for acquisitions and major investments o f banks (BCPS);

iii) to enact market risk-related computations and capital charges (BCP6);

iv) to provide a clearer definition o f “connected or related parties” (BCP10);

v) to set out requirements that banks have information and management systems that allow for proper identification, monitoring, and collecting o f country and transfer risk;

vi) to give SBP the legal authority to conduct consolidated supervision o f banks (BCP20 and BCP24).

Government and SBP should develop a strategy to privatize the remaining public sector commercial banks (especially NBP) and continue divestiture f rom the capital o f other banks.

The development of Islamic financial institutions and to closely monitor the r i sks associated with them.

B S D should continue working on the design o f the stress-testing framework, and use the test exercise on a routine basis.

Consideration may be given to tighten provisioning requirements, especially in light o f the recent rapid credit expansions.

41

Annex 7

Banking Sector Adjustment Loan (BSAL) (Ln. 4257)

Objective Arrest the Flow of Bad Loans. The most pressing need was to stop the hemorrhage and to prevent the situation f rom deteriorating.

Prevent Further Deterioration of the NCBs and DFIs.

Reduce the Stock of Non- Performing Loans

Action Analysis o f 250 largest defaulters, identif ied ma in source o f default as project lending by NCBs. In 1996-7 Government, as owner, and later SBP as regulator instructed N C B s to refrain f rom making new project loans and tighten lending policies and practices.

Management and boards o f the NCBs and DFIs were replaced and the l aw amended to insulate the appointment process f r o m pol i t ical interference. Pakistani bankers, working in reputable intemational banks, were appointed as presidents, and private sector professionals as board members.

The caretaker management o f the NCBs and DFIs were required to implement action programs, approved by SBP, aimed at conserving assets, reducing cost, downsizing staff and branches, increasing loan recovery, and l imi t ing lending to borrowers that have no default with any other bank.

The key mandate was to prepare these institutions for privatization according to an agreed timetable.

Defaulters "amnesty" to settle over dues (covering 39,000 defaulters and 300 sick units with loans amounting to Rs.27 b i l l i on and Rs. 15 bil l ion, respectively); mandatory filing with new banking courts o f default cases o f borrowers who did not participate in amnesty program; asset recovery departments o f NCBs and DFIs strengthened under new management.

Outcome 3nly 3% o f total new loans disbursed after 1997 have been Zategorized as non-performing, within the range o f intemational standards.

Operating costs at the NCBs were cut f r o m 3 1 % in December 1996 to 26.9% at end o f 1998.

Return o n assets improved f r o m (0.95%) to 0.72%.

70% o f the shares in Habib Credit and Exchange were sold in July 1997. N o progress was made towards further privatization o f NCB s ,

As ofNovember 15, 1998, total cash recovery amounting to Rs.34.7 bil l ion, or 25 % o f total defaults.

Tota l N P L s rose to Rs. 136 b i l l i on in 1999 versus Rs.lOlbn in 1996.

42

Annex 7

Reduce Po l i t i ca l and Social costs The government banks were overstaffed and over branched due to pol i t ical interference with mil i tant and corrupt unions.

Develop effective regulatory a n d supervisory capacity a t SBP

Cap i ta l Requirements To strengthen the-system's capital base and achieve international consistency.

Address M a r k e t Segmentation Interest rates were managed through a control o n auction volumes, high statutory liquidity reserve requirement for banks, administered rates o n the National Savings Schemes and interest subsidies for Special Credit Programs.

Staff downsized principally through voluntary separation with an attractive severance payment program (financed through loan at a cost o f $350 mi l l i on o n an after-tax basis.

Branches rationalized in accordance with plans agreed with SBP.

Supervision system o f SBP revamped. Information f r o m early warning system, off-site surveillance, and on-site inspection integrated and focused o n risk analysis. Banks are required to fo l low international accounting standards.

Twenty qualif ied and experienced middle-level staff recruited for bank supervision and 130 new graduates (54 with MBAIMA degrees) put through a six-month training program, and assigned to bank supervision departments. Eighty senior and middle-level officers trained in the U S in bank examination.

Implemented Basle minimum capital requirements.

SBP injected Rs.21 b i l l i on into UBL and Rs.9.7 b i l l i on into HBL to attain 4% capital adequacy ratio.

SBP to reduce the SLR to a level required for prudential purposes only.

SBP to pre-announce volume o f securities to b e auctioned and al low market t o determine the yield o n T-bills.

Government to benchmark N S S against Government bonds and rationalize tax treatment.

23,000 employees, o r 29 % o f total staff, were separated f rom the NCBs and DFIs

Some 500 NCB branches closed by end 1999, around 15% o f the total.

In 2000 the SBP was found to be non-compliant for 14 o f the 25 Basle Core Principles in supervision (an assessment was not entered for several principles for want o f information).

NCB aggregate capital adequacy 10.4% in June 1999 versus 3.3% in 1996.

Absolute amount and share o f concessionary financing to total private sector f inancing (including export financing) declined significantly.

However, lending by the Agricultural Credit Bank o f Pakistan trebled f r o m Rs. 10.2 b i l l i on in 1995-96 to Rs.30.1 b i l l i on in 1998-99.

Similarly refinance provided by the SBP for the Expor t Finance Scheme was Rs.81 b i l l i on as o f June 1998 compared to Rs.31.2 b i l l i on as o f June 1996.

43

Annex 7

Improve Legal and Judicial Enforcement of Financial Contracts (a) insulate state-owned financial institutions and the central bank f rom undue interference; and (b) facilitate process by which financial institutions gain control over collateral and enforce judicial remedies.

3BP to re-finance loans to the Agriculture Development Bank 3 f Pakistan,

SBP to reviewing export finance scheme.

Defaulters were pursued with the benefit o f new loan recovery l a w which strengthened the hands o f the banks in loan recovery;

Government adopted appropriate ordinances in January 1997 amending the State Bank o f Pakistan Act, 1956, Banking Companies Ordinance, 1962 and the Banks Nationalization Act, 1974.

Collateral l aw was amended to facilitate the exercise by lenders o f their r ight t o sell a mortgaged property without court intervention.

To effect these reforms, the Parliament passed in M a y 1997 the Banking Companies (Recovery o f Loans, Advances, Credits and Finances) A c t o f 1997 providing that a default case be disposed o f f in 9 0 days, otherwise defaulter required to kmish security, and in ter im decree can be passed by

n 2000 SBP created a scheme, :omparable to Foreign Currency lccount scheme which collapsed n 1998, requiring banks to leposit foreign exchange deposits l o t placed locally, and l isal lowing deposits abroad.

:n M a y 2000, NSS interest rates .ermined significantly higher :han comparable government debt 116% tax free Vs. 10% subject to :ax).

3BP lowered S L R in stages to 13% in June, 1998. However, :ate was increased to 15% July, 1999.

Cash Reserve Requirement reduced f r o m 5% in July 1997 to a l o w o f 3.5% in M a y 1999 but increased to 5% in July 1999.

Share o f government debt sold in market increased.

N e w legislation provided the init ial threat against defaulters and the high recoveries achieved are reflective o f this.

Court execution process remained weak recovery through this process improved marginally.

Dur ing 1995-96 an amount o f Rs. 16 b i l l i on was recovered through the courts while during 1998-99 a total o f Rs.16.2 b i l l i on was recovered.

44

Annex 7

the banking court in respect o f undisputed claims.

System o f Special Banking Courts, with jurisdiction over interest-based transactions; and Banking Tribunals with jurisdiction over non-interest based replaced by a uni f ied system o f banking courts through the enactment o f the Banking Companies (Recovery o f Loans, Advances, Credits and Finances) A c t o f 1997. Cases above Rs.30 m i l l i on tried bv the High Courts.

45

Annex 8 Banking Sector Restructuring and Privatization Project (BSRPP) (Cr. 3571)

Objectives Reduce NCBs size and market share to make more efficient.

Improve corporate govemance through privatization o f the N C B s to qualif ied strategic investors, and complete privatization o f partially privatized banks.

Discontinuation o f NDFC activities.

Satisfactory resolution o f energy fund (LTCF).

Sustain and deepen the banking reforms started in 1997.

Action Reduction o f the costlincome ratio o f the N C B s to 0.65;

Rationalization branch network o f NCBs by reducing number o f branches by 1,800 (40%);

Staff retrenchment in the NCBs to reduce headcount b y 35,560 50%;

Outsourcing o f non-core activities o f the NCBs. Sale negotiations commenced with pre-qualified strategic buyer(s) for HBL and UBL.

Privatization timeline agreed and Financial Advisor retained for NBP.

Full divestment o f M C B and sale of 49% government shares in ABL to a qualif ied strategic investor.

Amalgamation o f NDFC into National Bank.

LTCF transferred to National Bank.

Reform o f National Savings Schemes.

Bank branching pol icy Liberalized.

Discontinuance o f the Foreign Currency Deposit Scheme.

Announcement o f revised tax po l icy and regime for banking system.

Ordinance amending the Loan Recovery A c t o f 1997 promulgated.

Outcome 3y December 2003, a l l NCBs :ost/income ratios be low 0.65 NBP at 0.50).

CBs reduced branches by 835 mostly urban) or around [ 1 8%] o f otal.

JRS programs, combined with Iutsourcing o f non-core activities, ,educedNCB staf fby 11,101 or l1% o f total.

Sale o f 5 1 % o f UBL completed in 3ctober 2002.

3ale o f 5 1 % o f shares in HBL :ompleted February 2004.

23.2% o f NBP shares divested through IPO & market sales in 4 tranches between November, 2001, and November, 2003.

Residual 25% holding in MCB divested in three market sales f r o m Jan. , 2001, to Oct. ,2002. NDFC amalgamated into National Bank.

Deposits and assets transferred to National Bank; bad assets transferred to CIRC. Interest rates reduced and tax exemption removed.

State B a n k circular liberalized bank branching.

State B a n k circular disallowed this scheme.

Gradual reduction o f tax rates for banks to the tax rate for other enterprises.

Ordinance amended to a l low foreclosure o f collateral without court intervention.

46

Annex 9

Financial Sector Medium Term Outcomes Matrix

Improv ing the environment for financial intermediation and completing the process o f restructuring and privatization o f the remaining state owned financial institutions.

Strengthening and further deepening capital markets.

Improv ing financial markets infrastructure including legal framework and expanding access to financial services.

Medium Outcomes

1 Restructuring and privatizing state owned commercial, specialized, and provincial banks, DFIs, non-bank finance and insurance companies.

1 Rationalizing taxation and restructuring NSS.

Setting up a system for private occupational and personal pensions. Gradually replacing COT with margin financing. Training and developing skills o f SECP and exchanges. Putting in place adequate systems and resource for market surveillance. Strengthening investor protection and education.

Improved laws for banks, financial institutions and for financial transactions. Training and capacity building o f financial institutions. Expansion o f credit information services in the private sector. Enabling environment for housing finance.

1 Professional Board and management appointed and preserved. NBP, IDBP, NIT, ICP, BOK restructured and privatized. Tax rate o n banking reduced and equal t o corporate tax rate by 2007.

develoDed.

I

I Strategy to re form NSS

a Rules and regulations for private pensions notified.

1 Marg in financing rules introduced.

1 Capacity building program developed and delivered.

1 Report o n surveillance and market monitoring completed.

1 Banking laws reviewed and consolidated.

1 Public Debt Act, Insurance. Ordinance, laws pertaining to take-over o f companies and insider trading improved. AML and bankruptcy laws in place and banlung laws improved to facilitate RTGS and setup o f credit information bureaus in private sector. . Enforcement o f financial contracts under FRO

1 Training programs developec and delivered.

1

47

A n n e x 10 K e y M a c r o Economic Indicators

822 700 756 744 103 129 10 2 11 3

POVERTY and SOCIAL Pakistan

. i o 1 ' GDI -GDP

2002 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

Average annual growth, 1996-02

Population (%) Labor force (%)

Most recent estimate (latest year available, 1996-02) Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (% ofpopulation) Illiteracy (% ofpopulation age 15+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1982

GDP (US$ billions) 30.7 Gross domestic investmenVGDP 19.3 Exports of goods and servicesiGDP 9.9 Gross domestic savingslGDP 7.4 Gross national savingsiGDP 14.3

Current account balanceiGDP -3.6 Interest paymentsiGDP 0.8 Total debVGDP 38.1 Total debt serviceiexports 16.2 Present value of debVGDP Present value of debVexports

1982-92 1992-02 (average annual growih) GDP 6.0 3.3 GDP Der caDita 3.3 0.8

144.9 420

60.9

2.4 3.1

33 34 64 80

90 55 74 93 54

1992

48.6 20.2 17.4 17.1 25.5

-1.8 1.4

51.2 23.6

2001

2.6 0.1

South Asia

1,401 460 640

1.8 2.3

28 63 71

a4 44 97

108 89

2001

58.6 15.5 18.0 14.2 18.3

-1.9 1.3

54.7 25.7 43.5

221.7

2002

2.8 0.4

Low- income

2,495 430

1,072

1.9 2.3

30 59 81

76 37 95

103 87

2002

59.1 14.7 18.7 14.4 22.9

2.7 1.5

59.4 21.4

2002-06

5.3

1 Development diamond'

~

Life expectancy

J

Gross ''4 primary

capita enrollment

I

Access to improved water source

I *a Paklstan Low-mcome group

2 8

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

I Economic ratios'

Trade

Indebtedness

I ' - Paklstan ~ Low-income O ~ O U D

1982 'Igg2 2o02 Growth of investment and GDP (%)

31.6 26.3 25.3 23.2 ~ " T I 22.3 25.0 22.8 23.3 15.1 16.9 15.9 16.1 46.2 48.6 51.9 53.5

5

5

0 I 1982-92 1992-02 2001 2002

(average annual growth) Agnculture 4 5 3 6 -2 8 -0 1 Industry 7 2 3 5 3 8 5 4

Manufacturing 6 9 3 8 8 3 5 0 Services 6 1 4 1 4 1 4 1

Pnvate consumption 4 4 4 0 1 5 1 4 General government consumption 7 8 1 0 -5 3 13 5 Gross domestic investment 4 7 0 6 3 1 -3 0 Imports of goods and services 2 7 - 0 2 1 5 4 5

r - - -- =, - - - - - _ _ _ _ ~- - - - - - - ~ __r - - - il - -- - - - _ _ - _ - _ _ _ - - - , - -- - - - - - - ,~ ___ ,__

48

Annex 11

Public Information Notice

Public Information Notice (PIN) No . December 2004

EXTERNAL RELATIONS DEPARTMENT

International Monetary Fund 700 19th Street, NW Washington, D.C. 2043 1 USA

IMF Concludes 2004 Article I V Consultation with Pakistan

Public Information Notices (PINs) form part o f the IMF's efforts to promote transparency o f the IMF's views and analysis o f economic developments and policies. With the consent o f the country (or countries) concerned, PINs are issued after Executive Board discussions o f Article I V consultations with member countries, o f i t s surveillance o f developments at the regional level, o f post-program monitoring, and o f ex post assessments o f member countries with longer-term program engagements. PINS are also issued after Executive Board discussions of general pol icy matters, unless otherwise decided by the Executive Board in a particular case.

On December 1, 2004 the Executive Board o f the International Monetary Fund (IMF) concluded the Article IV consultation with Pakistan.'

Background

Pakistan has successfully emerged fkom crisis. By 1998199, foreign exchange reserves had virtually run out, public debt obligations were not being met, and economic growth had slowed to an average o f below 3 percent in 1996197-1998199. In response, the government and the State Bank o f Pakistan (SBP) implemented a strong macroeconomic stabilization program in the face o f a severe drought and the adverse post-9/11 environment. These policies are now bearing fruit. Real GDP growth accelerated to 6% percent in 2003104 (July-June), driven by exports, investment, and consumption. Inflation has been contained to 4.6 percent in 2003104, though, more recently, 12-months inflation has accelerated, reflecting supply side factors as wel l as easy monetary conditions. Foreign exchange reserves have reached 6.2 months o f next year's imports of goods and nonfactor services.

Significant fiscal consolidation has been achieved largely by savings on the interest bill and increases in revenues. The resulting fiscal space was used to reduce govemment debt whi le raising social- and poverty-related spending. In 2003/04, the budget overperformed, and the overall deficit (excluding grants) was l imi ted to 2.4 percent of GDP. Strong revenue collection reflected the buoyant economy and administrative efficiency gains. Support to public enterprises, and particularly power utilities, was reduced, due to better financial performance by these entities.

' Under Article IV o f the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses w i th officials the country's economic developments and policies. On retum to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. A t the conclusion of the discussion, the Managing Director, as Chairman o f the Board, summarizes the views o f Executive Directors, and this summary i s transmitted to the country's authorities. T h i s PIN summarizes the views o f the Executive Board as expressed during the December 1, 2004 Executive Board discussion based on the staff report.

49

Annex 11

The SBP has started to tighten monetary policy. Rapid growth o f broad money in 2003/04 has been driven predominantly by private sector credit growth in an environment o f l o w interest rates and ample liquidity. In response, the SBP has raised treasury bill cut-off rates in recent months. However, pol icy makers resisted market pressures to tighten more quickly in an effort to balance their inflation and growth objectives.

The external position remains comfortable. The current account registered a small surplus in 2003/04, despite high imports, reflecting strong domestic demand and rising international o i l prices. The government and other entities prepaid some relatively expensive external debt, taking advantage o f the favorable exchange rate and reserve inflows. SBP foreign exchange reserves increased to $10.6 b i l l ion at end-June 2004. The real effective exchange rate appreciated somewhat since the beginning o f 2004, given inflation differentials with Pakistan’s trading partners and efforts by the SBP to smooth exchange rate volatility.

There i s no clear evidence yet on poverty trends due to a lack o f comparable current data. Encouragingly, per capita GDP has grown significantly. However, real wages in the manufacturing sector have declined by 7% percent in real terms since 2000/01. Real per capita health expenditure grew on average by 5 percent, and real per capita education expenditure by 10 percent since 1999/00, albeit f rom l o w levels. This should at a minimum establish the preconditions for sustained poverty reduction in the future. Pakistan i s s t i l l ranked l o w in the 2004 U N D P human development index.

Structural reforms aimed at establishing a modern economy were successful in many areas. The banking sector i s more competitive and efficient following restructuring and privatization, as wel l as the strengthening o f supervision and prudential regulations. The revenue system has benefited f rom administrative reforms, elimination o f exemptions, as wel l as reductions and rationalizations o f customs tariffs and tax rates. Pakistan has liberalized i t s trade regime substantially in recent years, reducing tariffs and removing nontar i f f barriers, and now has one o f the most liberal trade regimes in South Asia. Reforms in the power sector are advancing with the unbundling o f the Water and Power Development Authority into generation, transmission, and regional distribution companies.

The role of the state in the economy has diminished and governance improved. Governance in fiscal and financial management has been strengthened, but wealmesses remain in the energy sector, tax and local administration, and the police. Regulatory agencies to protect the consumer and ensure stability have been established in many areas. However, government intervention continues to be evident in the wheat and cotton markets and in the pricing o f petroleum products and electricity, which has undermined the budget.

Executive Board Assessment

Executive Directors noted that Pakistan has successfully recovered f rom the 1998/99 crisis. Growth has rebounded in 2003/04, and fiscal adjustment, supported by off ic ia l inf lows and debt relief, has led to a substantial improvement in public and external debt indicators. Reflecting strong export growth and remittances, the balance o f payments has strengthened and international reserves n o w cover over five months o f imports. Directors attributed Pakistan’s recovery to the steadfast implementation o f sound economic policies and broad-based structural reforms, whi le noting that external support has also played a part.

Directors observed that, notwithstanding these significant achievements, poverty remains widespread and social indicators are weak in Pakistan. Thus, they considered that the key pol icy challenges for the medium term are to maintain strong economic growth and to ensure that this i s translated into a significant reduction in poverty. In this regard, Directors supported Pakistan’s ambitious growth targets, but cautioned that these would be realized only if the reform agenda la id out in the Poverty Reduction

50

Annex 11

Strategy Paper i s fully implemented and external factors are favorable. In particular, Directors emphasized the need for deepening structural reforms to improve the investment climate and governance, including through continued privatization and trade liberalization. At the same time, they noted the importance o f enhancing human capital and labor productivity through greater and more efficient spending o n health and education, Directors also underscored that accelerating growth will require the continuation o f sound macroeconomic policies. They encouraged the authorities to take advantage o f the current favorable conditions in pursuing these challenges.

Directors viewed Pakistan’s near-term economic outlook as positive. They thought that broad-based growth of over 6percent could be maintained in 2004/05, and considered the projected shift in the external current account to a small deficit appropriate given Pakistan’s development needs. They urged the authorities to resist any pressures for easing financial policies.

Directors commended the authorities on the progress made with fiscal consolidation. They noted, however, that Pakistan’s debt burden i s s t i l l relatively high. In this context, Directors viewed the fiscal pol icy stance in 2004/05 as appropriate, as it ensures both a further reduction in the public debt burden and an increase in social and development spending. The high o i l prices represent an important risk to the budget, however, and Directors stressed that the rise in international o i l prices should be passed o n to domestic consumers to safeguard fiscal targets.

Directors agreed with the authorities’ medium-term fiscal strategy. They welcomed the planned increase in social spending, which they considered a necessary condition to move toward the Mi l lennium Development Goals. Directors emphasized that raising social spending while lowering the sti l l high debt- to-GDP ratio i s possible only if the targeted increase in the revenue ratio i s realized. In this regard, Directors encouraged the authorities to pursue more ambitious revenue targets and to expand the tax base further into the services and agricultural sectors. Directors expressed concern about the new tax exemptions granted in the 2004/05 budget and urged the authorities to safeguard the integrity o f the tax system, which has been strengthened over the last years through hard-earned reforms. Directors also noted that the fiscal strategy calls for subsidies to the energy sector to be reduced significantly. They regretted the recent delays in implementing energy sector reforms and urged the authorities to speed up the reform process, in close coordination with the Wor ld Bank.

Directors noted that the provincial and local governments will n o w have the main responsibility for the provision o f social services. This step should, however, be followed up by administrative and financial devolution and also be supported by measures to enhance accountability, so as to enable the lower levels o f government to carry out their increased responsibilities more effectively. In this context, and given the lack o f recent poverty data, Directors welcomed the launching o f recent household surveys that are expected to provide insights into poverty incidence and trends. They also welcomed the authorities’ intention to deepen the poverty and social impact analysis o f their policies.

Directors considered Pakistan’s prospects for achieving external debt sustainability to be good. K e y indicators o f external indebtedness are projected to decline significantly over the next several years. Nonetheless, given the s t i l l high external debt burden and the dependence o n external nontax revenues and grants, i t will be crucial to limit the budget balance, excluding grants, to about 3 percent o f GDP over the medium term, as envisaged in the fiscal strategy.

Directors expressed concern about the increase in inflation over the past year. They welcomed the recent increase in interest rates, but urged the authorities to tighten monetary pol icy prompt ly and more forcefully to avoid inflationary expectations becoming entrenched. They recommended that monetary pol icy be focused primarily on maintaining l o w inflation. Directors noted that a further tightening of monetary pol icy wi l l also alleviate recent pressures on the exchange rate. Directors considered the level of

51

Annex 11

the real exchange rate to be broadly appropriate, but noted that external competitiveness needs to be monitored closely in view o f the uncertainties facing Pakistan, particularly stemming f rom the removal o f quotas on textile and clothes imports by industrial countries. Directors emphasized that competition- enhancing structural reforms are the most effective approach to maintaining Pakistan’s competitiveness.

Directors were o f the v iew that financial reforms have resulted in a more efficient and resilient financial system. However, they cautioned that banking supervision needs to be vigilant to ensure that rapid private sector credit growth does not weaken banks’ balance sheets. Directors encouraged the authorities to continue their reform strategy and fol low up on recommendations o f the Financial System Stability Assessment, including strengthening the pension and insurance system. Moreover, Directors urged the authorities to divest remaining public ownership o f commercial banks. Directors looked forward to the early passage o f new anti-money laundering legislation in l ine with international standards.

Directors welcomed the authorities’ efforts to improve the quality, timeliness, and reporting o f data and Pakistan’s participation in the General Data Dissemination System. They looked forward to further steps to address weaknesses that hamper the analysis o f economic and social developments to further improve Pakistan’s statistics, with a view to subscribing to the Special Data Dissemination Standard.

52

Annex 11

Pakistan: Selected Economic Indicators, 1998/99-2003/04 1/

(In percent o f GDP, unless otherwise indicated)

1998199 199912000 2000101 2001102 2002103 2003104 Prel. Est.

Domestic economy Real GDP growth (at factor costs, percentage change)

CPI inflation (period average, percentage change) CPI inflation (end-of-period, percentage change) Gross national savings Gross capital formation

Fiscal position Revenue (including grants) Expenditure (including statistical discrepancy)

Budget balance (including grants) Total govemment debt

Extemal economy Merchandise exports Merchandise imports Current account including official transfers Extemal public and publicly guaranteed debt

(in percent o f exports o f goods and nonfactor services)

Gross reserves (in millions o f U.S. dollars) 21

Pakistani rupees per U.S. dollar (period average, percentage change) Real effective exchange rate (period average, percentage change)

In months o f next year imports o f goods and services

Financial variables Broad money (end-period, percentage change) Net foreign assets (end-of-period, change in percent o f broad money) Net domestic assets (end-of-period, change in percent o f broad money)

Ofwhich: credit to the private sector Ofwhich: net claims on the government

Six-month treasury bill rate (period average, in percent)

4.2 5.7 3.7 9.9

12.9

13.8 18.1 -4.3 81.7

10.7 13.6 -3.0

329.4 1,680

1 .I 17.0 -9.1

6.2 1.6 4.5 8.5

-3.8 13.1

3.9 3.6 5.1

11.7 13.3

14.4 18.7 -4.6 83.7

11.2 13.1 -1.6

322.1 908 0.9 3 .O

-0.6

9.4 2.0 7.4 1.4 5.0 8.8

1.8 4.4 2.5

15.6 17.2

14.3 17.6 -3.3 88.8

12.5 14.3 -1.6

309.4 1,679

1.7 12.8 -2.5

9.0 5.1 3.9 3.5

-3.3 10.4

3.1 2.5 3.4

19.0 16.8

16.1 19.7 -3.6 80.2

12.7 13.1 2.2

295.8 4,330

3.7 5.2

-1.1

15.4 13.4 2.0 2.5 1.5 8.1

5.1 3.1 1.9

21.8 16.7

17.4 18.8 -1.4 74.3

13.2 13.7 5.1

238.0 9,521

6.5 -4.7 -1.5

18.3 18.9 -0.4 9.1

-1.4 4.1

6.4 4.6 8.5

20.1 18.1

15.1 16.9 -1.8 68.7

13.1 14.3 2.0

218.2 10,556

6.0 -1.5 -3.4

19.6 2.1

17.5 14.3 2.8 1 .I

Source: Pakistani authorities; and I M F staff.

11 The fiscal year runs July 1 through June 30. 21 Excluding gold, foreign deposits held with the SBP, and net o f outstanding short-term foreign currency swap and forward contracts

53

MAP SECTION