The bond market in Pakistan is comprised of debt and debt ...



THE DEVELOPMENT OF DEBT SECURITIES MARKET

COUNTRY EXPERIENCE OF PAKISTAN

PRESENTED BY

MS. UZMA KHALIL

STATE BANK OF PAKISTAN

SEACEN-WORLD BANK SEMINAR ON STRENGTHENING THE DEVELOPMENT OF DEBT SECURITES MARKET

JUNE 08-JUNE 10, 2004

Introduction

The bond market in Pakistan is comprised of debt and debt like securities issued by a) the Government; b) statutory corporations; and c) corporate entities. As of June 30th, 2003, the size of the Pakistan’s bond market was approximately Rs. 1,892 billion equivalent to USD 33billion. The bond market is clearly dominated by the Government, which accounted for Rs.1,852 billion (or 98%) of total bonds outstanding as of June 30th, 2003 followed by corporate entities Rs. 25 billion (1.32%) and statutory bodies Rs.15billion (0.79%).

The following table shows the outstanding position of bond market during the period June 30th, 2003 as compared to June 30th, 1996.

|Debt Instruments |FY2003 |FY1996 |

| |Amt Rs. in mn |USD in mn |Amt Rs. in mn |USD in mn |

|Government Debt |1,852,391 |31,938 |901,402 |15,541 |

|Permanent Debt |427,908 | |223,788 | |

|Floating Debt |516,268 | |421,742 | |

|Un funded Debt |908,215 | |252,902 | |

|Corporate Debt |25,000 |431.03 |1,000 |17.241 |

|Statutory Corporation |15,000 |258.62 |13,400 |231.03 |

The secondary market trading volume in the Government bond market as measured by average daily turnover is approximately Rs. 20 bn which is 5% of the total outstanding debt.

Government Debt Securities

The Government of Pakistan has run large fiscal deficits over the last two decades. This has lead to the accumulation of a large domestic debt of Rs. 1,852 billion as at end June, 2003. Of this amount, permanent debt accounted for Rs. 427.908 bn (23 %), floating debt for Rs. 516.268 bn (28%) and un funded debt (the various saving schemes) for Rs. 908.215 bn.(49%)

The large portion of floating and permanent debt has been raised through the auctions of short term Government of Pakistan Market Treasury Bills (MTBs) and long term Pakistan Investment Bonds (PIBs).

Characteristics of MTBs and PIBs

Market Treasury Bills (MTBs) are short-term instruments of Government borrowing having the following features:

• Zero Coupon bonds sold at a discount to their face values

• Issued in three tenors of 3-month, 6-month and 12-months maturity

• Purchased by individuals, institutions and corporate bodies including banks irrespective of their residential status.

• Can be traded freely in the country’s secondary market. The settlement is normally through a book entry system through Subsidiary General Ledger Accounts (SGLA) maintained by banks with State Bank of Pakistan (SBP). Physical delivery could be affected if required.

• Profit is taxable at 20%

As at end June 2003, outstanding amount in MTBs was Rs 516.268 bn (USD 8.901bn) including MTBs created for replenishment of Govt. cash balances with SBP.

Pakistan Investment Bonds

After the suspension of auctions of the long term Federal Investment Bonds (FIBs) in June 1998, there was no long term marketable government security that could meet the investment needs of institutional investors. Therefore, in order to develop the longer end of the Government debt market for creating a benchmark yield curve and to boost the corporate debt market, the Government decided to launch Pakistan Investment Bonds in December 2000. These bonds have the following features:

• Issued in five tenors of 3, 5, 10, 15 and 20-years maturity.

• Script less security managed through SGLA

• Purchased by individuals, institutions and corporate bodies including banks irrespective of their residential status.

• Coupon and target amount announced by SBP in consultation with Ministry of Finance

• Payment of Profit on semiannual basis. Profit is taxable @10%.

As at end June, 2003 outstanding amount under PIB was Rs. 228.665 bn. Equivalent to USD 3.94 bn.

Auction Mechanism

SBP is acting as an agent on behalf of the government for raising short term and long term funds from the market. The MTBs and PIBs are sold by SBP to eleven approved Primary Dealers through multiple price sealed bids auction.

❑ The Auction for MTBs is held under a fixed schedule on fortnightly basis.

❑ The Auction for PIB is held on quarterly basis. Since September 2003, the sale of PIBs is done under Jumbo issuance mechanism under which the previous issues are reopened in order to enhance the liquidity in the secondary market.

Corporate Bond Market

Pakistan’s bond market has seen increased corporate issuances following the rationalization of interest rate structure of National Saving Schemes (various government scheme to raise funds from non banks sources) in FY00. In addition to this, Government has also barred institutional investors from investment in National Saving Schemes in March 2000, which has substantially benefited the corporate debt market.

As a result of these measures, 48 new issues were launch during FY01 to FY03 whereas previously only 13 issues were launched during the period FY95-FY00.

The size of Corporate bond market as at end June, 2003 was approximately Rs. 25bn (USD 0.431 bn)

Role of Credit Rating Agencies

The Pakistan Credit Rating Agency (PACRA) was established prior to the first public issue of Term Finance Certificate (TFCs). This agency was incorporated in August 1994 by IFC in collaboration with Fitch-IBCA Inc of UK and Lahore Stock Exchange, while the second credit rating agency DCR-VIS Credit rating Co. Ltd was set up in 1997 to improve transparency in capital market.

Recent Developments in Domestic Securities Market

Primary Dealer System

• As a prerequisite for launching long term bonds, Primary Dealer System was introduced in FY00 and seven banks were chosen by SBP on the basis of their treasury expertise and infrastructure, past performance as market makers and capital adequacy. Based on the experience with the Primary Dealers the Primary Dealers rules were revised in FY03 in which the minimum paid up capital requirements were relaxed to allow brokerage houses to act as primary dealers. The Primary Dealers (PDs) are given explicit responsibility of developing an active secondary market by supplying non-PDs and institutional investors with PIBs.

• In order to allow an effective price discovery mechanism each PD is allowed to short sell 5% of the target amount before the auction.

• Non competitive bidding upto 10% of the target amount in PIB was introduced in FY03 in order to diversify the investor base and encourage participation from retail investors.

• With the view to enhance secondary market liquidity in long term bond market, Jumbo issuance mechanism for the sale of PIB was introduced in September 2003. This step is expected to lessen the segregation in Government bond market arising out of too many issues of different sizes and coupon rates trading in the market. Also the announcement of quarterly sale target, helps market participants in forming expectations about long term Government borrowing requirements.

• In January 2004, PIBs of 15-year and 20-year maturity were introduced to provide long term yield curve for corporate sector, housing finance and infrastructure projects.

Corporate Bond Market

• In order to develop the corporate bond market, several initiatives have been taken by the Government to remove the anomalies in interest rate structures for government saving schemes. In this respect, the rates on Government National Saving Schemes (NSS) been linked with the yields on market based instrument i.e. PIB of different maturities.

• In addition, the Govt. has also barred institutional investors from investment in NSS in March 2000, which has substantially benefited the corporate debt market.

• On the investment side, commercial and investment banks are main investors in private sector TFC’s. In 1997, listed TFC’s became “ approved securities” for the purpose of meeting statutory liquidity requirement (SLR) for NBFI’s.

• As an important step, Government has progressively liberalized the investment restrictions on institutional investors. According to the new Insurance Ordinance the minimum requirement of investible funds of life insurance companies in Government securities has been lowered to 40%. Immediately prior to the promulgation of the ordinance, the minimum requirement was 50% while in 1997 the requirement was 60%.

• The investment cap was raised for provident funds to invest in stocks and listed fixed income securities from 10% to 30%.

• Furthermore the Government has reduced stamp duties and taxation including withholding tax on profits of TFCs.

Implementation of Monetary Policy.

The financial sector reforms initiated in late 1980’s started to reform the financial markets rapidly from FY91. One of the objectives of these reforms was the reorientation of Monetary Policy away from direct controls towards indirect controls through market-based instruments. This reorientation triggered two important changes. First is the increasing assertiveness of the SBP in initiating and implementing its monetary policy, albeit within the framework of Annual Credit Plans, and second is the significant alteration in monetary policy transformation mechanism.

With respect to the monetary transmission mechanism, prior to reforms it was largely determined by the instruments of direct control such as high SLR, bank-by-bank credit controls and directed lending. After the initiation of reforms following indirect instrument are relied upon for the successful implementation of monetary policy.

Open Market Operations (OMOs)

After the abolishment of Credit to Deposit ratio in 1995, OMOs are being used as a major tool for the conduct of Monetary Policy. Regular OMOs are being conducted since January 1995. Effective from July, 2001 OMOs are conducted under a flexible schedule on as and when required by market conditions prior to that OMOs were conducted under a fixed schedule. The Government Market Treasury Bills created for replenishment of Govt. accounts are used as instruments.

SBP 3-day Repo Facility

The 3-day Repo facility is one of the main instrument of SBP. Changes in it shows the direction and stance of monetary policy. Cash accommodation is usually provided for overnight, however transaction period can be extended to 3-days or more to cover occasionally long week ends.

Cash Reserve Requirements

All scheduled banks in Pakistan are required to maintain a balance-non-remunerated with SBP upto 5% of their demand and time liabilities. Effective from July 26, 1997 banks were advised to maintain average balance of 5% of DTL on weekly basis with a minimum of 4% on daily basis.

Swap Desk

The Foreign Exchange Swap Desk was established in September 2001 to manage the liquidity in both the FX and Money Market.

Coordination between Monetary and Fiscal Policy

The SBP is managing the public debt on behalf of the Government. There exists a close coordination between Ministry of Finance and SBP as a result of which fiscal and monetary policy are closely coordinated to achieve the objective of high sustainable growth rate and low and stable inflation rate. To achieve this task the National Credit Consultative Council meet annually to formulate the Credit Plan for the year which is reviewed on semiannual basis.

Key Challenges facing the Development of Debt Securities Market

Enhancing Secondary Market Liquidity

This is obviously the most critical area for improving the efficiency of secondary market. In this respect the Primary Dealers have to play a more effective role in enhancing their market making abilities by quoting two-way prices for large volumes.

In addition to reduce fragmentation in the long term bond market, Jumbo issuance mechanism has been introduced in September, 2003 to by which previous benchmark issues are reopened to provide greater liquidity to the market. Further efforts are underway to introduce Coupon stripping in long term bonds.

Diversifying the Investor base

Presently, in the long term bonds are largely held by the banking system. As on April 30, 2004 banks held 59.65% of total outstanding PIBs whereas Non-banks held 40.35%. The high percentage of holdings by banks is exposing them to interest rate risk as their liabilities are short term whereas assets are long term. To help diversify the investor base SBP is maintaining close liaison with banks and recently guidelines on Risk Management are issued so as to guide the banking system in their efforts to develop effective Risk management system. In addition to encourage retail participation in long term bonds, non-competitive bidding upto 10% of the target amount was introduced in 2003.

Creating Awareness among Investors

One of the problems in long term bond market is that most institutional investors appear to lack proper professional skills and infrastructure to gauge market sentiments. This makes it difficult for institutional investors to quote prices and thus most of them have adopted a buy and hold strategy. In this respect SBP has held several joint meetings with Primary Dealers and institutional investors to assess the problems faced by institutional investors and have encourage Primary Dealers to hold seminars for creating awareness among institutional and individual investors.

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