THE DEVELOPMENT OF THE DEBT MARKET IN PAKISTAN

Can Pakistan come on the radar screen of international debt funds?

By Khurram Baig
Feb 03 - 09, 1998

In recent years, the economies of the Asian region have been growing rapidly, at about twice the global
average. International cash generation and commercial banks have traditionally financed most of this
growth, but the equity markets have developed to a stage where they now provide significant sources of
financing as well. In fact, several Asian markets despite the current crisis are now among the largest in
the world. Bond market development has however lagged throughout the region. The pattern of capital
market development in Pakistan has been similar.

Of late, the Pakistan economy has been growing at a steady rate. Starting at a low level of development,
the equity market in Pakistan has registered phenomenal growth in terms of the size of the market and
institutional development but the fixed income securities market has not developed as quickly. At around
15 percent of GDP, Pakistan's savings rate is one of the lowest among developing Asian economies.

The bond market in Pakistan covers debt and debt like securities issued by the government, statutory
corporations and corporate entities. As of June 30, 1995, the size of the Pakistani bond market was
approximately Rs. 811.3 billion, the equivalent to US$ 26.2 billion or about 43% of the country's GDP.
While this may seem a fairly large amount, its size largely reflects the cumulative effects of financing
Pakistan's continuing budget deficits, as government securities are auctioned, they have not yet emerged
as effective benchmarks.

The market for the bonds of statutory corporations and corporate entities is at an early stage of
development, but its prospects appear promising. These institutions have a genuine need to issue more
debt instruments, given their desire to secure term financing, the limited availability of alternative funds,
and their large capital expenditure needs. Moreover, there is a ready market for these bonds, given their
relatively attractive yields and a large and growing pool of investible funds. There is clearly potential for
growth.

There are various views on why the development has been so slow and unable to keep pace with the
development of the stock market. There appears to be a consensus that potential bond market institutions
in the country have suffered from a lack of expertise, capital and trained staff. Perhaps it is
understandable that institution building does not take place overnight, and that it requires a careful
strategy and long term commitment on the part of the government as well as the market participants.

There is widespread agreement among the government and private sector participants that Pakistan
needs a viable bond market in order to mobilise private savings efficiently for long term investments.
Moreover, the government and the financial community have recently taken important steps to foster
capital market development. While this support is important, even crucial, there are a number of areas
requiring greater attention in order for a robust bond market to develop.

Jahangir Siddiqui recently pointed out several anomalies which have been hampering the growth of the
bond market in Pakistan. He said that the Short term Federal Bond which was introduced in 1996 has a
structure which creates several problems in secondary market trading for outright purchases as it is not
possible to quote a specific bid for a particular auction since each instrument carries a different profit
payment and as a consequence the vibrant secondary market for T-bills where the average daily volume
was between Rs. 200 to 500 million has ceased since their introduction.
He also said that on the corporate bond front, one of the biggest problems regarding their marketability is
that Term Finance Certificates (TFCs) are not included as approved investments in the Statutory Liquidity
Requirement (SLR) of commercial banks and SLR of NBFIs. This is surprising because NIT units which
are similar to these certificates but have not been rated by an approved credit rating agency are approved
investments for maintenance of SLR.

Nasir Bukhari has also on occasion outlined several issues which are of paramount importance if the
Pakistan bond market is to be developed. He has stressed on increased awareness, especially in the
retail sector and the introduction of issues of blue chip companies which already enjoy a wider recognition
and investor confidence. He also said that at present TFCs are in direct competition with National Saving
Schemes (NSS) and Short Term Federal Bonds (STFB) and said that distortions related to tax and Zakat
should be removed to provide a level playing field.

Liberalisation and Deregulation

The 1990s have been a period of considerable development in the Pakistani financial sector. Conceited
efforts by the successive governments to liberalize and deregulate the economy have led to the growth of
financial markets.

The aspects of deregulation include several factors like the removal of restrictions on bringing in or taking
out foreign exchange from the country, no restrictions on repatriation of interest and principal invested in
government fixed income securities and the permission to non-residents to open 'foreign currency
accounts'. Now foreign currency transactions are exempted from local taxes, Zakat and withholding tax
and it is expected that these measures along with several others that have also been taken will help in the
development of the bond market in Pakistan.

The Limitations

There are currently several limitations that have hampered the growth of the Debt market in Pakistan.
One of course is size. International debt funds do not play with peanuts. If they make any investment it
has to be of a size that is worth their while and the size of the Pakistan debt market is definitely not very
large. To top that the private sector has very little or no presence with just about half a dozen companies
issuing TFCs and the rest are government securities. It is true that overall debt is fairly large almost all of
it is public sector and outside of the selected financial institutions it is not tradable. This obviously affects
liquidity and also interest in the market.

Private sector publicly floated debt is still a relatively new phenomenon and the first TFC was floated in
1995. There are several reasons why the private sector debt market has not developed.. The primary
reasons are the lack of a regulatory and legal framework and a very weak legal process of infrastructure.
There is no protection for the issuers and also no guarantee for those that subscribe to debt that their
interest payments will be made on time.

One of the key reasons is a lack of transparency and lack of proper disclosure in private companies which
is a big deterrent to investors, particularly foreign investors who are used to a more regulated
environment in which very little is left to chance. Even if we did have a well developed regulatory
framework and an across the board practice of good business ethics there are very few corporates with
the kind of credibility and back ground which would render them as potential candidates as issuers of
private sector publicly floated debt. The Chakwal Group and the Saigol Group, two of the largest business
groups in the country have lost credibility and this really narrows the field. There are less than a dozen
private sector companies which now have the credibility and the financial backing to issue security paper.

One other reason that there was very little development in the bond market is that until recently
Development Finance Institutions used to be responsible and had shouldered the bulk of long term
project finance requirements. hence the need for e bond issues was never felt as keenly as it is now. Until
recently there has also not been any credit rating mechanism in the country, and this is one of the most
vital ingredients for a viable debt market.

Because of the effort to develop Islamic financing in the country, we have two separate modes of
financing and this non-conformity of foxed interest rate payments with standard international debt
instrument/market practices is also a deterrent to investors, and again more so with foreign investors who
are uncomfortable if what they see is not crisp and crystal clear.

Risks

Then of course there is a very major reason and that is the country risk factor. Over the past few years
Pakistan's rating has generally been below international investment grade for debt instrument
investments. So the bottom line is that even if we had all the above factors in place the very high country
risk alone would automatically limit the potential inflow of funds into Pakistan's debt instruments.

The fact that our forex reserves are very low puts Pakistan in a very precarious position also. There are a
number of hedge funds in the international markers which could very easily come in and invest about half
a billion dollars in the country's debt market. In fact with the current risk the best that Pakistan can hope
for is top get the attention of these hedge funds. the only problem here is that these funds are not very
reliable long term partners and they are prone to making large withdrawals at the drop of a hat. With our
current very very low level of foreign exchange reserves the thought of one of these hedge funds pulling
their investment out in a very short term is nothing short of disastrous.

The cost of investing in Pakistan is also incredibly high and it does not make very much economic sense
in the current conditions.

From and issuers perspective the cost would include the basic government rate which is about 15%,
coupled with approximately 2% on top of that to woo investors and then about 1-2.5% which would be
their fees. This comes to approximately 19% which is a very very high rate. In other words anyone
borrowing at this rate would have to make at least 25% on the project which is not a very common return.
Thus this would not make economic sense to too many investors. If a prospective investors were to invest
in foreign debt, the cost would come to about the same with 6% LIBOR, about 9-10% forward cover from
banks (5% provided by the State Bank of Pakistan is subsidised) and then the 2% arrangement fee. Even
this which comes to about 18% does not make too much sense. It is a very costly investment, particularly
for long term loans.

This automatically jacks up the cost of capital for the project which means that the required rate of return
or needed return on equity or say even return on capital and equity becomes very high for any project to
be economically viable.

Opportunities for foreign investors

There have been several measures that have been taken with a view to speeding up the development of
Pakistan's money and bond markets and making them more attractive to foreign investors. debt
management policies were formulated in 1991 and debt management through the use of indirect
monetary tools was introduced. The TAP system was removed and the debt auction programme was
introduced.

And of course new debt instruments designed including Treasury Bills (T-Bills) which are short term,
Federal Investment Bonds (FIBs) which are medium and long term and Short Term Federal Bonds
(STFB) which are short term (STFBs replaced T-Bills in July '96.
Other measures included the development of secondary markets for government debt instruments. A debt
management committee was formed within the central bank (the State Bank of Pakistan). It regularly
holds STFBs and FIB auctions, conducts Open Market Operations (OMOs) and assists in the further
development of secondary markets. Efforts and measures have also been taken to more effectively
monitor the money supply and the monitor the reserve requirement for banks.

Then the formation of PACRA is Pakistan's first credit rating agency, which was established in 1994, with
equity partnership of IBCA and Lahore Stock Exchange is also a positive development and should give
encouragement to foreign investors. The objectives of PACRA are to provide technical assistance for
establishing operating procedures, establishing mechanisms for rating, the training of professional
personnel Joint handling of rating process in initial stages, a review of public information on the client and
its industry, preparation of agenda for discussion with the issuer. For this the agency meets the issuer,
and has a rating committee meeting. During this meeting the agency holds a discussion and assignment
of rating. The issuer is advised of the rating and the rating and report is made public. This is a very
significant development and in time should help in making the Pakistan market more acceptable to foreign
investors.

The Pakistan market

The Pakistan money market basically consists of the Interbank Market which is the Call market and the
Open market which includes a host of securities that can be traded. In the Call market banks can lend or
borrow funds upto their credit limits without any collateral.

In the Open market there are repos in which a holder of securities sell these securities to an investor with
an agreement to repurchase them at a fixed price on a fixed date.

there are Certificates of Investment (CoIs) which non-banking financial institutions are allowed to issue for
mobilizing deposits but only for short maturities. There are Term Finance Certificates (TFCs) which is the
domestic equivalent of corporate bonds.

The participants in the interbank market are commercial banks and Development Financial Institutions
(DFIs) while the participants in the open market are commercial banks, Development Financial Institutions
(DFIs), regional banks, corporate bodies, securities houses, leasing companies, insurance companies,
investment companies and individuals.

There are semi-government securities like the Water and Power Development Authority (WAPDA ) Bonds
and of course there are the Term Finance Certificates which are a form of corporate debt, issued by
corporations in the form of marketable securities. The returns paid to investors are determined on the
basis of the maturity and perceived credit risk. The advantage to investors who which to invest in TFCs is
that there is a secondary market available which provides liquidity to investors and credit rating from
PACRA is required. However, presently this is still a very limited field.

Risk factors for foreign investors

The biggest risk factor for foreign investors is the foreign exchange rate risk. This is because the Pakistan
rupee is subject to crawling rate adjustments which adjust the exchange rate by devaluing the currency by
small increments. Due to consistent devaluation of the PKR in the past years, there exists a strong
possibility that the exchange rate may not be stable. This has been proven time and again by unexpected
devaluations by the government after repeated assurance s that there would be none. And now there are
rumors again that there might be another devaluation after Eid.

Then there is inflationary pressure. A rise in inflation erodes the purchasing power of the PKR, leading to
the scenario where more rupees would have to be invested to reap the same amount of profit. This
obviously translates into a lower return on investment and makes the investment less appealing. Another
turn off for foreign investors are rising interest rates/price risk. This is something that has been seen over
the years in Pakistan. To combat the inflationary pressure the government resorts to interest rate hikes.
These interest rate rises raise the cost of doing business, leading to upward revision of prices.

The • TT Buying and Selling rate difference is another risk for foreign investors. The difference between
TT Buying and selling has on average been 0.7% p.a.

Role of various institutions

Apart from this the State Bank of Pakistan requires commercial banks to maintain certain reserves in
proportion to total time and demand liabilities. The commercial banks maintain and SLR and a cash
reserve

The secondary market allows such institutions to adjust the liquidity, composition and risk of their
individual portfolio in accordance with changing realities. This in turn instills a measure of confidence in
these institutions with respect to the instruments and their issuers. Thus commercial banks represent an
essential medium through which the monetary objectives of the central bank can be achieved.

Brokers provide assistance to dealers in matching the deals. Benefits provided by the brokers include
effective matching of counter parties, pooling and dissemination of market information., providing support
services to clients (settlement of deals) reducing pressure on back office staff.

The brokerage houses have devoted substantial resources to developing the market, acquiring expertise
and introducing new products.

Conclusion

On paper it appears that there have been several developments that seem to make the market more
attractive. However, the risks that we have outlined are still very much there and to be quite honest with
the kind of country risk that we have, there is no hope in the near future that foreign investors will even
consider entering the local debt market. The government needs to take immediate measures to try and
lower the risks and to increase its forex reserves by hiking industrial output which in turn will result in
higher exports. It is also imperative that interest rates be lowered. Interest rates must be brought down to
the level of 10% for the blue chip borrowers and about 15% for the less credit worthy clients. This can
only be achiever if inflation is brought down from the current level of about 11% to 6^. It may sound far
fetched but is not exactly impossible. India has managed to achieve this and there is no reason why
Pakistan cannot do the same. Until and unless these targets are achieved, and as a result of the
economic stability our country risk does not become less threatening, investment in the Pakistan bond
markers will always remain a less than viable option.