BANKS REQUIRED TO HOLD FEWER RESERVES

UNCLAS SECTION 01 OF 02 ISLAMABAD 003461

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN ETRD PREL PGOV PK
SUBJECT: BANKS REQUIRED TO HOLD FEWER RESERVES

Summary

1. (SBU) The State Bank of Pakistan (SBP) reduced the cash reserve
requirement of banks in Pakistan by 100 basis points to 5 percent, a
4 percent drop in the last three weeks. The reduction in cash
reserve requirement and statutory liquidity requirement carried out
earlier combined have generated the additional liquidity of Rs.270
billion (USD 3.3 billion at 81.05 Rupees per dollar) in the
inter-bank market. The SBP has also changed the definition of
"loans advanced" by banks to exclude export refinance and power
sector loans. Citibank sources estimate this measure will add
Rs.200 to 250 billion (USD 2.5 billion to 3.1 billion) in additional
liquidity. The SBP has been taking these measures to deal with the
liquidity shortages in the inter-bank market, which according the
SBP Governor are partly due to excessive government borrowing from
the central bank. The Governor also said that Pakistan's economic
ailments originated from large fiscal and external deficits, which
in turn are partly due to high commodity prices. Soaring inflation
is eroding the competitiveness of industry and the purchasing power
of masses. End Summary.

--------------
CASH RESERVE REQUIREMENT REDUCED. . .AGAIN
--------------


2. (SBU) The State Bank of Pakistan further reduced the Cash
Reserves Requirement (CRR) by 100 basis points to 5 percent on
November 1. The CRR has come down from 9 percent to 5 percent in
the last three weeks. Every one percent reduction in CRR generates
an estimated Rs 30 billion (USD 270 million) additional liquidity in
the inter bank market. The SBP also instructed banks that time
deposits will not require any cash reserve. The combined impact of
reductions in CRR and exempting the time deposits of 1 year tenor
will generate Rs.270 billion (USD 3.3 billion) in additional
liquidity. The SBP has also changed the loans definition to exclude
export refinance, loans to the power sector, and textiles and
apparel sectors, which has reduced the Advance Deposit Ratio (ADR)
from 75 to 57 percent. According to Citibank sources this change in
policy will add an estimated Rs.200 to Rs.250 billion (USD 2.5
billion to 3.1 billion) to the inter bank market.


3. (SBU) The SBP Governor, Dr. Shamshad Akhtar, announced the
policy change at the launch of Saudi-owned Samba Bank in Karachi on
November 1. (Comment: Two other Saudi-owned banks already have
branches in Karachi or Islamabad) Banks were facing liquidity
shortages for the last two months, which caused the overnight rates
to peak at 40 percent in the inter-bank market. Akhtar said that
the stress on liquidity stemmed from high public sector borrowing
from the banking system, withdrawal of government deposits, seasonal
cash withdrawals for Eid (Eid is a holiday that marks the end of
Ramadan and fell in September),low growth in deposits, and
precautionary withdrawals. Steadily, public confidence is being
restored and banks are regaining lost deposits.

-------------- --------------
FISCAL DEFICIT AND COMMODITY PRICES FEED INFLATION
-------------- --------------


4. (SBU) Akhtar said that the burden of fiscal expansion was
clearly unsustainable and the level of stress of the current
macroeconomic burden can be judged by the growing recourse to the
central bank financing of the budget, the visibly sharp decline in
foreign exchange reserves and the depreciation in the rupee. The
Federal Board of Revenue (FBR) collected Rs 349.8 billion in tax
revenue during July-October 2008-09 versus target of Rs 329.3
billion and against Rs. 271 billion collected in the same period of
last fiscal year. The tax revenue is up by 29 percent in the first
four months of the current fiscal year compared to the same period
last year, exceeding the target by 6.2 percent.


5. (SBU) Pakistan, being an open and highly import-dependent
economy, has been hit by the surge in global commodity prices. High
commodity prices exacerbated Pakistan's economic ailments through
sharp growth in the domestic fiscal deficit (due to subsidies) and
the external deficit. According to Akhtar, the FY08 oil import bill
was equivalent to 6.9 percent of GDP or almost 80 percent of the
external current account deficit. During FY08, the average price
per barrel was USD 94.4 while in the first quarter of FY09 average
price reached close to USD 115.5. Unless addressed, this high
inflation will hurt the future competitiveness of Pakistan economy

ISLAMABAD 00003461 002 OF 002


and has already significantly eroded the purchasing power of the
poor.

--------------
ROOM FOR IMPROVEMENT
--------------


6. (SBU) Governor Akhtar said the central bank legislation in
Pakistan has some outdated provisions, which need to be
appropriately amended to provide more autonomy to SBP, along with
proper accountability, to pursue clearly defined goals of monetary
and financial stability. Akhtar also warned that the financial
sector is too bank-centric, and the outreach and growth of the
Non-Bank Finance Companies (NBFCs) and the insurance sector have
languished in recent years. NBFCs face direct competition from
banks and are not likely to grow significantly until their funding
sources and costs are streamlined. At the same time, growth in the
insurance sector is weak, and private pension funds have only
recently started to gather some pace.

Comment

7. (SBU) Comment. Lowering reserve requirements is an expansionary
monetary policy that decreases the amount banks are required to hold
to meet depositors' claims and expands the effective amount of
currency in circulation. This policy will reduce upward pressure on
interest rates, yet it comes at the cost of feeding the 27 percent
inflation that is eroding the competitiveness of Pakistan's economy
and the purchasing power of its people, while marginally weakening
the historically stable banking sector of Pakistan. The Government
of Pakistan must address the causes of the current liquidity crisis
-- the fiscal and trade deficits -- rather than chasing the symptoms
with increasingly ineffective quick fixes. End Comment.

PATTERSON