SBP’s Financial Stablity Review: Fiscal slippage, external account pose ‘significant challenges’ to economy

KARACHI: The central bank on Friday said external account vulnerabilities and fiscal deficit are posing ‘significant challenges’ to the economy translating into short-lived volatility in the financial markets.

The State Bank of Pakistan (SBP) said the domestic economy managed a decent growth of 5.37 percent in the fiscal year of 2016/17 and an estimated growth of 5.79 percent in 2017/18. “However, the economy is confronted with significant challenges,” the SBP said in a financial stability review.

“The foremost being the pressures developing in the external sector because of widening trade deficit followed by fiscal slippages. Headline inflation has been subdued, though core inflation has remained at an elevated level.”

The SBP said the rising macroeconomic vulnerabilities have translated into short-lived volatility in the financial markets, particularly foreign exchange and equity markets, and impacted the performance of financial institutions.

“In the short-term, risks to domestic financial stability may elevate further if external account challenges remain, fiscal imbalances persist, and savings in the economy (especially, deposit growth) stay low.”

The SBP said risks to the financial system may decline in the medium-term “in perspective of sustained growth momentum, rising opportunities from CPEC (China-Pakistan Economic Corridor), improving energy availability, and expected increase in exports on the back of improving global demand”.

The central bank said the level of overall risks to financial stability, as measured by financial vulnerability index, bottomed out last year.

“However, despite tightening of macro-financial conditions, financial institutions have performed fairly well,” it said. “The consolidated asset base of the financial sector has expanded by 12.8 percent during CY17. Asset to GDP ratio has inched up to 74.7 percent in CY17 from 72 percent in CY16 indicating higher degree of financial deepening.”

The review presents performance and risk assessment of various components of the financial sector including banking, non-banking financial institutions, financial markets, exchange companies, non-financial corporates and financial market infrastructure.

The SBP said the banking sector registered an asset expansion of 15.86 percent largely due to robust growth in advances to private sector.

“Owing to rise in advances, non-performing loans to advances ratio — at 8.4 percent —has touched decade low level and capital adequacy ratio at 15.8 percent is well above the minimum regulatory requirement of 11.275 percent,” it said.

“Encouragingly, under resilience analysis, banks are expected to absorb shocks in domestic and global stressed scenarios in the medium-term. Nevertheless, declining profitability and deceleration in deposit growth are the key concerns.” The SBP said Islamic and microfinance banks are gaining maturity with improved performance, expansion in advances, deposits and customer base and growing share in assets of the financial sector.

It, however, said Islamic banks continue to face liquidity management challenges due to dearth of shariah-compliant investment instruments.

“The challenging macro-financial conditions, particularly in H2CY17, have influenced the performance of the non-bank financial sector as well,” the central bank said. “… mutual funds portfolio is still dominated by equities that are exposed to equity price risk.”

The SBP further said the other non-bank intermediaries like modarabas and leasing companies have been lagging behind in performance due to structural inefficiencies and insufficient availability of low cost funds. “The limited intermediation role being played by development finance institutions have hindered their growth and adversely impacted their performance during the year.”

The SBP said the insurance industry has witnessed healthy rise in gross premiums “but it is exposed to concentration risk due to the dominance of a few insurers”.

“It also faces market risk as adverse movement in interest rates or equity prices may affect its investment income,” it added.

“Exchange companies, with steady growth and improving profits during CY17, pose limited systemic risk to the financial system.”

The SBP said cyber security risks remain a key concern for financial market infrastructures (FMIs) particularly for retail transactions – via Pakistan Real-time Interbank Settlement Mechanism – due to increasing adoption of e-banking channels. “Further, rising interconnectedness among the FMIs might lead to contagion risk.” The SBP said the performance of the non-financial corporate sector remained upbeat as the estimates suggest broad based steady growth in assets and decent profitability during the last year.