STATE BANK OF PAKISTAN

Bond Market
Development in Pakistan
Muhammad Arif
September 2007

Abstract: Bond market development has now gained priority in fostering financial sector
growth in all economies whether developed or developing. Asian and Mexican crises
have given a clear message that this market, falling between equity and bank finance,
needs proper attention failing which investment climate within these countries would
remain under threat. With this perspective, the paper has been drafted highlighting
Pakistan’s economic conditions, its financial market architecture, securities market
structure with its status, issues, and reforms in hand and then finally proposing future
agenda.

Author is a Senior Manager in State Bank of Pakistan working on Monetary Policy

execution Framework and Debt Market Development. Views expressed in this paper are
not of SBP and are of the author’s. Paper has been drafted for the project “Capacity
building of bond markets in UNESCAP member states”. The paper has been read in
UNESCAP workshop in Bangkok on February 14-15, 2007. The author also
acknowledges the support of Mr. Athar Ghafoor, Mr. Muhammad Aamir Mahmood and
Mr. Muhammad Kashif Rahim of FSCD, SBP Karachi in accomplishing data for this
paper and its formatting. The source of data is SBP Annual Report 2005-06, SBP
website, Pakistan Economic Survey 2005-06.The paper has been finalized in the last
week of December, 2006 - first week of January, 2007 and now has been updated with
the Support of Mr. Hastam Shah of FSCD in Aug-Sep, 2007.
 TABLE OF CONTENTS

Introduction 3
History 4
Part I: Overview of the Economy and Financial Sector 5
Overview of the Economy 5
Policy Environment 7
Fiscal Policy / Debt Management 7
Monetary Policy / Monetary Aggregates / Interest Rate 7
Foreign Exchange Rate Policy / Foreign Exchange Rate 9
Financial System 10
Architecture of Financial System in Pakistan 10
Central Bank 11
Objectives, Functions & Organization 11
Banking System (Bank Institutions) 12
- Roles, Degree of Consolidation and Competition 13
Non-Banking Financial System (NBFI) 13
Financial Markets 14
Money Market 14
Equity Market 18
Bond Market (Government & Corporate Bond Market) 21
Debt and Foreign Exchange Reserve 23
Foreign Direct Investment Inflows 23

Part II: Development of Government & Corporate Bonds Market 24

General Overview 24
Size, Structure & Market Liquidity 25
Issuance in Domestic Market (in local currency) 25
Issuance in External Market (in foreign currency) 26
Bond Market Infrastructure 27
Government Efforts to Develop Capital Market 29
The Rationales for Developing Domestic Bond Market 29
Motivations for Developing Domestic Bond Market 30
Challenges and Strategies to Develop Well-Functioning Bond Market 30
Factors Hindering Bond Market Development 30
Past efforts / Recent Initiatives 31
Roadmap (Plan/Strategy) for the Development of the
Bond Market (Financial Sector) 31
Role of Central Bank / Government in Developing Bond Market 32

Part III: Policy Implications for Bond Market (Financial Sector)

Development 34

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INTRODUCTION
The fixed Income market falls in between equity market and bank finance. Hence
obviously, it suits to the class of investors/borrowers that are neither high risk lovers nor
completely risk averse or relatively act under safe parameters within bank finances.

Various financial market crises surfaced during the last decade of 20th century notably
Mexican and Asian Crisis in 1997 which gave clear message that without developing
domestic bond markets, an
economy would remain under risk
of capital outflows. To attract
capital flows and support growth
efforts, existence of domestic
bond market is highly essential
that provides opportunity to the
investors to diversify the risk
profile of their portfolio.

Geographically, Pakistan falls in

very important location with
immense appetite to attract
investment and it is therefore
imperative to give fresh thoughts to develop its Capital market especially focusing on
developing local Bond Market as its current size is very small and is not in conjunction
with its requirements.

The paper tries to discuss the status of debt market in Pakistan with issues and dilemmas
confronting its development with suggesting ways for their resolutions.

Page 3 of 37
HISTORY
Prior to 1990, Federal and Provincial Governments used to borrow on tap instruments
with predetermined rates. The main thrust of Federal Government borrowing was through
captive funding. Large statutory preemptions and borrowing from SBP at highly
concessionary rates enabled the Government to finance its large fiscal deficits. In such an
environment the only tool available to counteract was to makes successive increases in
Statutory Liquidity Requirement (SLR) and Cash Reserve Requirement (CRR). There
was very little scope for development of Government Securities Market in Pakistan that
could provide benchmarks for private sector to play their role in development of Capital
Market in the country. To cover non-banking segment, Prize Bonds were introduced in
1960 followed by various NSS schemes. However 1990 onward, market based
Government Securities came in to existence. With the introduction of long term paper in
1992 (FIB), long term yield curve emerged that gave opportunity to the Corporate to
come up with their instruments that became reality in 1995.

Long-term instruments gained momentum after the introduction of Pakistan Investment

Bonds (PIBs) in 2000, to stream line the auction of Government Securities and to develop
secondary market for the Government paper. SBP introduced selective Primary Dealer
System (PD) in 2000. In 2001 KIBOR/KIBID rates were introduced to provide inter-bank
call money curve. With the development of Fixed Income Securities Market in Pakistan,
SBP allowed Commercial banks to make available Derivative products to their clients. In
this regard SBP issued guidelines on Forward Rate Agreements (FRA), Interest Rate
Swaps (IRS) and Currency Options in 2005.

Foundation of the corporate bond market was laid in 1995 with the first issue of Term
Finance Certificates (TFC). Since then, issuance of listed TFCs has totaled approximately
PKR 67 billion. The Corporate Bond market in Pakistan has been much more vibrant
over the 2001-05 periods, adding approximately PKR 65 billion in issuance or 98% of
total issuance to-date.

Pace of development of Islamic Money and Sukuk market is a new phenomenon that
gained importance with the induction of 6 full-fledged Islamic Banks and 16
conventional banks to conduct Islamic banking business in Pakistan; however the size of
Sukuk Market is very small at the moment. To facilitate Corporates to raise short term
funding i.e. up to 9 months, Commercial Papers have recently been allowed but the
market has yet to take its roots.

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PART I
OVERVIEW OF THE ECONOMY AND FINANCIAL SECTOR

1. Overview of the Economy:

Pakistan’s economy has grown at an average rate of 7.0 percent per annum during the last
five years (2002/03 – 2006/07). The growth momentum sustained by Pakistan for the last
five years is underpinned by dynamism in industry, agriculture and services, and the
emergence of a new investment cycle with investment rate reaching new height at 20.0
percent of GDP.

The growth targets for FY07 have been achieved despite headwinds faced by the
economy from rising oil prices, hovering around $ 70-75 per barrel that put severe strains
on the country’s trade balance on the one hand and budget on the other, and massive
earthquake of October 8, 2005 causing extensive damage to property, infrastructure,
School, Hospital etc.

The current status of some of the macroeconomic indicators of Pakistan is as follows:

Table 1: Macroeconomic Indicators

Indicators FY 02 FY 03 FY 04 FY 05 FY 06 FY07
Real GDP Growth 3.1 4.8 7.5 8.6 6.6 7.0
Current Account Deficit % of GDP 4.0 4.9 1.8 -1.4 -3.9 -4.3
Currency Adjustments PKR/US$
6.42 3.79 -0.55 -2.56 -0.87 -0.51
% p.a.
M2 Growth 15.4 18.0 19.6 19.3 15.2 19.4
Interest Rate (6 months T-Bills) 6.43 1.66 2.23 7.98 8.48 8.90
Inflation CPI 3.15 3.1 4.6 9.3 7.9 7.8
Fiscal Deficit % of GDP 4.3 3.7 2.4 3.3 4.2 4.2

Real GDP:
Real GDP grew by 7.0% in 2006-07 as against 6.6% last year. Pakistan economy has
grown at an average rate of almost 7.0% per annum during the last five years and over
7.5% over the last four years, thus enabling it to join the exclusive club of the fastest
growing economies of the Asian Region.

Agriculture Sector:
Agriculture sector accounts for 20.9 percent of the GDP and employs 43.4 percent of the
total work force. Growth in the agriculture sector registered a sharp recovery in 2006-07
and grew by 5.0 percent as against the preceding year’s growth of 1.6 percent. Recovery

Page 5 of 37
of major crops from (-) 4.1 to (+) 7.6 on the back of higher production of wheat and
sugarcane helped this sector to contribute positively in the overall GDP growth.

Manufacturing Sector:
Overall manufacturing sector accounts for 18.2 percent of GDP. This sector registered an
impressive and broad based growth of 8.45 percent in FY07 compared with 9.9 percent in
FY06.

Large-Scale Manufacturing:
Growth in large-scale manufacturing (which accounted for around 70 percent of overall
manufacturing) at 8.75 percent somewhat decelerated against last year’s achievement of
10.68 percent. The decline in growth in the manufacturing sector is attributed to
multiple reasons like reduced production of cotton crop, sugar shortage, steel and iron
problems, high oil prices etc.

Services Sector:
The services sector continued to perform strongly for third year in a row and grew by 8.0
percent in 2006-07 as against 9.6 percent of last year. Growth in the services sector in
2006-07 was primarily attributable to strong growth in the finance and insurance sector,
better performance of wholesale and retail trade, as well as transport and the
communications sector.

Pakistan’s per capita real GDP:

Per capita real GDP has risen at a faster pace during the last five years i.e. 13.0% per
annum on average in US Dollar term leading to a rise in average income of the people.
Per capita income, defined as GNP at market price in dollar terms divided by the
country’s population, grew by 11 percent during 2006-07 to US$925 up from US$833
last year. Such increases in real per capita income have led to sharp increase in consumer
spending during the last couple of years which drives the growth in almost all the sectors.

Investment:
During the fiscal year 2006-07, the real gross fixed capital formation or domestic fixed
investment grew by 20.6 percent against 17.6 percent last year. As percentage of GDP,
total investment reached 23 percent in 2006-07 from 21.7 percent last year.

Public sector investment on the other hand registered massive growth of 46.7 percent as
against a hefty 32.9 percent increase last year. The growth in domestic investment was
largely a public sector phenomenon last year but this year, it was mainly public-private
sector partnership driven.

Savings:
National savings as percentage of GDP increased to 18.0 percent in 2006-07 from its
previous level of 17.2 percent last year. National savings contributed to around 84% of
financing of domestic fixed investment during 2006-07.
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Policy Environment:

Fiscal Policy:
Pakistan has gained further strength on fiscal side. Revenues are buoyant, expenditure is
rationalized, fiscal deficit is at sustainable level and revenue deficit has almost been
eliminated. Resultantly, Public debt is fast moving towards a sustainable level. Tax
collection by the Federal Board Revenue (FBR) has picked up. As a result of prudent
fiscal management over the last 5 years, the burden of interest payment in domestic
budget has declined sharply, thereby, releasing resources for development and social
sector program. Pakistan has succeeded in reducing fiscal deficit from an average of 7
percent of GDP in the decades of 1980s and 1990s to an average of 3.5 percent during the
last seven years.
Debt Management:
Pakistan’s public debt grew at an average rate of 18 percent and 15 percent per annum
during the 1980s and 1990s, respectively – much faster than the growth in nominal GDP
i.e. 11.9% and 13.9% respectively. Resultantly, public debt rose from 56 percent of GDP
at the end of the 1970s to 92 percent
by the end of the 1980s. In other
words, it increased by 36 percentage
points of GDP during the 1980s.
Public debt was 85 percent of the
GDP by the end of the 1990s. The
root cause of rising debt burden has
been the persistence of large fiscal
and current account deficits.
Pakistan, on average, sustained fiscal
and current account deficits of
almost 7 percent and 5 percent of
GDP, respectively during 1990-99.

It is in this background the Government decided to devise new debt management strategy
to arrest the rising trends of debt. Reduction in the fiscal and current account deficits,
lowering the cost of borrowing, raising revenue and foreign exchange earnings, and debt
re-profiling from the Paris Club have been the key features of the debt reduction strategy.
To provide legal cover to debt reduction strategy a Fiscal Responsibility and Debt
Limitation Act 2005 has been promulgated in June 2005. As a result of the credible
strategy being followed by the Government, the public debt- to-GDP ratio, which stood at
almost 85 percent in end June 2000, declined substantially to 53.4 percent by the end of
March 2007, a decline of 28 percentage points in country’s debt burden in 7 years.
Monetary Policy:
Easy and accommodative monetary policy stance that have been pursued during the last
few years by the SBP which underwent considerable changes during the FY05, switching
from a broadly accommodative to aggressive tightening. In order to arrest the rising
trend in inflation, SBP continued with its tight monetary policy stance till FY08 by
raising discount rate from 9.5 percent to 10.0 percent from 1st August, 2007. Tight
monetary policy stance is likely to continue until inflationary pressures are significantly
eased off in the time to come.
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Monetary Aggregates:
Annual trends of monetary aggregates i.e. M1, M2 and M3 since June 2000 are below:

Table 2: Stocks of monetary Aggregates

End Period Monetary Supply and (% age Change)
Stocks Monetary Assets
(M1) (M2) (M3) (M1) (M2) (M3)
June 2000 739.0 1400.6 2137.2 14.9 9.4 11.7
June 2001 761.4 1526.0 2313.9 3.0 9.0 8.3
June 2002 876.8 1761.4 2640.9 15.2 15.4 14.1
June 2003 1106.3 2078.7 3102.0 26.2 18.0 17.5
June 2004 1371.6 2486.6 3517.0 24.0 19.6 13.4
June 2005 1624.2 2966.4 3975.5 18.4 19.3 13.0
June 2006 1840.6 3416.52 4423.4 13.3 15.2 11.3
March 2007 3256.7 3793.0 4837.5 7.7 11.0 9.4

Whereas M1 consists of the outstanding stock of currency in circulation, the demand

deposits of scheduled banks and other deposits with the State Bank of Pakistan and M2 is
M1 plus the outstanding stock of time deposits of scheduled banks and the outstanding
stock of the Residents Foreign Currency Deposits (FRCDs). Similarly M3 includes: the
outstanding stock of the M2, outstanding deposits of the national saving schemes (NSS),
and outstanding deposits of the provincial cooperative banks of the Punjab, Sind, NWFP,
Baluchistan, AJK and the Northern Areas.

Interest Rate:
Pakistan experienced an unprecedented inflow of foreign exchange after the events of
9/11. SBP had to actively intervene in the FX market to purchase the excess supply of
foreign exchange with the objective to contain volatility in the exchange rate, manage
liquidity in the system and at the same time to build-up foreign exchange reserves. These
market interventions led to surplus liquidity in the banking system. Therefore, SBP had to
sterilize the expansionary effects of foreign capital inflows on monetary aggregates and
inflation. MTB yields - that are considered tool for interest rate signaling - went down
considerably without any change in discount rate during FY 02 and FY03 in wake of
heavy inflows that started coming in onward Sept,2001 (See Table 3 and Figure 3).

Page 8 of 37
Table 3: Interest Rate
2002-03 2003-04 2004-05 2005-06 2006-07
MTB End Change End Change End Change End Change End Change
June bps June bps June bps June bps June bps

03-M 1.66 (415) 1.74 9 7.51 577 8.32 81 8.69 37

06-M 1.67 (477) 2.23 56 7.98 576 8.48 50 8.90 42

12-M 2.37 (462) 2.24 (13) 8.45 620 8.79 34 9.12 67

Situation started reversing since mid 2003 and gained pace 2004 onward under rising
inflation figures that forced SBP to increase its discount rate by 200 bps in April 2005.
Thereafter SBP intervened in the
inter-bank market quite frequently.
For example during FY07 SBP
conducted 71 OMOs and withdrew
liquidity to the extent of Rs 936.65
billion against the marginal injections
of Rs 61.0 billion resulting in average
overnight rates to hover around 9.0
percent for most of time during FY07.

The present tight monetary policy

stance has been reflective in rising
interest rates in the secondary market,
particularly the short-term interest
rates as 6-month and 12-month
KIBOR rose by 92 bps to 9.61
percent and 76 bps to 10.06 percent,
respectively. The long-term interest
rates did not experience any
significant changes from their trend
levels due to lack of activity in long-
term papers in the absence of PIB
auctions for two consecutive fiscal
years. Therefore, the higher pace of
hike in short-term interest rates
relative to long-term rates flattened the yield curve.
Foreign Exchange Rate Policy:
One of the major responsibilities of the State Bank is the maintenance of external value
of the currency. In this regard, the Bank is required, among other measures taken by it, to
manage foreign exchange reserves of the country in line with the stipulations of the
Foreign Exchange Act 1947. As an agent to the Government, the Bank has been
authorized to purchase and sale gold, silver or approved foreign exchange and
transactions of Special Drawing Rights with the International Monetary Fund under sub-
sections 13(a) and 13(f) of Section 17 of the State Bank of Pakistan Act, 1956.

Page 9 of 37
In order to promote exchange rate stability, Pakistan has experimented with different
exchange rates systems i.e. fixed, managed; free float with a cap on its downward
movement till the rupee was finally set on free float from July 21, 2000.

One of the most important episodes in Pakistan’s FX history was the freezing of
Residents Foreign Currency Accounts after nuclear detonation by Pakistan in 1998. A
two-tier exchange rate system was introduced w.e.f. 22nd July 1998, with a view to reduce
the pressure on official reserves and prevent the economy to some extent from adverse
implications of sanctions imposed on Pakistan. However, effective 19th May 1999, the
exchange rate has been unified, with the introduction of market-based floating exchange
rate system, under which the exchange rate is determined by the demand and supply
positions in the foreign exchange market.

As the custodian of country’s external reserves, the State Bank is also responsible for the
management of the foreign
exchange reserves. The task is
being performed by an Investment
Committee which, after taking
into consideration the overall level
of reserves, maturities and
payment obligations, takes
decision to make investment of
surplus funds in such a manner
that ensures liquidity of funds as
well as maximizes the earnings.
These reserves are also being used
for intervention in the foreign
exchange market.
Table 4: End-Period Average Exchange Rate (PKR/USD)
SBP has successfully achieved FY01 FY02 FY03 FY04 FY05 FY06 FY07
exchange rate stability during Interbank 64.11 60.05 57.80 58.17 59.69 60.21 60.52
FY07 as rupee registered a
KERB 66.80 60.18 57.85 58.53 60.46 60.63 60.95
marginal depreciation of 0.51
percent compared to 0.87 percent last year (see Table 4). The stability of Pak rupee was
mainly contributed by prudent intervention of SBP in the inter-bank forex market and
increased inflow of workers’ remittances. Higher demand for dollar due to rise in oil
prices coupled with surge in demand for imported machinery generated some pressure on
Pak rupee during FY05 – FY07. However, this pressure was effectively managed by SBP
through provision of support for oil and commodities thus maintaining the exchange rate
stability.

2. Financial System
ƒ Architecture of Financial System in Pakistan:
The Financial system in Pakistan is now market oriented as against its past. State Bank of
Pakistan, Central Directorate of National Savings and Securities and Exchange
Commission are the main institutions regulating the financial system. The features of
financial system in Pakistan can be summarized as under:

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 • Autonomous Central Bank.
• Commercial banks, Investment banks, Leasing companies, Modarba, Mutual
Funds are permitted in the private sector.
• Deposits and lending rates determined by the banks themselves.
• Market oriented interest rate policy.
• Use of indirect monetary management tools.
• Floating exchange rate regime.
• Benchmark yields curve available for 3 months to 30 years on the basis of 9
benchmark issues.
• Equity and Corporate Bonds market being regulated by a separate entity viz.
SECP.
• Securities are exchanged on the basis of delivery versus payment system with T+3
for corporate securities and T+0 for Government Securities.
• National Saving schemes being regulated by a separate entity viz. CDNS working
under MOF. CDNS has been given autonomy in 2007.
• Commercial Banks are in phase of merger and acquisitions for having healthy
equity base for meeting Basle II requirements whereas new banking licenses are
now being issued to the Islamic banking institutions only.

Structure of Financial Industry in Pakistan:

Financial Sector in Pakistan

SBP SECP CDNS

Banks (46) Non Banking Financial Insurance Co. Capital Markets NSC’s
Sector

Public Sector Banks (4) Housing Finance Co. (6) Life Insurance Co. (5) Stock Exchange (3)

Local Private Banks (25) Leasing Co. (20) Non-Life Insurance Co. Central Depository Co. (1)
(50)

Foreign Banks (7) Investment Banks (16)

Specialized Banks (4) Venture Capital Co. (4)

DFIs (6) Discount Houses (2)

Central Bank: Objectives, Functions & Organization:

State Bank of Pakistan is the Central Bank of the country. Under the State Bank of
Pakistan Order 1948, the Bank was charged with the duty to "regulate the issue of Bank
notes and keeping of reserves with a view to securing monetary stability in Pakistan and
generally to operate the currency and credit system of the country to its advantage". The
scope of the Bank’s operations was considerably widened in the State Bank of Pakistan
Act 1956, which required the Bank to "regulate the monetary and credit system of
Pakistan and to foster its growth in the best national interest with a view to securing
monetary stability and fuller utilization of the country’s productive resources". Under
Financial Sector Reforms, the State Bank of Pakistan was granted autonomy in February
1994. On 21st January 1997, this autonomy was further strengthened by issuing three
Page 11 of 37
Amendment Ordinances (which were approved by the Parliament in May, 1997) namely,
State Bank of Pakistan Act, 1956, Banking Companies Ordinance, 1962 and Banks
Nationalization Act, 1974. The changes in the State Bank Act gave full and exclusive
authority to the State Bank to regulate the banking sector, to conduct an independent
monetary policy and to set limit on government borrowings from the State Bank of
Pakistan.

Like any Central Bank of developing countries, State Bank of Pakistan performs both the
traditional and developmental functions to achieve macro-economic goals. The traditional
functions, which are generally performed by central banks almost all over the world, may
be classified into two groups: (a) the primary functions including issue of notes,
regulation and supervision of the financial system, bankers’ bank, lender of the last
resort, banker to Government, and conduct of monetary policy, and (b) the secondary
functions including the agency functions like management of public debt, management of
foreign exchange, etc., and other functions like advising the government on policy
matters and maintaining close relationships with international financial institutions. The
non-traditional or promotional functions, performed by the State Bank include
development of financial framework, institutionalization of savings and investment,
provision of training facilities to bankers, and provision of credit to priority sectors. The
State Bank also has been playing an active role in the process of Islamization of the
banking system. The main functions and responsibilities of the State Bank can be broadly
categorized as under.

1. Formulation and Conduct of Monetary Policy - Interest Rate Management.

2. Regulations and Supervision – Sound Financial System
3. Exchange Rate Management --Maintaining Value of Currency
4. Payment and Settlement System – Smooth conduct of banking transactions

ƒ Banking System (Bank Institutions):

Financial landscape of the country was significantly altered in early 1970s with
nationalization of domestic banks and expansion of public sector development finance
institutions. By the end of 1980s, it became quite clear that objectives of nationalization
were not achieved. At the end of FY90, the share of public sector banks was 92.2 percent
in total assets, while the rest belonged to foreign banks as domestic private banks did not
exist at that time

During 1990’s realizing the inherent weaknesses of the financial structure, Government
initiated a broad based program of reforms in the financial sector. Reforms covered seven
important areas:

1. Financial liberalization,
2. Institutional strengthening,
3. Domestic debt,
4. Monetary management,
5. Banking law,
6. Foreign exchange
7. Capital market.
Page 12 of 37
Under financial liberalization banking licenses were allowed to Private Sector in 1992
and Privatization process was initiated under which major Public Sector Banks were
privatized to improve efficiency and competitiveness in the banking sector. Now there
are only four public sector banks with less than 15% of deposits base.

Roles, Degree of Consolidation and Competition between Private and Public Sector
Institutions:
SBP continued with its reforms agenda for banking system and strengthening of
supervisory capacity during FY 2007 to ensure soundness of financial system. It
undertook initiatives in a number of areas like enhancement of minimum capital
requirements (MCR) for banks to Rs.6 billion by end of December, 2009, introduction of
variable capital adequacy ratio based on Institutional Risk Assessment Framework
(IRAF) rating of banks/DFIs along with outlining a road map for smooth transition from
Basel-I to Basel-II. As the implementation of Basel-II poses tremendous challenges for
the banking system, SBP has encouraged the financial institutions for capacity building in
terms of upgrading the IT systems and enhancement of expertise in specialized areas like
risk management and Anti-Money Laundering (AML) through seminars and workshops.

Since 2000 mergers and acquisitions have taken place in the banking industry. The policy
of merger and consolidation has resulted in efficiency for banks/DFIs through high
penetration of technology and greater manoeuvrability in enhancing their business
volumes, sale and size to achieve cost efficiencies.

In order to reduce size on non performing loans schemes was devised that has enabled
banks/DFIs to make huge recoveries and write-off which reduced the ratio of non-
performing loans from 9.9 percent in 2002 to 1.98 percent by end-March 2007.

Table 5: Year-wise % of Net NPLs to Net Loans:

2002 2003 2004 2005 2006 2007*

9.9 6.9 3.8 2.1 2.1 1.98

*: Up to 31st March 2007

Non-Banking Financial System (Non-Bank Financial Institutions):

Non-bank Financial Institutions (NBFIs) play a pivotal role in mobilizing savings in the
economy. NBFIs can be categorized into ten groups: -

1. Development finance institutions (DFIs)

2. Investment banks (IBs),
3. Leasing companies
4. Mutual funds
5. Housing finance companies (HFCs)
6. Modaraba companies
7. Discount houses (DHs)
Page 13 of 37
 8. Venture capital companies (VCCs).
9. Investment Advisory Services.
10. Asset Management Services.

These institutions play a key part in channelizing funds in Pakistani financial system by
accepting term deposits of differing maturities and providing financing to a variety of
sectors of the economy, with SMEs and consumer financing being the areas of especial
focus. Parallel to the broader banking sector, in the early 1990’s, the financing activities
of these institutions registered healthy growth under the market reforms instituted. During
this period NBFIs in Pakistan underwent a significant shakeout due to a program of
comprehensive financial sector reform which included: -

o Liberalization of the foreign exchange market and interest rates.

o Increased autonomy to the central bank and its focus on monetary policy and
banking supervision.
o Establishment of an independent Regulatory Department at Securities &
Exchange Commission of Pakistan (SECP) for capital markets and NBFIs.
o Upgrading of legal and regulatory frameworks.
o Reduction of NPLs in the banking sector.
o Restructuring of government-owned financial institutions.

Further, structure of non-bank financial institutions was more skewed with a hefty share
of development finance institutions (all in public sector) at 78.6 percent. Apart from
DFIs, non-bank financial institutions remained practically unsupervised due to lack of
autonomy and multiplicity of supervisory agencies over them that included Corporate
Law Authority, Monopoly Control Authority and Controller of Capital Issues, all
attached directly with the Ministry of Finance. During 1990’s an NBFI Regulation and
Supervision Department was established in State Bank that subsequently issued ‘Rules of
Business’ to supervise them. In 2003 the regulations of NBFIs except DFIs were
transferred to SECP.
4. Financial Markets:
Financial Markets in Pakistan comprise of Money Market (MM), Equity Market, Bond
Market, Foreign Exchange Market (FX) and Derivatives Market. The main players are
Banks, Non Bank financial Companies (NBFCs), Corporates, Stock Exchanges,
Government and general public and the Regulators i.e. SBP and SECP.

Money Market (MM):

Money Market is mainly comprised of MTB issuances of 3, 6 and 12-month tenors,
OMOs, Repo, outright; Call Market, Discount window and FX market activities. It
operates through Primary and Secondary Market framework. MM is also used for
carrying out monetary policy operations through impacting interbank by changing the
Reserve Money Stock.

Primary Market: MTB Auctions:

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In Pakistan, MTB auctions provide interest rate signals to the market. Auctions are held
on fortnightly basis and are used for raising short-term funds for the Government. SBP
holds MTB auctions through selective
PDs (Currently there are 10 PDs i.e. 8 Table 6: MRTB Stock (Rs in billion)
banks, 1 DFI and 1 Brokerage house). FY02 FY03 FY04 FY05 FY06 FY07
MTBs are available at discount at 208.13 403.0 350.5 465.6 502.5 451.5
quoted prices i.e. auctions are held at
multi priced basis. MTBs with its risk profile serve the purpose of meeting banks SLR
requirements and as collateral in the Repo market.

Government Borrowing from SBP:

Government borrowing from the SBP impacts MM as it results in increase in monetary

base that subsequently constraints SBP to check it through its monetary policy
operations. In Pakistan Government can borrow from SBP without any limit (SBP Act
provides that SBP can enforce limit
if it is being understood that
Governments will meet its additional
credit requirements direct from
commercial banks through market
based auctioning system to be
conducted by the SBP). The
Government borrows from SBP at 6
month MTB cut off rate arrived at in
the last auction. Prior to 1990
Government used to borrow from
SBP at 0.5% that was discontinued
with the introduction of Financial
Sector Reforms initiated in 1990. Government borrowing direct from the SBP is one of
the major factor of market volatility and major cause of creating inflationary pressure. To
curb this ill some form of ceiling on GOP borrowing from the SBP is required to be
imposed to control volatility in the MM.

Secondary Market:

OMOs are conducted through Repo or outright basis and are intended to absorb or inject
liquidity in the MM using T-Bills. Only Commercial Banks are allowed to participate in
the OMO. The role of Open Market Operations as a monetary policy tool went under
various evolutionary phases. From 1995 – 2004, SBP’s Monetary Operations were
focused on T-Bill Auctions with pre-determined schedule of fortnightly OMOs of fixed
tenors with no forecasting capability of market liquidity. The mechanism resulted in high
degree of volatility in Overnight (O/N) & short-term Money Market Rates. In 2002, pre-
determined approach was abolished and the conduct of OMOs was made flexible on as
and when required basis to counter unpredictability of cash flows (but tenors were in the
multiple of one week). These arrangements helped in better management of liquidity and
kept short-term interest rates as per monetary policy targets.

Page 15 of 37
The complete profile of OMO’s since 1999 is as follows: -

Table 7: OMO’s Conducted

FY01 FY02 FY03 FY04 FY05 FY06 FY07
Mop-ups 26 8 6 26 46 64 34
Amt in Bln 103.0 56.4 66.9 410.7 611.2 644.6 469.3
Injections 18 31 4 9 5 30 2
Amt in Bln 45.4 251.5 54.8 76.6 44.2 429.3 21.2
Total OMOs 29 36 10 33 51 94 36

To counter interim flows and reserve averaging liquidity, it was decided in April-2005
that broken-date OMOs could be conducted (from 01-day onwards). This measure helped
SBP in managing market flows effectively and bringing short-term rates in line with
Monetary Policy objectives.
During 2005, SBP Treasury
introduced Money Market
Computerized Reporting System
(MM-CRS) for Banks which not
only helped in assessing the
Market Liquidity, but also helped
SBP to have a better grip on
Market Gaps and interbank
activity, thus strengthening the
market management capability of
SBP's through better forecasting.
These arrangements have so far
being helpful in curtailing market
volatility to a greater extent.

O/N Rates –Movements:

This is also evident from the SD and CV numbers for FY 2004-05, 2005-06 and 2006-07.
Table 8:
O/N Rates FY05 FY06 FY07
Average % 3.95 8.07 8.01
SD 2.33 0.75 0.97
CV 0.59 0.09 0.12

Repo/Call/Outright: - One of the strength of MM in Pakistan is its Repo Market that is

the largest in the region due to its volume. This facilitates MM players to match their
funding/securities requirements on short-term basis. Along with this non-collateralized
lending/borrowing market (Call) is also very active. However, the Outright Market
mostly remains in the vicinity of 10% of Repo volume. The spread between Repo and
Page 16 of 37
call market usually remains within a margin of 5-10 bps. In the last two years better
liquidity management of the SBP has brought stability in the rates in Repo/Call/Outright
markets.

Table 9: Secondary Market Transactions

Volume (PKR in billion) % of Total
Type
FY07 FY06 FY05 FY07 FY06 FY05
Outright 753 488 575 6% 5% 8%
Call 1,999 1,173 1,371 16% 13% 19%
Repo 8,590 6,842 5,100 68% 74% 70%
Clean 1,286 702 248 10% 8% 3%
Total 12,628 9,205 7,294 - - -

Discount window activities:

Through this window SBP provides funds to the banks as lender as last resort. This is
done through 3 day Repo arrangement but effectively market prefers to avail this kind of
borrowing on O/N basis. Further this also provides interest rate signals in addition to
signals given through MTB auction. Historically, the role of discount rate as a ceiling to
cap overnight interest rates has remained very effective.

Discount Rate as Ceiling for

O/N Repo Rate:

The role of DR as an interest

rate signal/direction has seen
various stages of effectiveness.
During the period of high
interest rates (before 2002), it
was effective in giving
monetary policy and interest
rate signals and MTB cut-offs
and sovereign yield curve used
to mimic changes in the
discount rate.

After 9/11 and in the wake of

huge foreign inflows, the
discount rate reduced gradually
to indicate monetary policy
stance. Since a decrease in
discount rate was always
followed by big drops in MTB
yields hence this gradual
process was followed in very
cautious manner. During this
period November 2002- August,
2003, consistent decline in MTB
yields took place, though SBP picked up large amounts in auctions. Normally the spread
Page 17 of 37
between discount rate and MTB yields remain within a range of 200 bps, but during this
period it went up to 600 bps.

The situation as such made the discount rate insignificant and market started to look for
some other explicit interest rate signal and consequently, 6-month cutoff yield emerged
as the major monetary policy signal during this period. The role of discount rate at that
time was dormant.
However, onwards Table 10: Discount Window Facility (PKR Billion)
August 2003, with MTB FY03 FY04 FY05 FY06 FY07
yields picking up, No of Occurrences 65 11 60 125 74
discount rate once again Volume in billion 688.9 46.5 521.4 762.3 687
gained its importance.
Since SBP has now started using OMO as more effective tool 2005 onward, so obviously
one can question that consequent to this occurrences of resorting to this activity should
have been dropped down. However this did not happen and cannot happen till monetary
policy execution framework in Pakistan is changed by adopting some other framework to
manage interest rate (currently it is being done by targeting monetary aggregates that are
not proving effective particularly when the Central Bank has no clue about Government
outflows/inflows i.e. Main component of MM flows).

FX Market activities:

FX market interventions Table 11: Impact of FX Interventions in

by SBP either in form of Money Market (PKR in billion
ready or swap have great FY05 FY06 FY07
impact in the money Impact in PKR in
market as either inter-bank millions (Mop up) (74,860) (119,342) 11,551
market goes liquid or short
in PKR being counterpart of USD. SBP undertakes these operations to achieve objectives
to impact MM liquidity, Exchange rate or Forward premiums in FX market.

Equity Market:
Equity Markets has remained buoyant during last three years and its shares in GDP have
jumped from 10% in 2002 to 36% in 2006. Equity markets have played an important role
in mobilizing domestic and foreign resources and channeling them to the most productive
medium and long term uses. Since these funds are not intermediated therefore it is
desired that the resource allocation should be more efficient. In Pakistan capital market
includes:

An Intermediated financial system dominated by NBFC’s. The performance of three

stock exchanges in Pakistan i.e. KSE, LSE and ISE can be viewed from Table 12.

Page 18 of 37
Table 12: Performance of Stock Exchanges in Pakistan

FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07
Karachi Stock Exchange
Total Listed 773 765 762 747 712 702 668 659 658 655
Companies
New 2 - 1 4 4 2 16 15 14 11
Companies
Fund Mobilized 2.2 1.6 0.4 3.6 15.2 23.8 4.2 54 41.4 22.3
(Rs. Billion)
Total Turnover
of Shares (in 15 25.5 48.1 29.2 29.1 53.1 97 88.3 104.7 33.5
billion)
Lahore Stock Exchange
Total Listed
- - - 614 581 561 647 524 518 519
Companies
New
2 1 2 3 3 2 18 5 15 7
Companies
Fund Mobilized
0.3 - 0.4 2.5 14.2 4.1 3.1 42.1 24.5 7
(Rs. Billion)
Total Turnover
of Shares (in
5.6 9.8 1.6 7.8 18.3 28.2 19.9 17.5 15.1 5.6
billion)
Islamabad Stock Exchange
Total Listed
- - - 281 267 260 251 232 240 240
Companies
New
2 1 0 5 3 1 8 5 6 6
Companies
Fund Mobilized
11.3 5 .0 0 0.8 3.7 11.5 2.6 27.6 - 12
(Rs. Billion)
Total Turnover
of Shares (in
0.5 3.3 3.1 1.4 2.7 2.1 1.4 0.7 0.4 0.04
billion)

Table 13: KSE-100 Historical Highs and Lows

KSE-100 FY03 FY04 FY05 FY06 FY07
Index High 4606.0 5620.7 10303.1 12273.8 13772.5
Index Low 2356.5 4473.3 6220.3 8766.9 10066.3
Change-% 95 26 66 40 36

Page 19 of 37
Performance wise equity market in Pakistan looks highly lucrative in the group of
emerging economies, however its
volatility as depicted through lows Table 14: Performance of Global Stock
and highs in its indices is causing Markets during FY07
problems and has invited attention Index (in local currency terms)
of its immediate regulators (Stock Country 30-Jun-06 30-Jun-07
% Change
Exchanges) and apex regulator in USD
(SECP) to take appropriate steps. Pakistan 9,989 13,772 37.6
Some of these are as follows. India 10,609 14,651 56.4
Taiwan 6,704 8,883 30.8
1. COT/Badla financing have Hong Kong 16,268 21,773 33.0
been replaced with Malaysia 915 1,354 57.0
continuous funding system Japan 15,505 18,138 8.7
(CFS) since august 22, 2005. China 1,672 3,821 139.9
This is an interim arrangement to enhance market liquidity and would end on
alternate mode of leverage financing i.e. margin financing.
2. To protect investors and curbing market abuse, the proprietary trading regulations
have been amended.
3. Listing regulations have been brought in line with code of corporate governance.
4. For protection of investors trading via account of other brokers have been barred.
5. Futures contracts have been standardized with multiple durations i.e. for 30, 60
and 90 days.
6. Risk management governance and transparency measures have been brought in
i.e. providing margin verification system, exit mechanism, regulations for good
governance and disclosure in future market.
7. Unique identification numbers have been developed by the central depository
company for each investor.
8. KSE has introduced free float index as KSE-30 sensitive index to represent the
market on free float rather then the number of outstanding shares.

Pakistan’s equity market performance was not good when compared to other emerging
markets of Asia. As shown in the accompanied table, Pakistan ranked amongst the worst
performing market by posting a dollar gain of only 3% in 2006 versus MSCI EM return
of 29%. In fact, Pakistan’s performance was slightly over stated as it also includes
dividend yield of approx. 6.0% in 2006. Pakistan has a “total return” Index compared to
most of regional indices which do not include dividends.

Page 20 of 37
Bond Market (Government &
Table 15: Asian Emerging Markets
Corporate Bond Market):
US$ Return
Country Index
Bond Market is composed of Pakistan 2006
Investment Bonds of 3, 5, 10, 15, 20 and China SSE A 138.3%
30 year maturities Corporate bonds Indonesia JSX 69.9%
(Term Finance Certificates), Sukuks and Philippine PSE 54.1%
Commercial Paper. Overall this market India SENSEX 49.3%
is 5% of GDP at the moment which is Sir Lanka CSE All 34.6%
very small as compared to other Malaysia KLCI 30.4%
economies. Taiwan TWII 20.3%
Korea Kospi 13.0%
Government Bond Market: Thailand SETI 10.1%
Pakistan KSE-100 3.2%
Volume of Govt. bonds market in Table 16: Outstanding Amount of Securities
Pakistan can be seen from Table 16. (Rs. In Billion)
June 04 June 05 June 06 June 07
Main features of government bond
market in Pakistan are as under: PIB 331.65 307.60 303.87 352.52
• Bonds are issued in 3, 5, 10, FIB 33.54 14.59 6.64 2.15
15, 20, and 30 years tenors. Total 365.18 322.19 310.51 354.67
• Bonds are issued through
auction system in which only Primary Dealers (PDs) can participate.
• Issued at Par.
• Coupon payments are made semi annually.
• Bonds are issued in the form of un-certificated bonds and are maintained in
SGLA maintained by the SBP.
• Bonds are SLR eligible securities and individuals, institutions and corporate
bodies including banks can purchase, irrespective of their residential status.
• Bonds are tradable in secondary market.
Corporate bond Market:

Main features of the corporate bond market in Pakistan are as under:

1. The corporate bond in Pakistan is in form of Term Finance Certificate (TFC).

2. TFCs are based on legislation enacted in 1984, which authorise issuance of
redeemable capital securities. As a debt instrument TFC is slightly different from
the corporate bond because it was specifically designed to comply with Shari’ah
law. The key difference is that the TFC substitutes the words “expected profit
rates” for “interest rate”.
3. TFC issuers include both NBFIs as well as public and private firms.
4. The coupon rates on the TFCs display a wide variety with different fixed coupons
as well as floating coupons linked to various interest rates including the discount
rates, PIB rates and the KIBOR.

Page 21 of 37
Table 17: Term Finance Certificates
FY No of Coupon Range Volume (Million Matured Outstanding
1995-00 11 16.25% - 19.00% 9,890 460 9,430
2001-03 50 8.00% - 11.25% 48,694 2,450 46,244
2004 4 7.00% - 16.00% 2,700 1,601 59,683
2005 14 4.47% - 14.30% 16,100 7,080 70,305
2006 9 10.66% - 13.42% 18,135 3,840 80,088
2007 10 12.07%-13.06% 11,650 22,402 84,767
Total 98 ----- 107,169 15,431 -

Sukuk (Shariah Compliant instrument) Market: -

Sovereign Sukuk market does not exist in Pakistan, though GOP has floated a Sukuk in
the international market in 2005 that fetched US$ 600 million at 6 months Libor+
220bps. The concept used in
Table 18: Corporate Sector (Sukuk)
this issue was Ijarah
(Leasing). SBP in this regard Rupees
Issuer Tenor Return
has proposed a product for in million
the domestic market based on Sitara Chemicals 5 years Variable
350
Ijarah concept. Moreover, to (Musharkah)
fulfil the needs of short-term Variable
Al Zamin Lease 5 years 275
(Mudarbah)
instrument having T-Bill
6 month KIBOR+
features, a hybrid product WAPDA (Quasi) 7 years 8,000
35bps
(Combination of Ijarah and
Murhabah concepts) has been proposed to the GOP.
On Corporate side three Sukuks have been issued as under:-
Commercial Papers:
Commercial Paper (CPs) is an unsecured tradable instrument used by highly rated
corporate entities to raise short tern working capital. It is usually sold to cash rich
financial institutions which have an appetite for short term MM instrument. CPs are
discount instrument like T-Bill and are issued in the form of promissory note. They can
even be traded in the secondary market; however secondary CP market is not yet
developed in Pakistan.

Derivative Market:
Derivatives business started in Pakistan in 2003 when Citibank Pakistan entered into a
Forward Rate Agreement with its client with prior permission of SBP. Since then banks
have executed thousands of derivative transactions mostly in the Foreign Currency (G-7
currencies only) Options, Forward Rate Agreements and Interest Rate Swaps. Dealing
into any other structure requires prior SBP approval on case-to-case basis.

Page 22 of 37
 The basic purpose of permitting banks to undertake derivatives is to enable the market
participants and/or corporate to hedge their exposures in the financial markets. However
since the market is at a very nascent stage therefore it was decided that initially Financial
Derivatives Business Rules (FDBR) issued by the SBP would cover only the vanilla
structures and Banks who wish to enter into non-vanilla structure would take SBP
approval.

5. Debt and Foreign Exchange Reserve

Gradual but persistent increase in reserves has taken place due to proactive monitoring
and liaison with inter-bank market, effective exchange rate management, minimizing the
exchange volatility, wining back the confidence of investors, implementation of new
computerized systems to keep complete track of FX cash flows and removal of
abnormalities in the Kerb market. FX reserves improved to such an extent that the State
Bank of Pakistan decided to opt for outsourcing a portion of reserves in 2002.

Table 19: Reserves V/S External Debt

FY02 FY03 FY04 FY05 FY06 FY07
15,61
Liquid Reserves US$ 6,432 10,719 12,328 12,618 13,137
million 1

Reserve to GDP % 8.77 14.62 14.77 11.44 10.24 10.76

Reserve to External Debt 19 32 37 37 37 39
%

Reserve Management function would continue to remain an area of high priority in the
years to come in order to achieve goals to bring SBP in line with the best practices of
other Central Banks in the area of Reserves Management

6. Foreign Direct Investment Inflows:

Flow of foreign direct investment (FDI) is an important indicator of economic
performance as well as the economic prospects of an economy; on the one hand, FDI
reflects the investors’ confidence in an economy, and on the other hand it provides the
required funds to capital deficient economies.

Table 20: FDI Flows in Pakistan

FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07
Billion
0.6 0.5 0.55 0.45 0.55 0.8 0.9 1.7 3.3 5.1
USD

During FY06, FDI flows into Pakistan sustained its trend. This reflects the improved
macroeconomic fundamentals and relative policy stability, while privatization proceeds
have registered an unprecedented rise to US$ 1.5 billion mainly on account of
privatization of PTCL, KESC and HBL.

Page 23 of 37
PART II
DEVELOPMENT OF THE BOND MARKET
1. General Overview;
Government Bond Market:
The Debt management reforms in early 90’s in conjunction with monetary management
measures resulted in establishment & development of well functioning primary &
secondary market for short as well as long term government papers.

In 2000 the State Bank of Pakistan introduced new long term GOP paper “Pakistan
Investment Bond” (PIB) with maturities of 3, 5, 10 years by replacing Federal Investment
Bonds (FIBs) having same maturities. The FIBs were discontinued in 1998.

To streamline the auction of government securities and to develop secondary market for
the government papers, SBP introduced selective Primary Dealer (PD) system in 2000.
Scheduled banks/DFIs/listed Brokerage Houses of good repute were selected under this
distribution mechanism as PDs. Currently there are 10 PDs including one DFI and one
brokerage house. Inception of auctioning mechanism coupled with PD system have
resulted in the development of secondary market for both short- and long-term
government securities and efficient price-dissemination mechanism improving overall
efficiency of Bond and Money Market.

In 2001 KIBOR/KIBID rates were introduced up to 6 months to provide interbank call

money curve. This was in addition to PKRV curve already introduced in the market by
Financial Market Association (SRO representing market) and used for revaluation of
Government Securities up to available tenors. In 2004, all corporate lending by banks
were made to be benchmarked to KIBOR. This created significant transparency in Fixed
Income Market. In 2003, non-competitive bid option was introduced in PIB auctions to
facilitate retail investors to access PIB at weighted average yield arrived at in the auction.
In 2003, to make Government Debt, Market based, NSS rates were rationalized by using
PIB rates as benchmark. To create liquidity in the Government Bonds market, two Jumbo
issues were floated in 2003 and 2004.

In 2004 KIBOR/KIBID was extended, further to 3 years to create benchmark rates

available up to this extent to the Fixed Income Market. In 2004, Yield curve was further
extended up to 20 years through introduction of 15 and 20 years PIBs. This provided
benchmark rates to mortgage /long term financing market in Pakistan.

In 2005, SBP introduced a system of performance measurement for PDs to ensure their
full role in creating liquid bond market in Pakistan. In 2005, SBP also facilitated market
participants in developing Government Bond Indices in Pakistan. Currently three indices
representing Total Return and Clean Price indices are being quoted by two brokerage
houses and Financial Market Association (FMA), body representing Treasuries of the
banks. With the development of Fixed Income Securities market in Pakistan, SBP
allowed Commercial banks to make available Derivatives products to their clients. In this
regard SBP issued guidelines on Forward Rate Agreements (FRA), Interest Rate Swaps
(IRS) and Currency options in 2005.

Page 24 of 37
Corporate Bond Market:

Foundations of the corporate bond market were laid in 1995 with the first issue of Term
Finance Certificates. Since then issuance of listed TFCs has totaled approximately PKR
80 billion A combination of factors resulted in the issuance boom in the past five years.
Amongst those were de-regulation of the banking sector, lower interest rates, availability
of benchmarks for both fixed and floating rate debt, active inter-bank trading markets in
government securities, coming of age for mutual funds, etc.

Corporate bond market in Pakistan is smaller in comparison to many equivalent rated

economies (less than 1% of GDP) although the situation is improving. The reduction in
interest rate volatility during 2005 brought life back into issuers. Issuers appear less
perturbed by higher rates than by volatility. Hence, 2005 and 2006 remained good years
in terms of the number of issues and volume of issuance.

Sukuk Market:
Immense growth in Islamic banking industry during the last four years has necessitated
for emergence of Sukuk (Shariah complaint instrument) market in Pakistan. However till
this day only three issuances have come into the market and that too from the corporate
side (See Part I for details). GOP Sukuk has yet to be issued that is being awaited as it
would in-fact provide yield curve for future Sukuk issuances.

Commercial Paper:

SBP and SECP issued guidelines for their issuance three years back. The tenor of
commercial papers is 3, 6 and 9 months. The Corporates can issue CPs on attaining
criteria i.e. equity of the corporate is not less than Rs 100 million, minimum credit rating
for short term CP should be A- and for long tenor A, it should have clean credit
information Bureau (CIB) report and as per the latest ended balance sheet report the
company maintains a minimum current ratio of 1:1 and a debit equity ratio of 60:40. CP
market is at very nascent stage in Pakistan. Packages Ltd was the first company to raise
working capital through CP.

2. Size, Structure & Market Liquidity

Issuance in Domestic Market (in local currency)

Table 21: Government Bonds
2001 2002 2003 2004 2005 2006 2007
Outstanding
46.12 153.8 228.6 331.6 307.5 303.8 352.52
(Rs in billions)
No of issues 11 12 3 5 1 3 5
Coupon%
3 years 10.5-12.5 7.0-10.5 6.0-7.0 6.0 6.0 9.1 9.1
5 years 11.0-13.0 8.0-11.0 7.0-8.0 7.0 7.0 9.3 9.3
10 years 12.0-14.0 9.0-12.0 8.0-9.0 8.0 8.0 9.6 9.6
15 years - - - 9.0 9.0 10.0 10.0
20 years - - - 10.0 10.0 10.5 10.5
30 years - - - - - 11.0 11.0

Page 25 of 37
Banks invested heavily in 10-years PIBs
(see Figure 10).followed by 5-years.
Investment in longer terms PIBs is still
mainly because they have been introduced
in recent past. We except more invest in
longer term PIBs in future as the market
matures.

The number of listed TFCs remained low

compared with FY01 and FY02 mostly
because corporate preferred to borrow from
the banks/non-banks due to its cost
considerations. Similarly, Issuance of
commercial papers also remained thin due
to high cost in its issuance.

Issuance in External Market (in foreign

currency)

On external sector GOP floated three of its

Sovereign Bonds including one Sukuk to
make its presence on the radar of
international debt market. The significant
achievement on this front is successful
auction of 30 years bonds at competitive Table 22: Turnover ratio (Rs in billion)
price. This has paved the way for Corporate
in Pakistan to access international debt Annual
PIB
market. Year Turnover Turnover
outstanding
(Time)
Pakistan floated its bond for the first time in FY05 307.60 2,124 6.91
1994 and then in 1997 to the amount of FY06 303.87 1,351 4.45
USD 610 million (US$ 150 million on 22- FY07 352.52 1,131 3.21
12-94 at 11.5%, US$ 160 Table 23: Sovereign Bonds Issuance in Global Market
million on 26-2-97 at 6% & US$ (In million US$)
300 million on 30-5-97 at 6 FY05 FY06 FY07
Month Libor+395 bps) however Amount Coupon Amount Coupon Amount Coupon
in 1998 on detonation of atomic EURO
bomb Pakistan was left with no Dollar 5 500 6.75% - - - -
position to repay them on their Years
maturity. So they were 6M
restructured at high premium i.e. SUKUK 5 - - 600
LIBO
- -
Years R+220
10% interest rate with final
bps
repayment in December 2005. EURO
7.125
Dollar 10 - - - - 500
%
Pakistan reverted back to the Years
international capital market in EURO
7.875
2004 with better credit rating Dollar 30 - - - - 300
%
Years
emanating from its improved

Page 26 of 37
macro economic indicators. Currently its Sovereign rating by Standards and Poors is B+
(Foreign currency) and B for short term and BB for long term
(Local Currency).

This process seems likely to Table 24: External Liabilities against Bond Issues
continue to keep Pakistan’s FY02 FY03 FY04 FY05 FY06 FY07
presence in the international
Volume in
Capital Market for developing its 620 465 810 1225 1900 1905
million USD
domestic bond market as well.

3. Bond Market Infrastructure:

SBP manages Government Securities market on behalf of the GOP, whereas SECP is
responsible for Corporate Bond Market. Both are autonomous bodies.
Trading and Settlement System: - Government Securities are exchanged through
depository of State Bank of Pakistan or through its Public Debt Offices in case the
security is in physical form. Equities and corporate bonds are exchanged through
computerized books maintained by Central Depository Company constituted under
Central Depositories Act, 1997. Funds are transferred through clearing system catered by
SBP. Securities are held and transferred in accounts maintained at Central Depository
Company of Pakistan on delivery versus payment at T+3 arrangements for Corporate
Securities. State Bank depository is providing settlement at T+0 arrangements for
Government Securities. National Clearing Company Ltd (NCCL) providing settlement
for equity trading would undertake Corporate Securities cash settlement in future.

The efforts are in hand for implementing RTGS system in Pakistan by the SBP.
Law: - For government securities issuance, profit payment and redemption, State Bank
Act 1956, Banking Companies Ordinance 1962, Public Debt Act, 1944 and Public Debt
Rules, 1946 are the relevant laws. For equity and corporate bonds issuance, Company
Law, Trust Act 1882, SECP Act 1997 and Securities and Exchange Ordinance 1969 are
relevant. The work is in hand with the Banking Commission for bringing reforms in
banking laws and SECP for modifying Capital Market Laws.

Investor Base (Individual/Foreign/Institutional Investor):

The efforts are in hand to bring about level playing field for all types of investors in
Pakistan. However, their present status is as under:

• The retail market meant for individual investors is weak in Pakistan. For easy
investment, either the individual investors have to resort to national saving
schemes or deposit schemes in the banks. However, immense volatility in interest
rates during couple of years has restricted their options which have to be
addressed by the regulating authorities.
• After discontinuation of investment by the institutional investors in the saving
schemes, Government has now provided them the long term bond viz. Pakistan
Investment Bonds. The other avenue for them can be the corporate bond market
which has started to take off within a period of last ten years.
• Foreign investors are allowed in Pakistan but their less presence denotes that the
investment policies are not perfect to the liking of foreign investors. In Pakistan,
capital account convertibility is not allowed nor did the reserve position of the
Page 27 of 37
 country allowed to go for such luxury in the past. However, the matter can be
addressed by allowing certain other incentives, like floating of exchange/inflation
linked bonds as have been experienced in other countries or by offering tax
incentives.
• Issuance Strategy: - In Government Securities market the T-Bills are issued on
fortnightly basis whereas PIBs are issued on quarterly basis; however no prior
announced calendar exists. PDs serve the distribution channel for Government
securities whereas Corporate Bonds are issued after taking approval from the
SECP and on getting rated from the Rating agencies and finally on listing from
the Stock Exchanges. Banks/ Asset Management Companies/Brokerage Houses
serve as manager for their issuances.

Table 25: Tax Structure

With holding Tax
Capital Gain Stamp Duty
Corporate Individual

Government
10% 10% - -
Securities
Corporate 0.15% (initially)
10% *10% -
securities 0.10% (Transfer)
*For amount above 0.150 million

Table 26: Accounting & Auditing Standards

Accounting standards to be Organizations that set the
applied to bond issuers accounting standards
IAS as per SBP Act 1956 and Institute of Accounting
Government Securities
BCO 1962 Standards of Pakistan (ICAP)

IAS as per Companies

Corporate securities ICAP
Ordinance 1984

Benchmarks: - Sovereign curve exists for 30 years. KIBOR Curve, reflecting clean
market, from 7 days to 3 year exists. PKRV curve up to 30 years and IRS Curve up to 10
years also exist.

Local Credit Rating Agencies:

There are two local rating agencies in Pakistan namely PACRA and JCR-VIS.
PACRA was established in 1994 as a joint venture between IBCA Limited (the
international credit rating agency), International Finance Corporation (IFC) and the
Lahore Stock Exchange. To date, PACRA has completed well over a hundred ratings,
including major industrial Corporate, financial institutions and debt instruments. In
addition to local ratings, PACRA has also successfully completed two international rating
assignments in collaboration with Fitch.

JCR-VIS is operating as a “Full Service” rating agency providing independent rating

services in Pakistan since January 2001. JCR-VIS is a joint venture between Japan Credit
Page 28 of 37
Rating Agency, Ltd. (JCR) - Japan's premier rating agency, Vital Information Services
(Pvt.) Limited (VIS) – Pakistan’s only data bank and financial research organization,
Karachi Stock Exchange and Islamabad Stock Exchange.

Government Efforts to Develop Capital Market:

Regulatory Framework:

SBP is responsible for monetary policy and managing government securities market
whereas SECP caters for corporate securities market. Autonomy extended to SBP and
SECP and with their automation a well-placed regulatory framework is already there for
securities market in Pakistan.

Clearing and Settlement System:

The importance of the payment and settlement systems mainly stems from their role in
the financial sector. Following the financial sector reforms that had targeted reducing
financial risks and increasing reliability and speed, the payment and settlement systems
have changed to a large extent.

To provide an efficient clearing facility Inter-Bank Clearing of Paper Based Instruments

State Bank of Pakistan has outsourced this activity to National Institutional Facilitation
Technologies (Pvt.) Limited (NIFT). NIFT has established centers in 14 cities and also
provide services as Local US Dollar Instruments Collection and Settlement System and
Society for Worldwide Inter-bank Financial Telecommunication (SWIFT).

The RTGS System named PRISM (Pakistan Real-time Inter-bank Settlement

Mechanism) is ready to start function in August 2007 which will automate the current
manual inter-bank settlement process of large value payments at SBP. The PRISM will
provide platform to commercial banks for settlement of inter-bank transactions in real
time mode. Moreover, SBP has also prepared a draft law called Payment Systems and
Electronic Funds Transfer Act and sent it to the Federal Government for enactment.

SBP/CDC depositories for government and corporate securities respectively work on

DVP with settlement at T+0 and T+3 respectively.

4. The Rationales for Developing Domestic Bond Market

Benefits of Having a Well-Functioning Bond (Government and Corporate Bond) Market

are:
o Linking issuers having long term financing need is established with investors
willing to place funds in long-term interest bearing instruments.
o Government Bonds provide benchmark yield curve and help establish the overall
yield curve.
o At macro economic level it provides an avenue for domestic funding and budget
deficits other than by central Bank.

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 o It helps implementation of monetary policy, including achievement of monetary
targets or inflation objectives through use of market based indirect monetary
policy instruments.
o Funding of Government Budget deficits on market-oriented funds reduces the
debt servicing cost over the medium to long term through development of a deep
and liquid market of Government Securities.
o At micro economic level development of securities market helps change the
financial system from bank-oriented system to multi layered system where capital
markets can complement bank financing.
o The development of bond market forces the financial intermediaries to develop
other products like Repo, Structured finance and Derivatives.

Motivations for Developing Domestic Bond Market:

Challenges and Strategies to Develop Well-Functioning Bond Market:

Basic pre requisites for developments are: -

(a) Credible and Stable Government.

(b) Sound fiscal and monetary policies.
(c) Smooth Exchange Rate and Capital Account Policies.
(d) Effective legal, Tax and settlement system.
(e) Smooth and Secure settlement System
(f) Liberalized financial system with competing intermediaries.

The strategies and techniques in bringing developments and reforms need to be properly
sequenced and phased; otherwise they can hamper the overall objectives of reforms. In
Pakistan the pre 1990 era was bit slow, however post 1990 era was amply fast which
brought distortions in some areas of Financial and Capital Market developments. It has
been experienced time and again that liberalization of financial markets can not bring
good results till it is followed with tailored made regulatory framework. The Mexico,
Brazil and Asian financial market crisis have made it abundantly clear that moving ahead
in financial market developments are to be based upon necessary regulatory framework.

Challenges and Strategies to Develop Well-Functioning Bond Market:

Factors Hindering Bond Market Development:

o Fiscal and Trade Deficits.

o Law and order problem.
o Cross border tension
o Bad Governance, lack of accountability on the part of bureaucracy, Public and
Private Sector institutions.
o Ineffective Implementation of law and delay in adjudication.
o Lack of market expertise.
o Lack of awareness of new financial products.
o Lack of infrastructure and automation.
o Lack of stringent regulatory policies and their effective enforcement.
o Lack of self-policing system in the market.
o Lack of awareness of market ethical values.
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 o Political interference in the regulatory functions.
o Clear laws curtailing clear interpretations.
o Inconsistent supply and small size issues of Government Bonds.
o Corporate Bond Market being not cost effective due to stamp duties levied by the
Provincial Governments on their transactions and certain fees to be paid on their
issuances and time taking procedures for their approval.
o Non issuance of Sovereign Sukuk
o Transaction cost as Stamps duties on Commercial Paper making them non cost
effective.

Past Efforts / Recent Initiatives:

Since its inception in 1990, Bond Market in Pakistan has witnessed lot of initiatives.
Some are as follows: -
o Sale of government securities auction based through introduction of 6-month
market treasury bills in 1990. 3 and 12 months MTBs were introduced in 1997.
o Government borrowing from SBP made market based.
o Liberalized current account restrictions
o Introduced OMO in place of direct controls to manage liquidity and interest rate
in the money market
o Introduced 3-day repo as lender as last resort facility
o Federal Investment Bonds were introduced in 1992 to provide yield curve up to
10 years maturity
o Extended depository arrangements by the SBP for government securities in form
of Subsidiary General Ledger Account (SGLA)
o Established Securities and Exchange Commission of Pakistan (SECP) as an
autonomous body
o Introduced Selective Primary Dealer System in 2000
o Introduced Pakistan Investment Bonds in 2000 in place of FIBs that were
discontinued in 1998
o Introduced Jumbo Issue of PIBs and Non-competitive Bidding Option for active
PIB trading in secondary market.
o Established Central Depository Company to introduce scrip-less trading in
shares/Corporate Bonds.
o Introduced PIBs of 15 and 20-year tenors in Jan 2004 that has now been extended
up to 30 years.

Recent initiatives that are yet to materialize include allowing bond strips against PIBs,
listing of Government Securities on Stock Exchanges, calendar for Government
Securities issuances

Roadmap (Plan/Strategy) for the Development of Bond Market (Financial Sector):

There cannot be any doubt that financial system of Pakistan has a lot of potential,
however, it is to be searched and put in place. Another angle, which needs to be brought
into the system, is to integrate it with global financial system. The vision, which anybody
can have in the market for the future financial system of Pakistan, can be briefed as
under:
o It has to be market based

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 o The market should have its own policing system in addition to Regulatory
framework.
o Development of new hedging products like derivates.
o Updating of accounting/auditing and reporting system in line with the
international standards.
o Fully automated financial system.
o New Government Securities Act to replace out dated Public Debt Act 1944.
o Listing of Government Securities on Stock Exchange to widen investor base.
o Implementation of Real Time Gross Settlement System to mitigate systemic risk
in fund settlement.
o Bond Stripping to create liquidity in the bond market and to induct zero coupon
yield curve.
o To foster growth of corporate Bond market in Pakistan by making it cost
effective.
o To develop Trading/Risk Management/price dissemination mechanism for
Corporate Bond Market.
o Financial Institutions to have controls i.e. Clear Strategies of duties at all levels,
Dual Controls, Rotation of assignment of duties, Internal auditing of all
operations, Audit programs for external auditing, Operational reviews.
o Development of newly inducted Islamic Finance (See Box 1)
o Development of Investor base specifically Mutual Funds (See Box 2)
o Development of Sub National Bond Market in Pakistan (See Box 3)
o Development of Infrastructure/Mortgage Finance (See Box 4)

Role of the Central Bank / Government in Developing Bond Market:

Government is very keen to develop Capital Market in Pakistan. SBP and SECP, the two
main regulators of the whole financial system are bringing about reforms for the
development of capital market of the country in conjunction with GOP support. Recently
the main efforts made in this direction can be summarized as under:
Capital adequacy requirements have been raised for the participant institutions.
T+3 system has been introduced to make the system efficient. T+0 is already in vogue for
Government Securities.

Badla Financing has been replaced with Continuous Financing System (CFS) with
restriction on In-House CFS to curb speculative business in equity. Trading systems for
Corporate Bonds and Risk mitigating mechanism are in phase of development.
Derivative instruments have been introduced and their further development is on agenda.
The automation of SBP, Banking industry, Non-banking Financial Companies and stock
exchanges are at full swing.

RTGS system is in wake of Implementation. Legislation on Payment system and Future

Trading is in process of finalization at the level of GOP.

New Government Securities Act to replace Public Debt Act 1944 for Government
securities is under finalization. Further new Act for Corporate Securities to replace
Securities and Exchange Ordinance 1969 is also under finalization.
Supervision systems of SBP and SECP have been revamped.
Establishment of Commodity Exchange is in phase of Implementation.
Demutualization of Stock Exchanges is in process.
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Professional hands are being appointed at the management level of all institutions of the
financial system to take care of their affairs efficiently and diligently.
Training arrangements have been given new importance and new shape to refresh and
enhance the working capabilities of staff working in the financial institutions
State Bank has been made completely free to decide its monetary management policies.
SBP/SECP and GOP are providing full support in growth of
Islamic/Mortgage/Infrastructure finance.

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PART III
POLICY IMPLICATIONS FOR BOND MARKET (FINANCIAL
SECTOR) DEVELOPMENT:

1. Creating depth in money and securities market to improve the transmission channel of
monetary policy. This would facilitate investors/issuers to have better view of interest
rate movements. This includes introduction of SBP own instruments, review of
monetary policy execution framework to switch over to explicit interest rate targeting,
establishment of Market Stabilization Fund (an arrangement in which Government
share the cost of monetary policy operations with Central Bank), Capacity building of
DPCO, Projections of Government Cash flows.

1. Building up institutional and market microstructure for developing Government

securities market in Pakistan i.e. developing distribution channel through market
makers and dealers having expertise in securities business.

2. Keeping consistent supply of large size long-term Government instruments for

creating liquidity and proper yield curve. To achieve this goal, reopening, stripping
and fungibility need to be allowed.

3. Timely market information to the issuers as well to investors through data

dissemination.

4. Diversifying the investor base. The steps include development of Asset Management
Firms/Mutual Funds/Discount Houses to diversify investor base through legislative
support.

5. Containing crowding-out effect through reducing deficit financing for developing

Corporate Bond Market.

6. Creating appetite for bond market by supporting Islamic Fund Industry, Mortgage and
Infrastructure Finance initiatives.

7. Building Benchmark curves i.e. Revaluation, Clean, IRS, zero coupon curves.

8. Aligning Sub National/local Governments/Public Sector requirements with

Government Bond Market by providing them same infrastructure.

9. Reducing fees/Stamp duties on Corporate Bonds/Commercial papers to make them

cost effective.

10. Allowing Supranational Bonds in Pakistan to create liquidity in Corporate Bonds

Market and to have best international practices through their presence.

11. Attracting non-resident investors by providing them better opportunities to have

positive yields by extending some concessions like tax exemptions.

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12. New legislation aligned with current environment for Government as well Corporate
Securities Market.

13. Creating tax base on equity providing level playing field to all investors.

14. Allowing international depositories linked with domestic depositories for facilitating
international investors to invest in Pakistan.

15. Establishing cross border settlement mechanism. This would reduce cost of doing
business in own and with others markets.

16. Developing Derivatives market for facilitating investors/issuers to hedge the risks on
their portfolios.

17. Developing Bond Market in sequenced manner i.e. from simple to complex
instruments/infrastructure.

18. For developing above Government as well Regulators (Central Bank and Securities
Commission) to work together in devising policies and than coordinating in their
Implementation process.

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Box 1: Development of Islamic Instrument Market (IIM)
State Bank of Pakistan is in process of developing IIM in Pakistan. In this regard GOP
has already been suggested by the SBP to issue its domestic Sukuk (Islamic instrument)
for fostering growth of Sukuk market in the country. Further SBP is also working to
develop the Islamic inter-bank market in collaboration with Islamic Financial Services
Board (A body representing Central banks of various countries for developing Islamic
banking). For the time being main challenge is to have such Instruments that can be used
to generate short term liquidity and for their use as monetary policy instrument. SBP is
working for their issuance /documentation/Term structure and pricing dynamics. The
purpose is to build up Primary and Secondary Market of Islamic instruments in Pakistan
enabling level playing field for Islamic banks to ensure their future growth.

Box 2: Development of Mutual Fund Industry

Pakistan was the pioneer in the field of Mutual Fund Industry in the South Asia Region
when it launched National Investment Trust (NIT), an open ended Fund in 1962 followed
by the establishment of Investment Corporation of Pakistan (ICP) in 1966 which launched
a series of close ended Funds. However in the subsequent years it lost pace. Now there are
27 Asset Management Companies in Pakistan. They are managing 20 funds in close ended
sector and 26 in open ended sector with total net assets valuing Rs 167.921 billion. The
plus point about these funds are their aggressive marketing and innovative approach.
Further they represent private sector as compared to NIT and ICP which were Public
entities. However recent decision of GOP to allow institutional investors (including
Mutual Funds) to invest in NSS (Tap instrument) would no doubt affect their strategies. It
is likely that they may adopt passive approach for their investment by investing in NSS
that provides ensured return above PIBs (Market based security) with put option. So for
growth of Mutual Funds in Pakistan, Government has to refrain from taking such steps in
future.

Box 3: Development of Sub National Bond Market

Prior to 1990, Provincial Governments used to borrow directly from the market though
predetermined rates (In 1991 this borrowing was Rs 3.9 billion), however during post
Financial Market Reforms era of 1990, this practice was discontinued and since than these
Governments are meeting their funding requirements exclusively from the Federal
Government.
With emergence of devolution process and constitution of Local Governments to the gross
roots level, the realization is getting back that Provincial/Local Governments may be
allowed to arrange their funding requirements direct from the Market using the same
infrastructure as being used by the Federal Government for such purpose. The main issue
confronting this kind of arrangement is agency and moral hazard problems as revenue
generation systems complemented with accounting and other standards of these
Governments are not strong and in case of any default the burden would fall on the
Federal Government. One way to solve this issue is the use of Securitization/Islamic
Financing techniques where underlying asset is necessary for generating funds. This
would mitigate risks on such lending. However to make such arrangement workable, there
is a need to evolve a mechanism/system in this regard.
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Box 4: Development of Infrastructure/Mortgage Finance in Pakistan
Since 1995 some of the developing economies in Asia have been able to finance a lot
of their infrastructure projects, however they are still unable to a substantial level of
liquidity for these infrastructure related sub sovereign securities.
In this regard, efforts were made in recent years in Philippines, Vietnam, Indonesia,
Malaysia, China, and Japan which have brought some successes. India is also showing
remarkable progress in this regard. Due to its geographical location Pakistan has lot of
potential to develop these sectors. ADB in one of its recent surveys has indicated that
Pakistan would be able to list its infrastructure funds in equity market in 2008, Bond
market could fund the city or the fund if the bonds were secured by infrastructure
assets, however they viewed that structured funds would need another few years to
emerge. As good sign, housing finance has grown from Rs 19 billion in 2003 to Rs 63
billion in 2006 paving way for providing critical mass to lay down foundation for
mortgage financing in Pakistan. However to proceed in this area following points are
pertinent: -
1. Activation of domestic Capital Market to mitigate credit/market risks and for
creating market liquidity.
2. Legislative support to have regulations and monitoring standards/arrangements to
perform real time surveillance of ongoing progress regarding
Infrastructure/housing projects.
3. Leading Institution/s exclusively equipped to deal in this kind of finance. To
develop this expertise, agencies (ADB, IFC etc) interested to invest in these
sectors can provide helping hand and technical support.

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