The Future's Bright - Cash Management in Pakistan

Muhammad Ismail, HSBC Global Payments and Cash Management - 16 Oct 2003 Originally published in HSBC's Guide to Cash and Treasury Management in Asia Pacific 2003 Increased competition is expected to result in the continuing consolidation of Pakistan's banking sector and this appears to be having a positive effect on the market's infrastructure. Inter-city clearing has been introduced, while an automated clearing house and real-time gross settlement are expected in the near future. However, certain areas, in particular liquidity management tools, have clear scope for improvement. Pakistan's strategic location as the gateway to the central People who read this article Asian republics and its strong links with the Middle East also recently read: and South Asia make it a strong contender for foreign Email this article investment. The country has abundant land and natural resources; a cost-effective, English-speaking workforce; well-established rail, road and sea infrastructure; advanced recipient email: telecommunications and IT services; modern company law based on English law; and a large and growing domestic market. These are only a few of the factors that have attracted and continue to attract foreign investment to Pakistan. Economic Overview Following nuclear tests conducted in 1998, Pakistan fell subject to a number of restrictions imposed by a disgruntled world community. However, the country has managed to restore relations with its international comrades, thanks in no small part to its emergence as a frontline state in the war against terrorism following September 11. The improved standing of Pakistan has helped it to secure better terms for the restructuring of its USD12.5bn bilateral debt in its 2001 negotiations with the Paris Club. This was reflected in the upgrade of Pakistan's credit rating by Moody's. In November 2001, Pakistan was able to negotiate the Poverty Reduction and Growth Facility with the International Monetary Fund. The economy has improved during 2001-02 with GDP growth of 3.6 per cent - lower than the original target of 4 per cent but slightly higher than the revised target of 3.3 per cent. Per-capita income grew by 3.2 per cent (against zero growth in the previous year) and GNP by 5.4 per cent (against 2.2 per cent, mainly due to an increase in inflows of workers' remittances). The inflation rate declined to 2.6 per cent against a target of 5 per cent, and significant improvements were recorded in the external account and trade balance, resulting in a current account cumulative surplus of USD2,098m, and a decline in external debt and liabilities by about USD2bn.

Post-September 11 scenarios also led to an unprecedented increase in the liquid foreign exchange reserves (over USD6bn in June 2002). Although donor support to Pakistan for the war effort figures prominently in this build-up, the reverse capital flight and stronger inflow of worker remittances were significant. The latter was due to increased efforts to clamp down on the 'Hundi' network of parallel foreign exchange markets. Despite favourable external developments, the outlook on domestic growth, investment, budgetary revenues and employment still needs to improve. There were visible signs of a turnaround in the economy in the second half of fiscal 2002, but according to the State Bank of Pakistan (SBP), "it is too premature to declare victory". Any continuing turnaround is conditional on many factors, such as the performance of the textile sector, the size of the wheat crop, resumption of export business and more. Regulatory Framework and the Central Bank The SBP has evolved to become a progressive and dynamic central bank, actively involved in and responsible for the monetary and financial stability of the country. The SBP is the regulatory body for all financial institutions in Pakistan, and ensures financial health and clean banking practices through various checks and balances. Banks follow a code of conduct laid out by the SBP called the Prudential Regulations. The trend in Pakistan has been towards a liberal and deregulated economy whereby market forces control the foreign exchange rates on the interbank market, compared to the official rate of only a few years ago. Individuals in Pakistan operate their foreign currency accounts freely and can remit funds to or receive funds from anywhere in the world. Companies are bound by certain parameters and reporting requirements for foreign currency transactions - particularly with regard to repatriation of funds, which requires prior approval from the SBP. Banking Sector The banking sector in Pakistan has undergone comprehensive restructuring since 1997. Signs of improvement have been noted in some indicators under the SBP's supervisory CAMELS1 framework, which involves the analysis of six indicators to gauge the economic standing of financial institutions. These are: capital adequacy; asset quality; management soundness; earnings; liquidity and sensitivity to market risk. Nationalised Commercial Banks (NCBs) The performance of these state-owned banks, the largest segment of financial institutions, significantly affects overall banking industry indicators. However, the relative size of the NCB sector has declined during the past decade, mainly due to the entry of new banks, especially domestic banks. With growing competition from the private sector, the NCBs find it difficult to maintain their market share in terms of assets, deposits, advances and investments. However, significant profits have arisen from restructuring and induction of professionals. These banks are due to be privatised in the near future.

Domestic Private Banks The Banks' Nationalisation Act of 1971 was amended in 1991 to allow the private sector to open banks. Since late 1991, 21 new Pakistani commercial banks have commenced operation. The SBP has initiated a process of screening this sector by increasing the minimum limit of the paid-up capital for banks to PKR1bn by 31 December 2002. Foreign Banks Foreign banks operating in Pakistan play a significant role and lead the way in product innovations, new technology and customer services. They are also important in trade financing due to their global strengths, and approximately 30 per cent of Pakistan's total trade is transacted through them. In 1991, when resident Pakistanis were allowed to open foreign currency accounts, foreign banks tapped this segment by introducing new products and services such as credit cards, housing finance, ATMs, corporate loans for employees and automobile financing. Foreign banks also played an important role in assisting local corporations to access international capital markets. This sector has shown strong profitability; however, when foreign currency accounts were frozen in 1998, foreign banks were severely affected. In addition, they face stiff competition from local banks that were gaining strength in customer services, product ranges and technology. The ratio of non-performing loans to gross advances of this sector is 4.5 per cent. Between 1995 and 1999, the ratio of operating expenses to total expenditure was the lowest among all financial institutions. Bank Account Structure Resident and non-resident companies, individuals and charities can open local and foreign currency accounts in Pakistan. No interest is paid on current account balances, but relief in certain tariffs may be granted depending upon the credit balances in such accounts. Any company, individual or organisation can open a foreign currency account, with the exception of: airlines and shipping companies operating in/through, or collecting passage and freight in Pakistan; and investment banks, leasing companies and modaraba companies, - financial institutions using financing modes permissible under the Islamic Law - including those which have been granted licences to deal in foreign exchange. Furthermore, the following funds cannot be deposited in foreign currency accounts: any foreign exchange borrowed under any general or specific permission given by the central bank, unless otherwise permitted; any payment for goods exported from Pakistan; proceeds of securities issued or sold to non-residents; any payment received for services rendered in or from Pakistan; earnings or profits of the overseas offices or branches of Pakistani firms and companies including banks, investment of resident Pakistanis abroad; and any foreign exchange purchased from an authorised dealer in Pakistan for any purpose. In addition, corporate bodies or legal entities cannot generate funds from the kerb market the term used for licensed money changers - for deposit in their foreign currency accounts.

Overseas branches and correspondents of non-resident banks can open rupee accounts. The PKR accounts of non-resident persons, firms and companies are subject to the following rules. Clearing System The clearing system in Pakistan is governed by the SBP, which has 16 branches throughout the country. In areas where the SBP has no presence, clearing is managed by the National Bank of Pakistan. In Karachi, the clearing activity has been assigned to National Institutional Facilitation Technologies (Pvt) Ltd (NIFT), a joint venture between six banks and a number of private investors. In addition to Karachi, NIFT has recently extended its network to other major cities such as Lahore, Islamabad and Rawalpindi, and has also commenced inter-city clearing. Funds for intra-city transactions are credited into customers' accounts the next business day, and on the third working day for inter-city clearing accounts. NIFT provides a same-day clearing facility for cheques of PKR500,000 or more drawn on selective banks' branches located within a radius of four kilometres of the clearing house. Although automated clearing house and real-time gross settlement systems have not yet prevailed, the introduction of such infrastructure is anticipated in the near future. Foreign Investment Incentives and Taxation Issues Net foreign private investment from July 2001 to April 2002 stood at USD306m, an increase of 138 per cent compared to the preceding period in fiscal 2001. Although the projected foreign direct investment (FDI) was USD600m during the fiscal year, the investment climate in Pakistan was tarnished post-September 11. Despite such adverse circumstances, FDI rose by 18.8 per cent and reported an aggregate inflow of USD307.6m during the first 10 months of the fiscal year, against USD259m in the comparable period the previous year. Approximately 55 per cent of FDI was recorded in the oil, gas and power sector, followed by trade, transport, storage and communications (21.3 per cent), chemical, pharmaceutical and fertilizer (5 per cent), and electronics (4.9 per cent). Incentives include zero or low customs duty on imports of raw materials, plant, machinery and equipment (PME), and tax relief is available to local and foreign investments, particularly in value-added or export industries, high-tech and agro-based industries, and priority industries (as listed by Cabinet committee). Furthermore, the government of Pakistan has announced a considerable reduction in tax rates for companies. Cash Management Overview Foreign banks have been pioneers in offering cash management solutions to the corporate sector, identifying the needs and practices of their clients, and structuring payment and receipt services accordingly. They have been able to charge premiums in the past due to their initiative and technologically superior services.

Organisations can reduce costs by matching payments and receipts to eliminate overdrawn accounts, and can enhance revenue generation with timely application of idle funds. A sound, organised and controlled cash management model with a powerful electronic system to track the status of all payments and receipts can achieve this, and foreign banks still enjoy an edge in provision of such services. However, their dependence on NCBs and private banks for correspondent arrangements exposes them to reduced margins as these banks develop their own cash management functions. Banks send cheques drawn on another city to their branches located in that city, which present the cheques in the local clearing system and remit the funds to the originating branch through internal settlement procedures. In case a bank does not have a branch in the city of the drawee bank, the cheque is collected using the services of a correspondent bank (since most of the foreign banks have a limited branch network). The choice of a correspondent bank depends on the branch network, charges involved and quality of services. Until recently, the NCBs were the natural choice for the foreign banks. However, due to gradual expansion in their networks and superior service, the local private banks have been signed up as correspondents by some foreign banks. NIFT has recently started offering inter-city clearing facilities between the major cities of Karachi, Lahore, Islamabad and Rawalpindi. The expansion of the NIFT's inter-city clearing to other major cities of Pakistan in the near future could result in the use of correspondent banks for cheque collection in remote areas only. Similar arrangements are used for payments. Banks draw demand drafts on their branches or correspondent bank branches. In Pakistan, there is no electronic funds transfer structure for interbank payments in local currency or foreign currency. Local payments can only be made electronically intra-bank. Liquidity management tools are still in their infancy in Pakistan. As far as pooling and netting are concerned, the former is not allowed by the SBP while the latter is permitted locally, but cross-border netting is exposed to foreign exchange regulations. Cross-border sweeping/cash concentration is also subject to regulation. Electronic Banking and Internet Banking More and more banks are pursuing superior technology to remain competitive in the growing demand for e-banking. The Hundi network of foreign exchange remittance is publicly perceived to be trustworthy, efficient and offering better foreign exchange conversion rates. However, there is increasing pressure on the Hundi network as a result of the war on terrorism, and thus the need for a comprehensive electronic funds transfer network within Pakistan is more vital than ever. A step in this direction is the formation of the M-Net, a network of 112 ATMs countrywide, involving seven participating banks. The government of Pakistan and the SBP are actively working towards a viable ecommerce environment in the country. To achieve the necessary infrastructure, the Ministry of Science and Technology has established the E-commerce Working Group with

the following initiatives in mind: The Export Promotion Bureau, Ministry of Commerce, Corporate Law Authority, local trading companies and trade associations shall be linked together to form a trade network. The SBP, domestic banks, insurance companies and foreign banks shall form the financial network. The customs network will comprise Pakistani customs, customs of other countries, airlines, shipping companies, dry ports, airports, seaports, shipping agents, and clearing and forwarding agents. The SBP has already accepted a proposal to enable Internet merchant accounts, and a taskforce has been formed to set up an electronic clearing house for funds transfer. IT legislation is also near completion. At present, both web-based and WAP-based e-banking services are offered by foreign banks to their customers. Two local banks have signed up with mobile telephone companies to enable customers to view their account balances on their cellular phones. Other e-banking tools on offer include account balances, statements and advices, internal transfers, remittances, letter of credit opening, and reconciliation of overseas accounts. Looking Ahead Major changes are expected in the banking sector in Pakistan. Two large NCBs, The United Bank Ltd and Habib Bank Ltd, have privatisation plans in 2002, and other mergers and acquisitions are expected to take place due to the highly competitive environment. Consumer banking and e-banking will remain the areas of growth for banks as growing use of the Internet is leading to consumer awareness of non-conventional banking options. Overall, in line with current banking developments and provided the flow of foreign investment is maintained, Pakistan can look forward to a positive future