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* Says SBP will keep exchange rate flexible

Staff Report

ISLAMABAD: State Bank of Pakistan will keep exchange rate flexible and will increase the policy rate if inflation continues to exceed expectations.

International Monetary Fund paper on Pakistan said that monetary policy would continue to focus on combating inflation and strengthening reserves. Headline inflation (YoY) is expected to subside in the months ahead, but there is a risk that inflationary expectations may become more entrenched. In this context, the SBP has indicated that it would change the monetary policy bias toward tightening (and later signaled it in its March 27 decision) and, subsequently, it would increase the policy rate if inflation continues to exceed expectations. The SBP will keep the exchange rate flexible, which will help ensure that the accumulation of international reserves continues.

The SBP will also seek ways to broaden the government securities’ market and increase the space for private sector credit. In this regard, a reduction in credit related to commodity operations and the clearance of public enterprise debt (e.g., in the energy sector) will help. The SBP considers that additional space may come from the development of the debt securities market, including the use of the electronic bond-trading platform, which is expected to attract more non-bank investors to the government securities market.

Financial sector: Financial soundness indicators through end-December point to a steady, albeit slow, deterioration in banking conditions. Non-performing loans (NPLs) increased further in the last quarter of 2009, and regulatory measures adopted last fall to foster the restructuring of NPLs have not yet yielded the intended results. NPLs are generally adequately provisioned for, and banks remain profitable and generally well capitalized if the fraction of NPLs remains average. However, a few small banks and one medium-sized bank faced capital deficiencies, partly related to increases in minimum capital requirements and capital adequacy ratios. Most of these banks have agreed with the SBP on plans to comply with the increased requirements by mid-2010. These banks hope to solve their problems through mergers and fresh capital injections by foreign and domestic partners.

The exposure of Pakistani banks to Dubai World is reported to be limited to one bank that has adequate capital to absorb the possible losses. On a separate note, there are concerns about the qualifications of some bank managers and owners, as well as a generalized concern over governance (e.g., related to directed lending) in some public banks. The SBP intends to draw on its strengthened supervisory powers (arising from BCO amendments) to address these concerns.

The SBP is evaluating the modifications proposed by the Basel Committee to strengthen the regulatory framework. In many respects, the framework used in Pakistan already meets the proposed enhancement requirements, but the SBP will conduct a full impact assessment of the Basel Committee proposals in the near future. A preliminary assessment suggests that the introduction of the additional criteria would confirm that Pakistani banks are liquid and well capitalized and their capital is largely composed of Tier 1 capital, a large share of banks’ assets are held in liquid (government) securities, and their exposure to derivative products is very low.
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