Pakistan : Third Capital Market Development Program (Subprogram 1)

Finance / Finance sector development

1. A central objective of the government's economic development strategy, as reflected in 'Vision 2025 , is to elevate Pakistan's status from a lower-middle-income country to an upper-middle-income one by 2025. The government has targeted the generation of job opportunities and enhancement of income levels as top priorities. Achieving these objectives will require substantial investments of private and public capital to accelerate economic growth, and robust financial markets will help to mobilize these resources. The government has become increasingly aware of the need to institute appropriate reforms so that the financial markets can better intermediate savings and investments to drive future economic growth, in a fiscally prudent manner, and has approached ADB and other development partners for assistance. This is especially true given the fact that the government is currently implementing an Extended Fund Facility (EFF) Program initiated by the International Monetary Fund (IMF) in 2019 with tight fiscal deficit targets.

2. ADB's Strategy 2030 prioritizes the development of the financial sector and capital markets to support the development of the private sector and enhance financial stability. This program will not only support expansion of the private sector, but will also contribute to the operational priorities of (i) strengthening governance and institutional capacity through specific institutional strengthening reforms, and (ii) accelerating progress in gender equality through reforms that enhance participation of female investors. Facilitation of private sector investment is identified as a key driver of economic growth in Pakistan's endeavor to transform the economy into a competitive marketplace, and a strategic area for ADB support. This is not only reflected in the country partnership strategy for Pakistan (20152019), but has also been highlighted as a key area in the ongoing discussions between ADB and the government for country partnership strategy for 20202024.

3. Ineffective mobilization of savings. Pakistan's gross domestic savings to GDP ratio (5.2%) is at its lowest in over 3 decades and amongst regional peers (Bangladesh 25%, Sri Lanka 21%, India 28%). Underdeveloped financial markets have contributed to the ineffective mobilization of these resources. As a result, the infrastructure investment gap persists and impedes long-term sustainable growth.

4. Dominant bank-based financial sector. The financial sector is a dominant bank-based system that does not effectively play its intermediation role. Bank assets account for almost 70% of the country's total financial assets, while non-bank intermediation remains underdeveloped. The banking sector is not the most appropriate nor does it have the capacity to offer the long-term financing essential for private capital investments and infrastructure projects as they are weighed down by the risk of an asset-liability mismatch.

5. Coordination between the regulators is limited. The opportunities for reform begin with the financial market regulators. The most important of these agencies are the Securities and Exchange Commission of Pakistan (SECP), the State Bank of Pakistan of (SBP), and the Debt Management Office (DMO) at the Ministry of Finance (MOF). There is no updated strategic plan for financial market development and no forum for the key agencies to coordinate their efforts. Financial stability is compromised due to limited policy coordination and joint supervision of the financial system by the key regulators.

6. Weakness persists in governance structures. The SECP's operational and financial efficiency is constrained in terms of the opaque appointment process, absence of operations of the commission as a collegiate body, limited clarity in the role of policy board, non-exemption from income tax, and provision for surrender of surplus funds to MOF. The SECP's market surveillance system needs to be upgraded to ensure effective market monitoring. The enforcement effectiveness of the SECP is also challenged by the absence of a dedicated capital market tribunal as a result of which the pace of resolution of securities cases pending in the court system is slow. Further, the DMO faces structural capacity issues and does not function as a properly empowered treasury operation that develops and implements a consolidated administrative framework for debt management. The DMO is merely collating information and acting as a conduit to SBP government securities auctions. All decisions on terms, tenor and structure of debt are made on a fragmented basis across MOF. The DMO also does not possess a centralized database for effective cash management and planning. This exposes the government to a risk of default in the case of any volatility in demand in the auctions for government bonds. This is compounded by the fact that the country's Audit Oversight Body (AOB) does not have the operational and financial independence to effectively regulate the auditing profession in terms of its board structure, regulatory powers, and stable funding source.

7. The financial markets remain underdeveloped (reference is the Sector Assessment Report, which is accessible as a linked document in Appendix 2). Pakistan's financial markets currently do not play a significant role in financial intermediation and resource mobilization. The Pakistan Stock Exchange (PSX) lacks both depth in terms of number of investors and the number of companies raising capital. Fewer than 250,000 individual investors (less than 0.1% of the population) have a stock investing account. The absence of a centralized Know Your Customer procedure and cumbersome customer onboarding requirements impede participation of new investors in the financial markets. From 2015-19, only 25 companies raised capital at the PSX. Market capitalization of the PSX accounted for only around 16% of the country's gross domestic product in 2019. With 558 listed companies and $58 billion market capitalization, the PSX is below most of its regional peers in terms of market capitalization as a percentage of gross domestic product (GDP) (Bangladesh 12%, Sri Lanka 21%, India 41%). The accounting and auditing standards of listed companies are also unreliable and lack facts for informed investment decisions. Brokerage firm failures have occurred at an average annual failure rate of 2.7 since 2000 which adversely impact market confidence. The rules for listing on the PSX are still very restrictive and not a single company has listed on PSX's dedicated SME Board, despite Pakistan possessing a growing tech startup eco-system and more than 100 companies having collectively raised over $500 million in 2015-19 in the private markets. The depth and breadth of the financial markets have also been restricted in that many state-owned enterprises (SOEs) have not been listed on the PSX. As a result, SOEs also miss the benefit from performance and efficiency improvements through the discipline of stock market listing. Innovative products such as options and derivatives are not available in the financial markets.

8. Bond market development is also constrained. The corporate bond market remains in its nascent stage, undermining long-term infrastructure financing requirements. The corporate bond market is at 2.2% of GDP (Bangladesh 1%, Sri Lanka 1%, India 16%). Issuances in the primary market are dominated by government bonds with limited and costly corporate bond issuances. The government bond market is primarily short-dated and, thus, does not fulfill its role as a benchmark pricing reference due to ad hoc government debt management practices arising from the lack of a professional DMO. The absence of an effective government bond market yield curve impedes the appropriate pricing of corporate bonds, and corporate bond issuances are therefore less attractive to both issuers and investors. On the demand-side, major institutional investors (such as pension funds, insurance companies, and mutual funds) have a limited role in financing government bonds and corporate bonds since these investors prefer National Savings Scheme instruments that offer the same return as government bonds, but unlike government bonds they have insignificant downside risk prior to maturity. The participation of investors across the maturity spectrum is critical to support market development. A diverse investor base lowers the debt cost and volatility in market yields.

9. Increasing threat of fiscal dominance. Pakistan is experiencing pressure that prevents the competitive auctioning of government securities based on market prices and also hampers formulation of a credible government yield curve and a liquid bond market. The current operating framework of the government bond market system does not promote competitive bidding. Although auctions are conducted based on a pre-announced auction calendar, the government decides the cut-off yield for the debt rather than accepting a market-determined yield for the announced volume. When the market asks for a price higher than what the government is willing to offer, the bids are frequently rejected. The price-driven approach has deep implications for Pakistan's financial markets. It has restricted both volume and liquidity in longer tenor government bonds; yields do not then reflect true market conditions, which hinder the process of establishing a credible benchmark for medium-to-long term financing rates. This undermines the credibility of the primary market, as does the rejection of auction bids.

10. Future potential. The government knows that it must take several important steps to promote investment and achieve greater and more sustainable GDP growth. It can remove current obstacles to this growth by moving toward measured market-based structural reforms through deregulation of the financial system while laying the foundations to ensure financial stability and resilience. The crucial steps are the strengthening of the existing legal and regulatory frameworks, continuing improvements in the market's infrastructure, and empowering such institutions as the SECP, DMO, and AOB. Creating an efficient, reliable capital market is a prerequisite for attracting more foreign investment. Most foreign investors require a good enabling environment and market depth before they will gain the confidence to invest. Furthermore, an efficient capital market ensures balanced development of the finance sector, which will reduce systemic vulnerabilities in the bank-dominated financial system.

11. Thrust. To address these constraints, the government and ADB have agreed to anchor the Financial Markets Development Program to the design of a long-term national capital market master plan. The formulation of this master plan during 2019-2020 is supported by subprogram 1. The approval of the capital market master plan is included as a crucial subprogram 1 policy action under the program to build strong (i) ownership at the highest level on the policy front, and (ii) coordination across the agencies.

12. The program will seek to deepen and broaden Pakistan's financial markets by (i) extending

the government yield curve and thereby promoting a more liquid government bond market and eventually a more developed corporate bond market; (ii) catalyzing institutional investor demand by broadening, deepening, and diversifying the investor base; (iii) strengthening the institutional and regulatory capacity of the SECP, the DMO, and AOB; (iv) developing important market infrastructure such as a surveillance systems, and trading system; and (v) enhancing the supply of alternative financial instruments such as derivatives to include for commodities.

13. The structural reforms to be taken under the program include costly measures, such as the costs of a significant enhancement in the regulatory and enforcement capacity of the SECP and of a short-term increase in the rates of treasury bills and government bonds to better align them with market rates. Budget support is crucial under the program to help cover the costs of implementing the reforms. Since the reforms are an integral part of the government-owned long-term national capital market master plan, the government is firmly committed to instituting the actions under the program given its ability and political will to implement the needed reforms.

Financial markets act as a major catalyst in transforming the economy into a more efficient, innovative and competitive marketplace within the global arena (Pakistan Vision 2025).

Capacity and size of capital markets augmented.

Market stability strengthened

Market facilitation enhanced.

Supply measures enhanced.

Demand measures enhanced.