A. Introduction

1. The financial sector in Pakistan is diverse and growing, but remains small. Banks dominate the industry, commanding 74 percent of total assets, are predominantly private, with high penetration of foreign ownership and a quickly growing Islamic component. The rest of industry includes a variety of non-bank and other specialized financial institutions (Box 1). The banking system is small relative to regional peers and countries with similar fundamentals. It declined after global financial crisis, but has begun to expand again as a share of GDP.

Total Bank Assets to GDP

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

Source: IMF International Financial Statistics

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Total Bank Assets to GDP

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

Source: IMF International Financial Statistics

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Total Bank Assets to GDP

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

Source: IMF International Financial Statistics

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Box 1.

Pakistan Financial Sector Snapshot

The financial sector is diverse, but remains dominated by banks. Banks account for 74 percent of total financial sector assets and are classified into five major groups. There are 5 public sector commercial banks (about 19 percent of bank assets) and 21 local private commercial banks (76 percent). The penetration of foreign ownership is high, as more than 50 percent of total banking sector shareholders’ capital is foreign owned. Since 2001, the enabling regulatory environment and large Muslim population helped Islamic banking grow very rapidly to get to the current market share of about 12 percent. The remaining categories represent microfinance banks (1 percent of bank assets) and specialized banks, focusing on particular groups of customers such as rural or industrial customers and small and medium enterprises (2 percent).

The rest of the financial sector comprises a variety of non-bank and other specialized financial institutions. The largest is the National Savings Scheme (NSS; 15 percent of assets), a public sector savings program channeling retail savings into government debt. The second largest is insurance industry (5 percent of assets). It includes 36 life, non-life and reinsuring companies and is dominated by three state-owned entities. Other non-bank financial institutions are primarily mutual funds (accounting for two thirds of the non-bank non-specialized financial sector assets), pension funds, development finance institutions, leasing companies, investment banks, real estate investment trusts and Modaraba Islamic funds.

Pakistan: Financial Sector Structure

as of end-December 2016

Sources: State Bank of Pakistan, unaudited financial statements of financial institutions. Insurance data is as of September 30, 2016.

Pakistan: Financial Sector Structure

as of end-December 2016

					Assets
				Number	PRs billion	Share, %
Banking System				45	16,001	74.0
		of which Islamic financial institutions		21	1,853	11.6
			Islamic banks	5	1,147	7.2
			Islamic banking branches	16	706	4.4
	Public sector commercial banks			5	2,964	18.5
	Private commercial banks, incl. IBs			21	12,226	76.4
	Foreign banks’ branches			4	391	2.4
	Specialized banks			4	250	1.6
	Microfinance banks			11	170	1.1
Non-bank and Other Specialized Financial Institutions				314	5,636	26.1
	Insurance Companies			36	1036	18.4
			Non life	29	177	3.1
			Life	6	841	14.9
			Reinsurance	1	18	0.3
	Asset management companies			22	39	0.7
	Mutual funds			175	654	11.6
	Pension funds			17	23	0.4
	Discretionary and Non-discretionary
	portfolio management
	REIT			1	40	0.7
	Leasing companies			8	44	0.8
	Modarabas			25	41	0.7
	Investment bank and MFIs			21	123	2.2
	National Savings Scheme (NSS)			1	3,287	58.3
	Development Finance Institutions			8	209	3.7
TOTAL				359	21,635	100

Sources: State Bank of Pakistan, unaudited financial statements of financial institutions. Insurance data is as of September 30, 2016.

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Pakistan: Financial Sector Structure

as of end-December 2016

					Assets
				Number	PRs billion	Share, %
Banking System				45	16,001	74.0
		of which Islamic financial institutions		21	1,853	11.6
			Islamic banks	5	1,147	7.2
			Islamic banking branches	16	706	4.4
	Public sector commercial banks			5	2,964	18.5
	Private commercial banks, incl. IBs			21	12,226	76.4
	Foreign banks’ branches			4	391	2.4
	Specialized banks			4	250	1.6
	Microfinance banks			11	170	1.1
Non-bank and Other Specialized Financial Institutions				314	5,636	26.1
	Insurance Companies			36	1036	18.4
			Non life	29	177	3.1
			Life	6	841	14.9
			Reinsurance	1	18	0.3
	Asset management companies			22	39	0.7
	Mutual funds			175	654	11.6
	Pension funds			17	23	0.4
	Discretionary and Non-discretionary
	portfolio management
	REIT			1	40	0.7
	Leasing companies			8	44	0.8
	Modarabas			25	41	0.7
	Investment bank and MFIs			21	123	2.2
	National Savings Scheme (NSS)			1	3,287	58.3
	Development Finance Institutions			8	209	3.7
TOTAL				359	21,635	100

Sources: State Bank of Pakistan, unaudited financial statements of financial institutions. Insurance data is as of September 30, 2016.

2. While the government has remained large borrower from the banking system, lending to the private sector has begun to recover. Bank private credit significantly contracted after 2008 before beginning to recover over the past few years to 15.1 percent of GDP (2016), but continues to lag behind economies in South Asia and countries with similar income and population (Figure 1). The decline reflected an upsurge in non-performing loans after 2008 and large government financing needs that led banks to increasingly orient their lending activities to the government (Figure 1). NPLs have declined since mid-2011, and, more recently, private credit growth has begun to pick up amid a decline in the fiscal deficit.

Pakistan’s Financial Sector: Peer Comparison and Bank Lending

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Pakistan’s Financial Sector: Peer Comparison and Bank Lending

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Pakistan’s Financial Sector: Peer Comparison and Bank Lending

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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3. The efficiency of the financial sector remains favorable. Pakistani banks feature sound profitability, low overhead costs, and a favorable share of non-interest income in total income, as they were able to generate revenue outside traditional financial intermediation.

4. Access to finance and the use of financial services in Pakistan have been rising from a low base and have significant potential for further improvement. Despite significant progress, few firms have access to bank loans or enjoy a credit line and, per World Bank’s Findex data, less than ten percent of adult population have accounts with formal financial institutions.² Very few people use these accounts to receive wages or government transfers or to pay utility bills, and very few people use financial institutions for their saving and borrowing needs. Although the most recent survey by the State Bank of Pakistan indicates that between 2008 and 2015 the share of adults formally served by the financial system has doubled and the share of women has almost tripled (Figure 2), major gaps remain, in particular regarding financial exclusion of women, rural population and small and medium enterprises. A National Financial Inclusion Strategy, spearheaded by the SBP, has been adopted in 2015 and an action plan to boost financial inclusion is being implemented. These efforts have been recognized internationally as Pakistan has been ranked among the top five countries for its enabling environment for financial inclusion (Economist Intelligence Unit’s Global Microscope 2015 and 2016).

Progress in Financial Sector Development and Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Progress in Financial Sector Development and Inclusion

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Progress in Financial Sector Development and Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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5. A stronger, more developed, deep, and inclusive financial sector would help Pakistan increase the resilience of its economy to shocks and to promote strong economic growth and greater equality. It will also help channel savings towards productive investment, improve the allocation of resources, foster sharing of information, and allow to better diversify risks. Countries with better functioning banks and markets grow faster and better financial systems ease the external financing constraints that impede firm and industrial expansion (Levine, 2005). Similarly, more inclusive financial systems allow the poor and other disadvantaged groups such as women, youth and rural population to smooth their consumption over time by insuring themselves against many economic vulnerabilities, to build assets and to make business and human capital investments that would improve their livelihood, thereby contributing to reduced poverty and income inequality (Demirguc-Kunt, Klapper, Singer, Van Oudheusden 2015; Demirgüç-Kunt, Levine 2009). At the same time, as the size of the sector and access to bank credit grow, economic and financial stability risks may increase and would require continued adequate focus on proper regulation, supervision and risk mitigation (Sahay et al., 2015a).

6. This paper assesses Pakistan’s financial development and inclusion, estimates potential growth gains from further financial deepening, and suggests policies in support of these goals. We first use recently developed measures of financial development and inclusion (Sahay et al., 2015b; Aslan et al., 2016) to document where Pakistan stands relative to regional peer countries and countries with similar fundamentals (Section II). The exponential growth of Islamic banking in Pakistan and its contribution to financial development warrant particular focus in this section. Then, we proceed to quantifying the effects of progress in financial development on economic growth (Section III). Finally, we suggest policies that would help promote greater financial deepening and inclusion and secure safe and sound financial development.

B. Financial Development and Inclusion: Where Do We Stand

7. Financial development and inclusion have made progress over the past decades, with large potential for further improvement. Despite some peaks and troughs reflecting economic crises and political and security uncertainty, the composite index of financial institutions’ development (Box 2) has increased by more than 33 percent over the past two decades. The most recent SBP survey indicates that from 2008 to 2015, the number of people formally served by the financial system has increased from 12 to 23 percent (Figure 2). However, major gaps remain, in particular on the financial inclusion side, where Pakistan still ranks very low against peers and where financial exclusion of women, rural population and small and medium enterprises persists.

8. The overall level of financial institutions’ development has more than recovered from its post-2008 decline, but remains low. Although the index has recovered and surpassed pre-crisis levels on the back of strengthening economic growth and a conducive regulatory environment (and made sizable progress relative to 1997 trough), it remains just slightly below its 1980s average, underscoring the potential for further improvement.

9. While Pakistan lags behind its peers in the level of development of financial institutions, recent trends show positive momentum. A comparison to regional countries and peers with similar income and population suggests that Pakistan has strong potential to further strengthen the level of development of its financial institutions. In 2014, the indices of financial institutions in Asia and Pacific and in the Emerging Market economies exceeded that of Pakistan by 54 percent and 71 percent, respectively³.The rankings of South Asian peers such as Bangladesh, India, and Sri Lanka were 7 to 33 percent higher.⁴ That said, from 2007, a peak year just before global financial crisis, financial institutions in all peer economies have sizably improved, while Pakistan’s index initially fell and by 2014 had just recovered to pre-crisis levels (Figure 3). Since 2014, Pakistan has been able to maintain strong positive momentum in financial institutions’ development, benefitting from higher private credit growth and better access to finance. In line with this trend, the Islamic banking component of Pakistan’s financial sector has been expanding rapidly and has strengthened its contribution to financial development (Box 3).

Financial Institutions Index: Pakistan vs Peers and Region

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Financial Institutions Index: Pakistan vs Peers and Region

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Financial Institutions Index: Pakistan vs Peers and Region

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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10. Pakistan’s financial sector development trends over the last decade have shown a beginning recovery from low and shrinking depth, low yet quickly growing level of access, and favorable efficiency relative to peers and benchmarks. Particularly during FY 2015–17, depth has begun to recover and growth in level of access has further accelerated. Below we discuss these aspects, benchmarking Pakistan’s performance against (i) peer countries with similar per capita income and population,⁵ (ii) regional averages for South Asia, and (iii) statistical benchmarks (expected medians) derived from a regression framework following the World Bank’s FinStats 2016 (Feyen, Kibuuka, and Sourrouille, 2015).⁶ Statistical benchmarks are estimated based on structural and economic non-policy fundamentals. By excluding policy-driven factors, the benchmarks determine the level at which Pakistan would be expected to perform in a policy-neutral environment. A gap between actual performance indicator and its benchmark can in part be attributed to the quality of financial sector policies.

Depth

11. Despite recent progress, the Pakistani financial sector remains shallow. Empirical evidence suggests that financial depth, capturing the size of financial institutions relative to the economy, is a key aspect of financial development, and bigger and more liquid financial systems facilitate economic growth and help dampen macroeconomic shocks (Rajan, Zingales 1998; Dabla-Norris, Srivisal 2013). Despite its recent recovery, the overall index of financial institutions’ depth remains low relative to both South Asian peers and Emerging Markets averages (Figure 4). From its 2007 peak, it has shrunk by about 40 percent, reflecting the declining size of the financial sector and the private credit to GDP ratio.

Depth of Financial Institutions’ Development

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Depth of Financial Institutions’ Development

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Depth of Financial Institutions’ Development

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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• Following the global financial crisis, the assets of banks and other depository institutions in Pakistan have declined from 59 percent of GDP in 2007 to 48 percent in 2011, and subsequently recovered to 57 percent of GDP in 2016 in contrast to other countries in the broader region whose banks have been able to expand relative to the size of the economy beyond pre-crisis levels (Figure 4).

• Bank credit to the private sector has contracted from a peak of 27 percent of GDP in 2008 to 15 percent of GDP in 2015 before beginning to recover. The earlier decline in part reflected a surge in NPLs after 2008⁷ and growing government financing needs amid high fiscal deficits that crowded out the resources from the rest of the economy and led banks to orient their lending activities toward the government. The share of government in total bank lending has increased from 38 percent in 2008 to 64 percent in 2016, while fiscal deficit peaked at almost 9 percent of GDP in FY 2011/12 (Figure 1). Since then, fiscal deficits shrank owing to fiscal consolidation efforts, the non-performing loan ratio has declined, and more recently, as interest rates declined, private credit growth has begun to recover.

• Non-bank financial institutions—except pension funds—suffered as well, with mutual fund assets and insurance premiums shrinking relative to GDP.

12. The financial depth index has begun to recover over the past three years. In addition to a growing private credit-to-GDP ratio, this trend has reflected an increase in the pension fund assets and improved insurance life and nonlife premiums collected relative to the size of the economy.

13. Benchmarking. Compared to peers, bank private credit to GDP in Pakistan is lagging behind the economies in South Asia and countries with similar income and population size (Figure 4). It also remains well below the statistical benchmark (expected median) of about 31 percent estimated based on Pakistan non-policy fundamentals indicating significant room for improvement. The mutual fund industry seems to be relatively well developed and in line with predictions implied by expected median assets to GDP (although being quite lower than regional average), while premiums in insurance industry, in particular non-life, and pension fund assets remain a fraction of what they should be based on Pakistani fundamentals (see footnote 32).

Efficiency

14. The efficiency of the Pakistani financial sector has moved in sync with the business cycle and remains favorable. Most recently, banks in Pakistan have been able to provide financial services at relatively low cost and with sustainable revenues. In 2014, the overall index of financial institutions efficiency has exceeded that of Emerging Markets average by 10 percent, Asia Pacific average by 13 percent and India by 23 percent (Figure 5). However, historically, bank efficiency (driven by profitability) has been following the business cycle, overperforming against benchmarks during boom years (2005–07) and underperforming during decelerations (2008–10). Over the past decade, the ability of banks to generate revenue outside traditional financial intermediation from fees, commissions, trading activities, etc. has strengthened markedly evidenced by rising noninterest income to total income ratio. Profitability has also been supported, however, by ample availability of risk-free lending to the government. More recently, as interest rates have declined, bank profitability has begun to moderate.

Efficiency of Financial Institutions

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Efficiency of Financial Institutions

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Efficiency of Financial Institutions

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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15. Benchmarking. Compared to peers, South Asia, and statistical benchmarks, the efficiency of Pakistani banks has improved and is favorable. This has reflected strong profitability measured by return on equity and return on assets, low overhead costs and favorable share of non-interest income in total income against most benchmarks. On the other hand, net interest margin remains high at 4.5 percent, compared to 3.8 percent in Bangladesh and 2.9 percent in India. Lending to government and Public Sector Enterprises is large: in 2014 it was estimated at 20.2 percent of GDP against statistical benchmark of 11.3 percent implied by Pakistani fundamentals and 12.8 percent for South Asia.

Table 1.

Pakistan: Benchmarking Non-Bank Financial Institutions

Source: FinStats 2016Note: All data is for 2014. Pakistani pension fund assets/GDP refer to 2012.

Table 1.

Pakistan: Benchmarking Non-Bank Financial Institutions

	Pakistan	South Asia Median	Income Group Median	Expected Median
Insurance premiums (life) / GDP (%)	0.5	0.5	0.3	0.5
Insurance premiums (non-life) / GDP (%)	0.2	0.5	0.6	0.6
Mutual fund assets / GDP (%)	1.7	4.1	1.8	1.7
Pension fund assets / GDP (%) 1/	0.02		3.5	2.9

Source: FinStats 2016Note: All data is for 2014. Pakistani pension fund assets/GDP refer to 2012.

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Table 1.

Pakistan: Benchmarking Non-Bank Financial Institutions

	Pakistan	South Asia Median	Income Group Median	Expected Median
Insurance premiums (life) / GDP (%)	0.5	0.5	0.3	0.5
Insurance premiums (non-life) / GDP (%)	0.2	0.5	0.6	0.6
Mutual fund assets / GDP (%)	1.7	4.1	1.8	1.7
Pension fund assets / GDP (%) 1/	0.02		3.5	2.9

Source: FinStats 2016Note: All data is for 2014. Pakistani pension fund assets/GDP refer to 2012.

Table 2.

Pakistan: Benchmarking Efficiency of Banks

Note: All data is for 2014, sourced from FinStats 2016.

Table 2.

Pakistan: Benchmarking Efficiency of Banks

	Pakistan	South Asia Median	Income Group Median	Expected Median	Bangladesh	India
Net Interest Margin (%)	4.5	4.2	4.5	4.3	3.8	2.9
Overhead Costs / Total Assets (%)	2.7	2.3	3.4	3.5	2.3	1.7
Credit to Government and SOEs / GDP (%)	20.2	12.8	4.4	11.3	19.1	19.6

Note: All data is for 2014, sourced from FinStats 2016.

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Table 2.

Pakistan: Benchmarking Efficiency of Banks

	Pakistan	South Asia Median	Income Group Median	Expected Median	Bangladesh	India
Net Interest Margin (%)	4.5	4.2	4.5	4.3	3.8	2.9
Overhead Costs / Total Assets (%)	2.7	2.3	3.4	3.5	2.3	1.7
Credit to Government and SOEs / GDP (%)	20.2	12.8	4.4	11.3	19.1	19.6

Note: All data is for 2014, sourced from FinStats 2016.

Financial Access and Inclusion

16. The access to financial services has been quickly rising from a low base, with significant potential for further improvement. Pakistan ranks low on the level of financial institutions’ access relative to individual peer countries and to the South Asia region and has large potential to improve against Emerging Markets and Asia Pacific averages (Figure 6). From the providers’ side, this reflects the moderate coverage by commercial bank branches and low coverage by ATMs as compared to peers and the region. It also reflects the low penetration of bank accounts (in 2014 Pakistan had 333 accounts in banks per 1000 adults compared to 979 accounts for the South Asia region) and limited ability of firms to tap bank resources. According to WB Enterprise Survey, only 6.7 percent of firms (3.4 percent for small firms) had access to bank loans or enjoyed a credit line and only 8.1 percent of firms (2.0 percent for small) used banks to finance investments (Figure 5).

Pakistan: Access to Finance

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Pakistan: Access to Finance

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Pakistan: Access to Finance

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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17. That said, sustained efforts led by the SBP ensured that the level of financial access has been growing very quickly in the recent years (Figure 3). For instance, the ATM coverage has increased 5-fold over the last decade and the mobile money infrastructure under branchless banking model has expanded at a fast pace, with penetration of active mobile money agent outlets and active mobile money accounts increasing 9 times and 17 times, respectively, over 2011–2016 (Figure 6). At present, Pakistan enjoys 20 million easy to operate branchless banking accounts and further growth would help boost financial access.

18. Benchmarking. Despite overall low level of financial access, the coverage of population by bank branches is in line with the peer group average and even exceeds the statistical benchmark (Figure 6). However, the rural access to bank branches remains an issue, in part mitigated by about 360,000 branchless banking agents across the country. Bank account penetration remains below peers and the benchmark level of 438 accounts per 1000 adults, and can be further improved by promoting access of underserved segments of society such as small firms, the rural population, and women and by further developing financial sector infrastructure delivered via existing bank branches and innovative digital channels. There is also sizable potential for improvement in overall access of firms to bank finance from the current low level to the South Asia average of 27 percent or the statistical benchmark level of 31 percent.

19. Financial inclusion is a multifaceted concept broadly defined as the access to and the use of formal financial services. Following Sahay et al (2015a), in addition to providers’ side, we also consider the users’ side of financial inclusion and also look at the aggregate measure such as micro-survey based financial inclusion index (Box 2).

20. While Pakistan has made considerable and sustained reform efforts, the level of financial inclusion has remained low. The SBP’s Access to Finance Survey 2015 indicates that access to formal financial services has increased from 12 percent in 2008 to 23 percent in 2015 and adult population with a bank account has increased from 11 percent in 2008 to 16 percent in 2015, well below both the South Asian average of 46 percent and the average for all developing countries of 54 percent. Women’s access to financial services has expanded considerably, as 11 percent now have access to a bank account, compared with merely 4 percent in 2008, but significant gender gap remains.

21. Despite these improvements, the aggregate index of financial inclusion ranks Pakistan low. The financial inclusion index (Aslan, Deléchat, Newiak and Yang, 2016, see Box 2) that captures common component of both access and use of financial services places Pakistan at 135 out of 142 countries (2014). The positive association between financial development and inclusion (Figure 7) suggests that improvements in financial development to the sample average could potentially lead to significant improvements in financial inclusion.

Pakistan: Financial Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Pakistan: Financial Inclusion

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Pakistan: Financial Inclusion

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22. The low ranking reflects limited access to financial institutions and limited use of the existing access in everyday activities. According to the World Bank’s Findex 2014 survey, just 8.7 percent of adult population in Pakistan have accounts with formal financial institution against 45.5 percent in South Asia and 38.6 percent on average in peer countries (Figure 8).⁸, ⁹ Only 1.4 percent of the population use these accounts to receive wages, 1.8 percent to receive government transfers, and 0.4 percent to pay utility bills.

Pakistan: Aspects of Financial Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

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Pakistan: Aspects of Financial Inclusion

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Pakistan: Aspects of Financial Inclusion

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Similarly, few people use financial institutions for their saving (3.3 percent) and borrowing (1.5 percent) needs.

23. A key challenge is low financial inclusion of women, low income and rural population, as well as agricultural and small and medium enterprises. The mean financial inclusion index for men is twice as high as for women in Pakistan, while the same gap in peer countries is about 30 percent (Figure 8), reflecting strong gender barriers. The poor are more excluded than other income groups as the share of the population in the bottom income quintile having either a bank or a mobile account is disproportionately low relative to higher income quintiles. The urban/rural gap in financial inclusion is less pronounced than the gender gap but remains significant (Figure 8). Although agriculture contributes 23 percent to GDP and employs about 42 percent of the labor force, it accounts for only 8.6 percent of total bank credit to the private sector and heavily relies on cash.¹⁰ SMEs are also underserved by the financial sector. WB Enterprise Survey 2013 suggests that only 3.4 percent of small firms (6.7 percent of all) had access to bank loans or enjoyed a credit line and only 2.0 percent of small firms (8.1 percent for all) used banks to finance investments (Figure 6).

24. Although aggregate inclusion remains low, Pakistan has made fast progress in Islamic Finance, digital finance and branchless banking. Islamic Finance has been rapidly growing in recent years, and further growth could help improve financial inclusion, as survey evidence points to large untapped interest in Shariah-compliant financial products and services (Box 3). Moreover, a conducive regulatory environment created by the SBP, a dynamic private sector, and computerized national identity cards helped pave the way for significant expansion of mobile accounts and branchless banking. As banks were able to leverage mobile phone communication networks to bring their services closer to customers and mobile money infrastructure expanded (Figure 6), penetration of mobile accounts in Pakistan increased to 5.8 percent of adult population in 2014, twice as high as the average in South Asia (2.6 percent). Digital transaction accounts may be more effective in addressing the gender gap in financial inclusion than traditional bank accounts, as difference in access to mobile accounts for men and women is narrower (about 7 percent) than for financial institutions’ accounts (11 percent). Recent initiatives to foster branchless banking include the revised regulations to allow remote account opening through biometric verification at agent locations and launching a capacity building program to train more than 100,000 agents. In addition, SBP has also developed an Asaan (Easy) Mobile Account scheme under which the digital finance service providers will join an integrated platform, allowing any person with a basic mobile phone to swiftly open a digital transaction account.

25. Significant progress has also been achieved in promoting SME, agricultural and micro-finance. In agriculture, credit guarantee and insurance schemes, publication of value chain reports and national rollout of value chain financing, streamlining of agri-loan application processes and other measures have resulted in a robust increase of agricultural credit: over 2012–16, it has grown at an average rate of 14 percent per year and its share in total private credit has improved by 2.5 percentage points. Helped by a conducive policy environment, with separate legal and regulatory framework in place (Box 4), the microfinance industry has grown significantly over the past five years and continues to maintain a healthy loan portfolio.¹¹ The number of active borrowers increased from 2 million to 4.6 million, of which more than half were women, the gross loan portfolio quadrupled to PRs 137 billion and deposits of microfinance banks expanded six-fold to PRs 121 billion. Despite small and medium size enterprises being underserved by the financial sector, their access to credit has been gradually improving. During 2012–16, the stock of SME finance and the number of SME borrowers have grown by 51 percent (to PRs 401 billion, 9.2 percent of total private credit) and by 35 percent (to about 178,000 firms), respectively. Amendments to prudential regulations (raising sales and employment thresholds and allowable per party exposures), incentives schemes, such as the Credit Guarantee Scheme for Small and Rural Enterprises and the Prime Minister Youth Business Loan Scheme, and capacity building programs have – among other measures – contributed to this outcome.

Performance of the Microfinance Industry

Source: SBP, Pakistan Microfinance Network

Performance of the Microfinance Industry

		2012	Dec 2016	% chg
No of borrowers, million		2.0	4.6	130
	of which women	1.3	2.5	95
Gross Loan Portfolio, PKR billion		33.1	136.9	314
No of branches		1,460	3,220	121
Deposits, PKR billion		20.8	120.6	480
Depositors, million		1.6	20.2	1191

Source: SBP, Pakistan Microfinance Network

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Performance of the Microfinance Industry

		2012	Dec 2016	% chg
No of borrowers, million		2.0	4.6	130
	of which women	1.3	2.5	95
Gross Loan Portfolio, PKR billion		33.1	136.9	314
No of branches		1,460	3,220	121
Deposits, PKR billion		20.8	120.6	480
Depositors, million		1.6	20.2	1191

Source: SBP, Pakistan Microfinance Network

26. Despite recent progress, considerable challenges to fostering financial inclusion at both the supply and demand sides remain. Levels of financial literacy and awareness are low, especially with low-income segments, making the demand for financial products and services much lower than optimal. 39 percent of the population consider lack of financial awareness of banking products and services as one of the key barriers.¹² Challenges also exist at the supply side, with considerable infrastructure and strategic commitment needed to cater to the government-to-person beneficiary market segment¹³ Other broad factors inhibiting financial inclusion in Pakistan that often span beyond financial sector policy include:

• Business cycle factors (economic slowdown following global financial crisis),

• Business climate and governance challenges,

• High government financing needs leading to banks’ orientation toward lending to government,

• Gender barriers,

• A large and persistent informal economy,

• Challenges in the basic financial infrastructure and in legal and judicial frameworks, and

• Capacity issues on the financial sector providers’ side that often focus on the upper end of business and retail markets.

27. Since the launch of National Financial Inclusion Strategy in 2015, Pakistani authorities have implemented several initiatives to boost financial inclusion. The goal is to achieve by 2020 the financial access for at least 50 percent of adults, including at least 25 percent for women, and to increase the percentage of SME loans in bank lending to private sector to 15 percent (Box 4).

Box 4.

Progress on Financial Inclusion Initiatives ^1/

Since 2001 Pakistan has put in place many policies and initiatives that helped create enabling environment for financial inclusion. These efforts have culminated in the adoption of the comprehensive National Financial Inclusion Strategy (2016–20) to provide a vision, a framework and a roadmap for priority actions aiming to increase the access to and the use of quality financial services. The NFIS strategy focuses on four key drivers: promoting digital transactions and reaching scale through bulk payments, expanding and diversifying access points, improving capacity of financial services providers, and increasing level of financial awareness and capability. To implement the strategy, Pakistan has set up a public-private coordination mechanism that includes the high-level NFIS Council, chaired by Finance Minister, the NFIS steering committee, chaired by SBP Governor, responsible for action plans and monitoring, and technical committees, with participation of more than 160 members from ministries, regulators, associations, and networks.

Recent progress on the financial inclusion initiatives, including on the NFIS, is provided below.

• Creation of a regulatory framework for Microfinance Banks (2001);

• Expansion and modernization of online credit information bureau (e-CIB, 2005);

• Issuance of branch licensing policy mandating banks to open 20 percent of branches in rural areas (2005);

• Establishment of the Pakistan Interbank Settlement System (PRISM) (2008), the development of inter-operable inter-bank card payments platforms;

• A number of credit enhancement facilities aimed at encouraging financing to the underserved sectors including the Microfinance Credit Guarantee Scheme (MCGF, 2008) and the Credit Guarantee Scheme for Small and Rural Enterprises (2010);

• Adoption of Branchless Banking Regulations (2008, amended in 2011);

• Establishment of a specialized Microfinance Credit Information Bureau (MF-CIB, 2011);

• Launch of a National Financial Literacy Program (NFLP) (2012). After its successful pilot, NFLP is being scaled up to the national level with target of one million beneficiaries, and a new component on child and youth financial literacy, is being initiated (2017);

• Issuance of revised SME Finance prudential regulations, with separate sets of regulations for small enterprises and medium enterprises (2013);

• Development of Inclusion, Stability, Integrity, and Protection (I-SIP) methodology in policy making (2014);

• Review of regulatory framework for microfinance banks to promote sustainable growth of microfinance in the country (2014);

• Enhancement of biometric infrastructure to aid real-time account opening (2015);

• Payment Systems Interoperability of MFS platform with Core Banking Accounts through financial switch (1-Link) enabling ATM, POS and Interbank funds transfer facilities through m-wallets (2015);

• Government of Pakistan accepts membership of the UN’ “Better than Cash Alliance” (2015);

• Issuance of Guidelines on Low Risk Accounts namely “Asaan Account” with simplified due diligence to expand the outreach of banking services to underserved segments of the society through conventional and innovative channels. Since the launch of the initiative, commercial and microfinance banks have opened more than 1.79 million accounts;

• Establishment of Centers of Excellence in Islamic Finance Education to ensure adequate supply of trained human resource to the industry (2015);

• Incorporating the Pakistan Mortgage Refinance Company to address the long-term funding constraints hindering growth of primary mortgage market (2015);

• Launch of Credit Guarantee Scheme for Small and Marginalized Farmers (CGSMF) with the funding support of Government of Pakistan to share the losses with banks against their collateral-free financing to small and marginalized farmers (2016);

• Approval by the NFIS Council of key strategic actions such as:

  • Development of a National Payment Gateway;

  • Automation of the government collections and disbursements;

  • Introduction of a Warehouse Receipt Financing system;

  • Integration of National Savings Scheme with national payments system;

  • Initiation of new schemes of registered prize bonds;

• Development of Digital Transaction Accounts (Asaan Mobile Account) scheme to support rapid expansion of DTAs, in particular in rural areas. The unified DTA scheme is expected to help design a common technology-led platform for individuals to access and use full range of payment, savings, insurance and credit services (2017).

¹ UNESCAP First High-Level Follow-up Dialogue on Financing for Development in Asia and the Pacific, 30–31st March 2016, Incheon, Republic of Korea.

C. Quantifying the Effects of Financial Development on Economic Growth

28. Given Pakistan’s significant potential for financial development, we estimate the potential benefits of accelerated financial development on growth. Following Sahay et al., (2015b), regressions link countries’ growth performance with the financial institutions development index and a set of controls. To overcome significant endogeneity between finance and growth documented in the empirical literature (e.g., Levine 2005), we use dynamic panel system generalized method of moments estimator (Blundell, Bond 1998) with lagged variables as instruments. Following Sahay et al., (2015b), we include a standard set of controls such as initial per capita income, educational attainment (secondary school enrollment rate) and the ratio of government consumption to GDP, as well as a banking crisis dummy as suggested by the literature. The generic equation regresses real per capita GDP growth on the level of financial development measured by the Financial Institutions (FI) development index, its square, additional interaction terms (“banking crisis,” “emerging markets” and other) and a set of controls. The sample covers 113 countries and includes non-overlapping 5-year averages of the variables over the 1980–2010 period. To better capture Pakistan’s and regional peculiarities, we introduce a regional dummy for countries in the Middle East, Central and South Asia (MCDSA) and also estimate a specification with initial GDP per capita interacted with the level of financial development to capture the notion that as country’s income grows, benefits from greater financial development may be getting more limited.

29. Empirical results confirm that deeper financial development is associated with higher economic growth and suggest that the growth dividend for Pakistan could be around one percent. The results confirm that there is indeed a positive significant impact of greater financial development on economic growth (Table 3). Given Pakistan’s low level of financial development relative to peers and the South Asia region, there is sizable scope for the financial sector to better support growth. Depending on the specification, raising Pakistan’s Financial Institutions index (0.269) to the Emerging Market average (0.461) would imply annual growth gains of around 1 percentage point, with some specifications pointing to even higher potential gains (Figure 9). Relatively lower gains are projected by the models with linear impact of FI on economic growth (column 1 and 4 in Table 3). However, the specifications with quadratic FI terms (columns 2 and 5), capturing non-linearities, suggest that for Pakistan whose level of financial development is low, the growth dividend could be higher at about 1 percent. Finally, specifications with interaction between the level of initial GDP per capita and financial development project even larger potential gains of between 1.6 and 1.8 percent, but are perhaps on the upper side of the plausible range. The average across the six specifications would yield about 1.2 percent, a plausible point estimate for the impact of financial development on annual growth.

Table 3.

Pakistan: Finance and Growth Regressions–GMM Estimation

Notes:1. Additional controls included initial GDP per capita, educational attainment, and ratio of government consumption to GDP2. Z-stats in square brackets, ***: p<0.01 **: p<0.05 *: p<0.1

Table 3.

Pakistan: Finance and Growth Regressions–GMM Estimation

Dependent variable: per capita real GDP growth
Sample: non-overlapping, 5-year period averages covering 1980–2010
excluding offshore financial centers
Explanatory variable	Specifications
	(1)	(2)	(3)	(4)	(5)	(6)
Financial Institutions (FI) Index	0.042 * [1.708]	0.161 *** [3.312]	0.309 *** [2.731]	0.049 * [1.954]	0.163 *** [4.018]	0.296 *** [2.944]
MCDSA x FI				0.024 [0.792]	0.039 [0.689]	0.003 [0.150]
Emerging Market x FI	0.022 ** [2.556]
FI^2		−0.151 *** [-3.242]			−0.149 *** [-3.825]
MCDSA x FI^2					−0.089 [-0.632]
y0 x FI			−0.030 *** [-2.597]			−0.029 *** [-2.847]
Crisis x FI	−0.029 *** [-3.508]	−0.013 * [-1.817]	−0.021 *** [-2.716]	−0.030 *** [-3.584]	−0.016 ** [-2.501]	−0.025 *** [-3.564]
Constant	0.086 ** [2.180]	0.072 * [1.749]	−0.005 [-0.130]	0.074 ** [2.028]	0.062 * [1.772]	−0.011 [-0.289]
Observations	548	548	548	548	548	548
No of countries	113	113	113	113	113	113
AR(2)	0.422	0.356	0.385	0.421	0.334	0.372
Hansen	0.202	0.118	0.112	0.146	0.244	0.197
Instruments	90	90	90	90	112	101

Notes:1. Additional controls included initial GDP per capita, educational attainment, and ratio of government consumption to GDP2. Z-stats in square brackets, ***: p<0.01 **: p<0.05 *: p<0.1

View Table

Table 3.

Pakistan: Finance and Growth Regressions–GMM Estimation

Dependent variable: per capita real GDP growth
Sample: non-overlapping, 5-year period averages covering 1980–2010
excluding offshore financial centers
Explanatory variable	Specifications
	(1)	(2)	(3)	(4)	(5)	(6)
Financial Institutions (FI) Index	0.042 * [1.708]	0.161 *** [3.312]	0.309 *** [2.731]	0.049 * [1.954]	0.163 *** [4.018]	0.296 *** [2.944]
MCDSA x FI				0.024 [0.792]	0.039 [0.689]	0.003 [0.150]
Emerging Market x FI	0.022 ** [2.556]
FI^2		−0.151 *** [-3.242]			−0.149 *** [-3.825]
MCDSA x FI^2					−0.089 [-0.632]
y0 x FI			−0.030 *** [-2.597]			−0.029 *** [-2.847]
Crisis x FI	−0.029 *** [-3.508]	−0.013 * [-1.817]	−0.021 *** [-2.716]	−0.030 *** [-3.584]	−0.016 ** [-2.501]	−0.025 *** [-3.564]
Constant	0.086 ** [2.180]	0.072 * [1.749]	−0.005 [-0.130]	0.074 ** [2.028]	0.062 * [1.772]	−0.011 [-0.289]
Observations	548	548	548	548	548	548
No of countries	113	113	113	113	113	113
AR(2)	0.422	0.356	0.385	0.421	0.334	0.372
Hansen	0.202	0.118	0.112	0.146	0.244	0.197
Instruments	90	90	90	90	112	101

Notes:1. Additional controls included initial GDP per capita, educational attainment, and ratio of government consumption to GDP2. Z-stats in square brackets, ***: p<0.01 **: p<0.05 *: p<0.1

Pakistan: GDP Growth Dividend from Higher Financial Development and Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

* Financial Institutions index improving to 2014 Emerging Markets average.

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Pakistan: GDP Growth Dividend from Higher Financial Development and Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

* Financial Institutions index improving to 2014 Emerging Markets average.

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Pakistan: GDP Growth Dividend from Higher Financial Development and Inclusion

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A002

* Financial Institutions index improving to 2014 Emerging Markets average.

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• Download figure as PowerPoint slide

D. Policy Implications and Considerations

30. While financial sector development in Pakistan has made significant contributions to economic growth, it remains well below its potential. It has recently been characterized by a beginning recovery after a period of shrinking depth, low yet quickly growing level of access, and favorable efficiency. Regarding financial inclusion, considerable and sustained efforts over the past years are bearing fruit, but there remains large room for further improvement.

31. As potential growth dividends from further progress in financial development are large, Pakistan should continue to formulate and implement policies that will help promote greater financial deepening and inclusion and would also secure safe and sound financial development. In addition to maintaining macroeconomic stability by keeping inflation low and public debt in check, the focus should be on strengthening the legal and institutional framework, enhancing regulation and supervision of the sector, creating conditions that allow for an increased role of private credit with due regard to risks, increasing financial inclusion so that benefits of more finance are widely shared, promoting Islamic finance, encouraging bank competition, and developing debt markets.

32. An appropriate macroeconomic policy mix is key to facilitating further financial development. Pakistan should focus on fiscal consolidation and proactive debt management efforts to reinforce its resilience to shocks and to allow the financial sector to allocate more funds to private sector credit. Prudent monetary policy will ensure low inflation and positive real interest rates that encourage savings.

33. Implementation of the forthcoming deposit insurance would support depth of the financial sector. In 2016, Pakistan has enacted the Deposit Protection Corporation Act to establish a deposit protection scheme that would enhance the stability and soundness of the banking system and help encourage growth in bank deposits. It would be important to swiftly move ahead to make the deposit protection scheme fully operational.

34. Reforming credit information systems would facilitate greater access to finance and reduce exposure to credit risks. To improve the credit information system and help banks extend credit to broader sections of society, in 2015 Pakistan has enacted the Credit Bureaus Act and the SBP has subsequently issued regulatory and operational guidelines to relicense the existing private credit bureaus. Among other things, the Act has improved access to credit information by guaranteeing borrowers’ rights to inspect their credit data and existing credit bureaus expanded their borrower coverage. Further steps to implement the improved credit information framework will be key to increase currently low credit bureau coverage.

35. Addressing the still high level of NPLs can help support banks’ credit to the economy and private sector-led growth. Enhancing the debt enforcement regime, developing an appropriate bankruptcy framework, and continuing to strengthen the market infrastructure for distressed debt are needed for more efficient NPL resolution. In this context, Pakistan has enacted the Corporate Restructuring Companies (CRC) Act to allow setting up companies that would take over assets of bankrupt firms and passed amendments to the Financial Institutions (Recovery of Finances) Ordinance aimed at enabling out of court enforcement of collateral, which are both welcome steps. The Corporate Rehabilitation Act (CRA) that will establish a mechanism for the organization and rehabilitation of distressed companies has been submitted to parliament. Pakistan should move ahead with the adoption of the CRA to further strengthen the bankruptcy framework, improve NPL recovery and support the provision of credit to the economy.

36. The legal framework for secured transactions should be strengthened to facilitate SME, micro and agriculture finance. In 2016, Pakistan has enacted the Financial Institutions (Secured Transactions) Act that provides for a legal regime for the creation, registration, priority and enforcement of security interests over movable property. It further envisages the establishment of an electronic secured transactions registry to be created on a federal level. To bear fruit and increase access to credit, swift implementation of the provisions of the law, including making the collateral registry operational, would be key.

37. Improving the business climate, enhancing governance, and reducing barriers to private sector development would support growth and financial development. According to the World Bank’s Doing Business 2017, in FY 2015/16 Pakistan was among the 10 economies with the largest improvements in their business climate, notably in the areas of registering property, getting credit and trading across borders. Despite these improvements, Pakistan still ranks low relative to other countries (144/190) and governance indicators are well below emerging markets’ average. A new comprehensive strategy to improve business climate has been adopted in 2016 and is being implemented. Progress in the implementation of the business climate strategy and further improvements in rule of law, control of corruption and government effectiveness will support private sector development and help further financial deepening.

38. Review of the regulatory and taxation structure at different financial market segments would help ensure a level playing field. Unfavorable tax treatment adversely affects non-bank financial institutions in competing with fixed rate government debt instruments and banks and thus restrains progress in financial development. For example, mutual funds are subject to provincial sales tax, federal excise duty, and Workers Welfare Fund payments, while direct investments in stock market, bank deposits and the National Savings Scheme instruments are not affected by these taxes. The non-bank leasing sector and insurance companies remain tax disadvantaged relative to other segments of financial market or in terms of the federal/provincial corporate taxation regime.

39. Gradually moving toward registering prize bonds would help avoid currency substitution and promote healthy formal financial sector. Prize bonds are bearer instruments issued by the government to mobilize retail savings. However, due to their bearer nature, they can effectively be used as medium of exchange and a substitute to Pakistan rupee currency. In FY 2015/16, demand for high-denomination bonds of PRs 40,000 and PRs 25,000 has increased by 60 and 80 percent, respectively, and the outstanding stock of bonds amounted to about 20 percent of currency in circulation.

40. Indicative bank lending targets to particular sectors should be pursued with caution. The SBP and the government should pursue such policies carefully to avoid generating greater access to finance at the expense of financial stability risks. For example, lending to SMEs could be facilitated by more conducive market conditions and better financial infrastructure. In this regard, the operationalization of the EXIM bank, with an appropriate governance structure, could help enhance export credit and reduce the cost of borrowing, notably for SMEs. Similarly, a credit guarantee company, with adequate safeguards and transparent funding arrangements, can provide risk coverage to financial institutions lending to SMEs.

41. Existing incentive schemes to foster flow of credit to the private sector can be reviewed to maximize effectiveness. Current schemes are administered by the SBP and envisage providing to commercial banks and development finance institutions subsidized lines of credit to on-lend to selected segments of the private sector: (i) the Export Finance Scheme, (ii) the Refinancing Facility for Modernization of SMEs, (iii) the Long-Term Financing Facility for Plant and Machinery, (iv) the Scheme for Financing Power Plants Using Renewable Energy, (v) the Financing for Agricultural Storage Scheme, (vi) the Credit Guarantee Scheme (CGS) for small and rural enterprises, (vii) the Microfinance Credit Guarantee Facility, and (viii) Prime Minister’s Youth Business Loans Scheme. The performance of these schemes in achieving their objectives should be reviewed to determine whether they constitute the best use of public financing support and to maximize their effectiveness.

42. Further progress on the National Financial Inclusion Strategy Action Plan would help boost financial coverage of underserved segments of society. Recent steps in moving ahead with traditional bank and mobile (DTA) accounts are welcome and will help raise the level of financial inclusion. Other priority areas to boost access to and use of finance include: (i) strengthening financial literacy and awareness, in particular among underserved client groups such as women, low income and rural population, and small and micro businesses; (ii) addressing gender gap in access to finance; (iii) strengthening financial, payments and information and communication technology infrastructure (access points, DTAs, balanced Know-Your-Customer regime, National Payments System); (iv) ensuring that businesses and people have access to full and transparent information on financial products and services and that minimum consumer protection standards are followed for microfinance and Islamic finance providers; (v) enhancing conducive policy environment for development of SME, agriculture and housing finance and pensions.

43. Continuing to promote microfinance would help provide economic opportunities for the smallest businesses and the poor and promote financial development and inclusion. Although the microfinance industry has grown significantly over the past decade, the sector is estimated to serve 4.6 million customers, about 17 percent of the potential borrower pool. Further growth of the microfinance sector would facilitate access to finance, reduce poverty and also help existing businesses to grow and foster employment generation. With women accounting for about 50 percent of gross loan portfolio, microfinance providers promote gender equality and women’s empowerment and could help reach the NFIS target of 25 percent of women having formal accounts. The recent launch of rules and regulations governing non-bank microfinance providers by SECP will create a level playing field in the industry, can catalyze the investor interest, help attract capital and diversify sources of funding.¹⁴ The key challenge going forward will be the effective implementation of the new regulatory and supervisory framework.

44. Pakistan has made considerable progress in adapting the institutional, legal and regulatory framework to the specifics of Islamic finance, nevertheless significant scope remains for further strengthening. Additional reforms are needed to address gaps with respect to consolidated supervision, tax neutrality for some products, inadequacies in disclosure requirements, the resolution framework, and the absence of liquid secondary markets. In addition, further development for human capital and financial awareness and literacy of Shariah compliant products and services as part of the consumer protection framework are needed. Ongoing reforms with respect to capital adequacy requirement, liquidity framework and deposit insurance schemes should be expedited. Concentrations in bank financing, maturity mismatches and development of interbank markets warrant attention and further efforts are needed to develop deep Sukūk markets.

45. Encouraging healthy bank competition should facilitate private sector credit growth. Although Pakistan’s banking system is not overly concentrated, the limited degree of competition among banks is highlighted by system’s small size relative to the economy, the large share of assets in government securities, and the low level of advances to assets. Reducing the share of government borrowing from banks should help encourage banks to compete for lending to the private sector, benefitting private investment and growth. To this end, consideration could also be given to encouraging new entry to the system (with adequate safeguards).

46. Developing the domestic debt market will promote alternative sources of financing, help expand the domestic investor base, and contribute to further financial development. Although the debt market is dominated by large and liquid government securities market, there is strong potential for private sector issuance as alternative to bank financing. Private fixed-income instruments such as corporate bonds, corporate Sukūk, asset-backed securities, mortgage-backed bonds, and covered-mortgage bonds can be essential pillars, providing long-term financing to the private sector and diversifying the financial sector (IMF, 2014). In this connection, strengthening the Debt Policy Coordination Office capacity to act as central debt manager would help increase the efficiency of government bond markets, while removing tax and other distortions should facilitate diversification of domestic investor base to include insurance companies, mutual funds and pension funds.