When we are at n-1...

"I became deeply attracted to theory of choice and economic growth, subjects that dealt with the core nature of rationals, decisions and ultimately all welfare systems; a life spent studying these topics would be a life devoted to the transcendental. Like many of my economics friends, I began to develop an almost religious passion for economic theory. But beneath my passion was
an even greater desire for fame and immortality. I dreamed of being another Keynes. I wanted to spend my life focusing on the discovery of truths that would live forever. Sometimes, I felt arrogantly superior to people who were headed for more mundane professions."


I know at least one of us could be authoring (this). Hassan. Bob. Moaiz. Bilal. Lala. Hadi. Shahbano. Mehr.
Only time will tell who gets to it first.

Is protest another form of insurance?

Days in Karachi have been a little cruel lately. Domestic protests have restricted urban life and protests on the internet are taking a toll on our cyber-selves. It makes me wonder, why would rational beings be forced to take decisions, which, at least in foreseeable future, and in all likelihood, are deemed to harm them? Why do people spend money and bear a cost by bycotting and banning stuff they previously liked? What really is the economics of protests?

One answer I got yet: protesting is like buying insurance. People protest against laws, actions, events and other people because they want to hedge their odds. For example, promulgation of a particular law will cause long term loss to a community, which subsequently protests against it by incurring short term cost, or in insurance jargon, paying premium. Protesting also entails the same costs - moral hazard and adverse selection.

If protesting is really like insurance, are we sitting on a huge business proposition? Could "protest firms" be the next big thing? Would one be able to buy a 'protest option/coverage' in exchange of a premium?

Banking Sector: Challenges and Opportunities

Banking Sector: Challenges and Opportunities
The last two years have been extraordinary for financial sector globally – both obstacles and opportunities alike. In the aftershocks of the global financial meltdown, domestic economic vulnerability and political instability, the solvency of banks came under serious stress tests. Add on to it tight monetary policy pursued by State Bank of Pakistan (SBP) and banking sector’s performance is under further pressures. However, backed by the strengths gained over last few years, presence of high quality capital cushion and effective systemic regulation form SBP, the sector has shown remarkable resilience in combating both domestic and international crises – apart from financial weakness in some small banks. In the wake of rising costs of business, both in terms of risk and inflation, exploring novel avenues of growth may be a hard task; mending domestic macroeconomic conditions and comparative exchange rate advantage gained provide platform of expansions for banks.
Expansions in capital and assets of Banks had undergone major setbacks in during 2008-09. Despite continuation in rapid credit expansion in 2008, successive increments in interest rates, high inflation, and fragile macroeconomic profile caused significant decline in profitability of banks. Corporate sector, which provides bulk of business to banks, took a serious hit. Although major bankruptcies were low, subdued economic growth and erosion of equity base for large businesses resulted in 64% increase in Non Performing Loans (NPLs) to PKR368billion in 2008. 62% of incremental NPLs were classified as substandard and doubtful (early stage) while 78% of banks saw an increment in NPLs. This lends credence to the fact that business failures are mainly due to cyclical downfall in economic activity, although part of them can be attributed to imprudent lending in 2006-07.
Another key strain on Bank’s resources was liquidity risk. Through 1st half of 2008, system carried excess liquidity; however a number of factors started liquidity drain later in the year. First, expansion in overall bank deposits failed to keep pace with ambitious credit extension. Despite witnessing a 17% increase in remittance based inflows and onset of 5% floor on PLS accounts, deposit growth remained stifled. Banking sector was able to mobilize a mere 9.4% growth in deposits in 2008 against 20.4% increase in 2007. The growth decelerated due to stiff competition from National Savings Directorate, which offered higher profit rates. Subsequently, banks increased borrowings from financial institutions (up by 10%) which, in a high interest rate environment, increased cost of funds. Second, lower economic confidence spiked demand for currency. By October’08, continued increases in inflation due to international commodity price rally, floor on KSE-100 index to avoid decline in equity prices, falling foreign exchange reserves, and period of unstable political transition had caused widespread panic in financial system. This caused massive drain on already decelerating banking deposits while liquidity permium jumped to 1720 bps. The situation was tackled in the short-term by quick regulatory changes, such as easing of reserve requirements for banks. However, liquidity shortfall has continued in the system since then due to substantial borrowing requirements of government which is crowding out funds for private sector.
Small borrowers are characterized by higher credit risk. Due to structural riskiness in Small and Medium Enterprise (SME) and agricultural financing, loan portfolio of banks is skewed towards larger corporate borrowers. By end 2008, 0.5% of borrowers with loan size PKR10million and above accounted for 72% of total advances in the system while 63% of total loans were provided to corporate sector. This portfolio mix indicates a general approach of banks’ in credit management in times of recession; it increases the incident of credit concentration risk. Further credence to this claim comes from the fact that textile sector, with highest share in corporate loans (19.5%) has the highest infection ratio (NPLs to total loans) of 14.6%. IN 2008, SME, agricultural and consumer financing had infection rates of 15.8%, 15.8% and 6.9% respectively compared to 8.9% average for corporate. Since SME financing has proved to be a risky venture for Banks historically, it is rational for individual banks to pull back funding at the first sight of crisis – thus, impairing SME’s debt service capacity in the short run and weakening business environment in the long run. To sum, fragile demand globally and weak growth capacity domestically caused structural obstacles to local businesses and in turn badly affected banking sector’s asset and capital quality.
Despite going through period of low profitability, increasing NPLs and high cost of funds; effective regulatory framework has kept Pakistan’s banking industry on solid footing. For 2008, capital Adequacy Ratio (CAR) stood at 12.3% against a minimum requirement of 9% under Basel II framework while core-capital constituted 83% of total capital. Though total liquid assets for banks declined to 28%, the advances to deposits ratio was 72% indicating that banks are in a strong position to meet liabilities and remain solvent. These trends are positive signs for the liquidity and solvency of banks. However, the lagged impact of decline in assets quality from NPLs and presence of smaller weak banks in the system might have implications on capital positions of banking sector in the future.
Having a strong capital cover internally and growing opportunities externally, banks can return on growth trajectory soon. A series of recent ominous developments provide platform for business avenues. Firstly, rupee-dollar parity has undergone 35% depreciation since Oct’08 and has remained relatively stable after deregulation by SBP. Compared to regional competitors like India and China, Pakistan enjoys a comparative advantage to European and Middle Eastern markets. Secondly, higher cotton crop has caused a decline in costs and increment in margins for textile sector. Amidst a growing global demand and favorable exchange rate, cotton and textile exports can lead revival of manufacturing in Pakistan. This provides banks with an opportunity to refresh financing lines for working capital and gain from textile sector expansion. Thirdly, consumer financing has gone through consolidation and is now subject to a comprehensive regulatory framework. As domestic asset prices have stabilized, their demand could be reignited by stimulating consumer business like autos, home appliances and house financing. This will not only provide a broad based market for banking products but initiate growth in construction, electrical, automotive, materials and related industries in Pakistan.

Pakistan External Account & Exchange Rate

External Account & Exchange Rate
Pakistan’s external sector has witnessed improvement since joining IMF standby agreement in late 2008, and since then PKR exchange rate has depicted relative stability. During Jul09-Feb’10, USD/PKR has undergone an average monthly depreciation of 0.56%. Deregulation of foreign exchange inter-bank market and uncertainty over maturity of foreign support has increased volatility in recent months.

External account
Stabilization in external account continued as Jul’09-Jan’10 current account deficit shrank to USD2.5billion, down 69% year-on-year (YoY). Reduction in deficit was led by sharp decline in trade deficit, which stood at USD6.6billion (down 27% YoY) and healthy inflow of remittances (up 22% YoY). Based on current trend, the current account deficit could potentially outperform the IMF projected target of USD7.5 billion.

Remittances
Remittance inflows for Jan’10 stood at USD668million (down 4% MoM), aggregating Jul’09-Jan’10 inflow to USD5.2billion (up 22% YoY). Despite paring strong compared to last year, a persistent down-trend is visible in remittances since their peak of USD804million in Sep’09. Consistent decrease in remittances could deteriorate economy’s deficit financing capability, and result in increased pressure on USD/PKR.

Oil Prices
Petroleum products compose bulk of our imports, constituting 30% of total import bill. Crude oil prices are once again on the rise (mainly due to recovery in global economies) and have almost doubled from last year’s low of USD40.22/bbl.

Exchange Rate Outlook
Based on some semblance of stabilization in Pakistan’s external accounts, we expect the exchange rate to remain less volatile in coming months. However, we are of the view that the Rupee will continue to remain weak in line with IMF forecasts (refer to Table 2).



--Asim Jahangir

Economy Update: Status quo maintained on Interest Rates

Discount rate maintained at 12.5%

Our expectations remained largely on-track in projecting a status-quo in the discount rate for the next two months. Financial markets broadly expected discount rate to remain unchanged since no dramatic movement was witnessed in market interest rates. We believe that central bank’s actions remain in line with its outlook on key risks and improvements in the economy so far, and would continue to have a cautious approach in managing expectations going forward.

Key risks highlighted in MPS
According to Monetary Policy Statement, the following key risks facing the economy were reason to avoid easing of interest rates.
· Despite lowering of inflation to 10.5% in Dec’09, structural obstacles in supply of food items, upward adjustments in energy tariffs and incipient international commodity prices increases make an uptick in inflation during Jan-Jul’10 highly likely.
· Prevailing energy crises and deteriorating law & order conditions in the country have substantially reduced economy’s productive capacity.
· Although agricultural sector has shown signs of robust growth, the likely shortfall in water availability during the remainder of year could affect agricultural productivity.
· Higher security expenses, uncertainty over foreign support and dismal revenue collection have constrained fiscal management. Based on current trend, meeting the fiscal deficit target of PKR740billion seems unlikely.
· Despite spike in total deposits on banking sector, liquidity in the system remains constrained. Based on substantial outstanding amounts to the government for commodity operations, continuation of credit utilization by Public Sector Enterprises and scheduled outflow due to PIB (PKR30billion) and T-bills (PKR430billion) auction targets, significant constraint on banking sector resources will remain.
· Based on projected growth in NDA and realization of external inflows, monetary expansion is projected to grow by 14.5% in FY10
· Decline in Current Account and Trade Deficit coupled with strong remittance inflows are positive developments in external sector. However, rise in imports, delays in maturity of FoDP support and repayment of IMF’s budget financing (~USD750million) could worsen improvements in external accounts.
· Gradual deregulation of exchange rate including the transfer of oil payments to inter-bank market has caused PKR to depreciate by 3.6% during Jul-Dec’09 and increased the incident of volatility. Further depreciation could augment efficiency of markets and boost competitiveness of exports; it could also add to inflationary expectations as cost of imports increases.

Cautious approach to continue

Mending macroeconomic conditions have provided breathing space to economic managers in the short term; upcoming prospects for the economy remain challenging. Headline inflation remains the prime concern for SBP and under current situation CPI inflation could continue to rise. Our forecast for average inflation in FY10 is ~12%, which is in line with SBP’s projections. Moreover, political uncertainty, precarious fiscal position, deteriorating liquidity and vulnerability to another international commodity price surge add to difficulties of managing domestic monetary framework. In our view, the central bank will not have room to judiciously lower the discount rate during the remainder of the year.

Weakening of Rural Institutions: Causes and Remedies

Weakening of Rural Institutions: Causes and Remedies
Strong institutions are critical for economic and social growth. It is generally established that greater security of land rights would be related to higher efficiency and profitability. In developing countries, where poverty is widespread, populations are on the rise, access to land is limited and agrarian economy contributes significant proportions of both national and household income, establishment of secure land rights institutions can have far reaching effects on poverty, equality and social mobility.

A growing body of microeconomic literature shows that strong property rights translate into higher investments in land quality. This impact comes through three important channels. First, value of land is tied to its productive capacity. The right to willfully sell land or to bequeath it to ones ancestors would increase the incentive to invest in land quality, in turn raising the potential gains from such a transaction. Second, the right to operate on land or to accrue the benefits from it would increase the amount of investments which raise crop production over the long run (Goldstein and Udry) . Third, clearly defined rights would allow farmers a higher access to credit, especially when land is the only collateral available (Besley). However, the weakness of rights would deter investments in land quality, leading to lower crop productivity on farms and decreasing profitability for households.

In Pakistan, where agriculture sector contributes 22% of GDP and employs 60% of labor, highly unequal land owning patterns (median land holding below 25000 yards) and declining crop yields escalate the problem of land rights insecurity(Ministry of Finance). The geographically varying land institutions in Pakistan have evolved through fusion of Islamic inheritance law, colonial preferences of revenue collection and regional practices. In the Sargodha district of Punjab province alone, three dominant practices can be traced –single ownership systems as in zamindari, pattidari based tenure of equal communal ownership and private entitlements as in bhaichara have historically existed (Nelson). This multilayered pattern of property tenures coupled with poor land record maintenance has led to overlapping claims on farmlands where land holding was communal and division into very small plots where private ownership is prevalent – both causing lower investments in land. Moreover, the existence of parallel bureaucratic authorities exacerbates the problem, as the civil court and the land revenue department can, practically, independently establish title on a given plot. Prolonged cases in both the departments have increased the incident of land disputes while raising the threat of eviction for socially marginal farmers arising from land-grabber and rural elite.

Nationwide land reform is necessary to counter this issue; sweeping land redistribution might not be a comprehensive solution. At first stage, extent of joint ownership and existence of weak property rights needs to be established. The exercise is not simplistic because of the wide variation de jure and de facto measures of tenure security. Patterns of family ownership practices and intra-household bargaining power complicate the analysis of de facto measures while overlapping documental evidence hinder establishing an official land holding record. Second, the impact of land insecurity on key variables like investments, productivity, access to land, credit availability and poverty needs to be estimated broadly. Additionally, promoting private ownership on communal lands could increase intra-generational poverty. As ancestral land gets divided into smaller plots of land, commercial viability of farming decreases as productivity falls – pushing farmers to the brink of sustainability and even below. Further, social mobility into non-farm professions might decrease as weaker land markets make it hard to sell the land and hinder diversifying to other vocations.

Reforms at governance level are essential for making bureaucratic procedures understandable and executable for the public. The land revenue system needs to be streamlined countrywide by use of modern geo­-mapping technologies. Segregating the scope of agricultural departments, simultaneously ensuring synchronization of their operations, is a vital step for raising the transparency and accountability of public works. Increasing the measures to make land markets more effective and efficient by lowering of transactions costs, both actual and imputed, through condensing the number of procedures required to sell/transfer land is also significant. Further, creating a transparent dispute resolution mechanism is indispensable. Slow judicial procedures, higher incidence of appeals on decision combined with increased costs of trials impede the process conflict resolution. A survey of land dispute record in Sargodha revealed that most cases have lasted more than decades, before settling out of court (Jahangir, Mazhar and Rehman). Moreover, efforts to grow and secure land tenancy contracts could also serve as a complement to enhancing land institutions in Pakistan (Budhani and Mallah).

Current Account Deficit Shrinks; Remains vulnerable

Current Account Deficit Shrinks Further

For quarter ended in September, Pakistan’s external accounts saw the much needed stabilization as Current Account deficit shrank both on quarter-on-quarter (down 48%) and year-on-year (down 89%) basis. The reduction is driven by a 28% fall in imports and steady rise in remittances, which stood at USD2.3billion for the first quarter (up 24% year-on-year).

Non-essential imports fell…

Both volumes and payments for non-food non oil imports have reduced over last year as commodity prices have tapered down and domestic growth remains slow. Decrease of USD420million and USD100million (quarter-on-quarter basis) was witnessed in imports of machinery and metal products respectively corroborating that domestic production has slowed down. We believe that if the prevailing trend of reduction in non-essential imports continues, a low current account deficit for the remainder of the year may be sustainable. …But oil imports will be key Petroleum products constitute bulk of our imports, constituting 30% of total import bill. Crude oil prices are once again on the rise (mainly due to the weakness in the dollar) and have almost doubled from the year’s low of USD40.22/bbl. The experience from last year tells us that any persistent rise in oil prices could lead to structural instabilities in our balance of payments.

As per our analysis, if oil prices stay around USD80/bbl, Pakistan’s current account will remain stable with little or no depletion in the country’s foreign exchange reserves. If, however, oil prices rise and peak above USD100/bbl during the remainder of the year, balance of payments pressures will likely return. The table below highlights the sensitivity of oil price for our external Accounts