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The Mortgage-Backed

Securities Market in Pakistan

by Naz Chohan

The Fixed-Income Securities Market

STRUCTURE OF THE FINANCIAL SECTOR

The financial sector in Pakistan comprises financial institutions, the capi-

tal markets, and regulatory bodies. The financial institutions can be broadly

divided into scheduled banks1 and nonbank financial institutions (NBFIs).

As of 31 March 19982 there were 46 scheduled banks (private, national-

ized, and foreign) operating in Pakistan. Most of the other financial insti-

tutions, including development finance institutions, or DFIs (of which there

are ten), investment banking companies (15), leasing companies (33),

modarabas3 (48), and housing finance companies (2), are referred to as

NBFIs.4 Corporate brokerage houses do not fall in either the scheduled

bank or the NBFI category.

Scheduled banks and the NBFIs (excluding modaraba and leasing com-

panies) are both subject to the prudential regulations of the central bank, the

State Bank of Pakistan (SBP), but are regulated by different wings of the

SBP and must comply with different capital, liquidity reserve, and other

requirements. While commercial banks provide mostly short-term working

capital, NBFIs cater to the medium- to long-term financing needs of clients,

and are barred from such commercial banking activities as trade business

1Commercial banks operating in the country.2Government of Pakistan, Economic Survey, 19971998.3Trust financing arrangements.4Khadim Ali Shah Bukhari & Co. Limited (Research).

Chapter 6

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400 CHAPTER 6

and check issuance. Commercial banks, on the other hand, were allowed

by the SBP in September 1997 to undertake long-term project lending.

Among the scheduled banks, only Pakistani commercial banks are listed.

There are three stock exchanges in Pakistan, one each in Karachi,

Lahore, and Islamabad. The Karachi Stock Exchange (KSE) is the old-

est as well as the largest in terms of trading activity and number of listed

companies. The KSE had 777 listed companies on 30 June 1998; the

Lahore Stock Exchange (LSE) had 631; and the Islamabad Stock Ex-

change (ISE) had 285.5 The KSE and the LSE are computerized while

the ISE uses the open outcry system. To facilitate the transfer of shares

traded on the stock exchanges a Central Depository Company (CDC)

was established in 1995 and officially inaugurated in September 1997.6

Most of the trading in the money and bond markets is in government

securities and bonds issued by government authorities. Corporate bonds in

the form of term finance certificates (TFCs) were first introduced in 1985.

Two main regulatory bodies govern the financial sector: the SBP and

the Corporate Law Authority (CLA). The SBP regulates the financial

markets and has full autonomy in formulating and implementing monetary

policy by virtue of an amendment to the State Bank of Pakistan Act of

1956. The CLA, under the Securities and Exchange Ordinance of 1969,

has the task of promoting the development of the capital markets in Paki-

stan. It regulates all aspects of corporate activity, including the operations

of the stock exchanges, company registrations, and share and debt issu-

ance by companies. Like the SBP, the CLA reports to the Ministry of

Finance (MOF), which thus plays an important role in both monetary and

fiscal policies and capital market development.

The CLA will eventually be replaced by a Securities and Exchange

Commission (SEC) as part of the US$500-million Capital Market Devel-

opment Program (CMDP) being financed by the Asian Development

Bank (ADB) and the Exim Bank of Japan. The Parliament has already

approved the SEC Act, which authorizes the SEC to regulate the capital

markets. The SEC will have seven members: four from the public sector

and three from the private sector. Except for the inclusion of the private

sector in policymaking, the SEC Act does not seem to change the func-

tioning of the stock markets.

5Ibid.6Institute of Business Administration, Report on the Central Depository Company.

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401THE MBSs MARKET IN PAKISTAN

FINANCIAL SECTOR REFORMS

The economic development of Pakistan is based on five-year rolling macro

plans. Financial reforms began under the 19881993 plan, which focused

on the privatization and deregulation of major sectors of the economy,

including banking, communications, and manufacturing, which had been

nationalized in 1972. This plan also included measures to attract foreign

investment into Pakistan and to develop the local corporate debt market.

A critical part of the financial reform program was the SBPs issuance

of separate prudential guidelines for commercial banks and for NBFIs.

The guidelines governed lending, exposure limits, and other issues, and

were meant to imbue banks with the discipline of financial management.

The financial sector in Pakistan has long suffered from the inefficien-

cies of large state-owned banks. Three ordinances were issued by the

government in 1997 and later passed by Parliament to institute wide-

ranging reforms in the banking sector. These laws were related to the

Bank Nationalization Act of 1974, the Banking Companies Ordinance of

1962, and the State Bank of Pakistan Act of 1956.

The SBP has been given sole authority to formulate and monitor mon-

etary and credit policies as recommended by the Monetary and Fiscal

Policies Coordination Board, and to keep a close eye on the limits set by

the board on federal and provincial government borrowing. The abolition

of the Pakistan Banking Council has made the SBP the only regulatory

body for banks in Pakistan. It nominates the presidents and boards of

directors of nationalized banks, and approves the chief executive officer

nominees of all private banks. This move appears to run counter to the

spirit of the banking sector reforms, but in effect nullifies the governments

leverage in the operations of nationalized banks. The massive loan de-

faults in the country were caused by the imprudent credit policies of the

political appointees who used to head the nationalized banks. However,

requiring foreign banks to seek SBP approval can be viewed as over-

regulation of the banking sector and could lead the markets to question

the governments sincerity in liberalizing the banking industry in Pakistan.

The SBP has taken a number of steps to make bank operations more

transparent and to deal with the problem of defaults on loans granted by

nationalized banks. New, professional management has been appointed

and given the task of improving the quality of new loans of these banks

and tackling the problem of nonperforming loans. To facilitate loan re-

covery the government has also announced new foreclosure laws. Bank

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402 CHAPTER 6

disclosure laws have been revamped and a highly informative new for-

mat for presenting annual accounts has been introduced.

On the capital markets side, the CLA introduced the Employees Provi-

dent Fund (Investment in Listed Securities) Rules in 1996, allowing provi-

dent funds to invest in listed securities. Amendments to these rules in

June 1997 increased the investment limit in listed securities from 10 per-

cent to 20 percent of the provident fund size. The investment in each

scrip is limited to 5 percent of the paid-up capital of the issuing company.

Since 1994, the government has made significant progress in ad-

dressing constraints on the development of the fixed-income market,

as follows:

The company law was amended, permitting companies to raise debt

directly from the public by issuing TFCs.

Stamp duty was reduced from 4.5 percent to 0.15 percent at issu-

ance, and 0.1 percent on subsequent transfer (in line with the stamp

duty on equity securities).

Rating agencies were established.

TFCs could be listed on the exchanges, provided that they were rated.

Foreign investors, as well as provident funds, were allowed to invest

in listed securities.

Foreign investors were allowed forward exchange cover for up to

one year against the listed securities.

Listed securities were made eligible for the statutory liquidity require-

ment of NBFIs.

In the last quarter of 1997, the KSE formed a debt listing committee to

simplify and facilitate the listing process, allow shelf registration, reduce

listing expenses, and speed up listing. The committee has met regularly

since then and is expected to streamline the listing process for debt secu-

rities significantly.

MARKET INFRASTRUCTURE

Regulatory Framework

All securities generally classified as bonds are regulated by the SBP and

the CLA. Bonds listed on the stock exchanges must also comply with

their listing requirements. The SBP regulates the issuance of all govern-

ment securities including Treasury bills (T-bills) and federal investment

bonds (FIBs). The CLA is the apex regulatory body that administers all

laws for the corporate sector and the securities market. It administers

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the Securities and Exchange Ordinance of 1969 and the Companies

Ordinance of 1984. Until the 1995 Finance Bill (Annual Budget) abol-

ished the Capital Issues (Continuance of Control) Act of 1947, as part

of the economic deregulation measures, this statute was also adminis-

tered by the CLA. The abolition of the Capital Issues Act transferred

the regulation of public issues (both debt and equity) to the Companies

Ordinance of 1984, which also provides the legal framework for the

corporate sector.

The Securities and Exchange Ordinance of 1969 was enacted to

regulate the securities market and the working of the stock exchanges.

Over the years, the ordinance has been under continuous review, and

the focus has shifted toward encouraging self-regulation by the stock

exchanges.

The Companies Ordinance of 1984 gives the name term finance cer-

tificates to what are essentially debt securities, whose important feature

is that the return promised by the issuer to the investor is built into the

repurchase price at maturity. The difference between the original price

and the repurchase price is not referred to as a fixed return but as ex-

pected profit. The labels, particularly expected profit, are chosen to

confer an Islamic character on the instrument, since interest in the form

of a fixed return (riba) on capital is deemed un-Islamic by most religious

scholars. Thus, while both the issuer and the potential investor share the

perception that the return on a TFC, in purely legal terms, is a fixed re-

turn, there is no certainty of a fixed obligation on the part of the issuer.

This appears to be an unavoidable and unrectifiable anomaly which casts

doubt on the character of the TFC as a fixed-income security. Interest-

ingly enough, the government itself promises a fixed and specified return

to investors in its federal investment bonds.

Various other interesting solutions have been devised to deal with the

riba issue and to promote Islamic banking in the country. Trade-related

L/Cs are discounted by first being purchased from the exporter and then

resold back. The difference between the purchase and the resale price is

treated as profit. Funding sources for business activities have been given

Islamic names like modaraba (trust financing), murabaha (cost-plus fi-

nancing), musharaka (venture capital), and ijara (leasing). Modaraba is

an arrangement between two parties in which one agrees to provide 100

percent financing for a project while the second party agrees to run the

operation, and they share the profits on a predetermined basis. Murabaha

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404 CHAPTER 6

is an agreement under which a bank buys equipment on behalf of a client

and sells it to him at a profit. Musharaka is a partnership agreement be-

tween two parties who agree to finance a project and jointly manage it,

and then share the profits on a preagreed basis. Ijara is an agreement

under which a bank purchases equipment for a client and leases it to him

for a rental fee. The lease is an operating one, and the bank still owns the

equipment.

TFC issues are regulated under Section 120 of the Companies Ordi-

nance of 1984. The CLAs interpretationand current practicerequires

issuers to obtain CLA approval only for public TFC issues. The approval

is contingent on several factors: security for the TFC holders, as speci-

fied; a fully underwritten issue (the KSE no longer requires this); the

creation of a redemption reserve; the appointment of trustees; and man-

datory credit rating (for public issues). These guidelines are not binding

but are applied on a case-by-case basis.

Credit-Rating Agencies

There are two credit-rating agencies in Pakistan, the Pakistan Credit

Rating Agency (PACRA) and DCR-VIS. PACRA was established in

August 1994, and is a joint venture among IFC, Fitch IBCA, and the

LSE. DCR-VISwas established in 1997 and is a joint venture between

Duff & Phelps Credit Rating Co. and Vital Information Services (a local

company).

The companies are registered with the CLA under the Credit Rat-

ing Companies Rules of 1995 which were issued under Section 33 of

the Securities and Exchange Ordinance of 1969. These rules require

all credit-rating companies operating in the country to register with

the CLA. To qualify for registration, a company must be affiliated

with an internationally recognized rating agency, among other eligibil-

ity criteria. Registration remains in force for one year and may be

renewed yearly.

All NBFIs, whether or not they are mobilizing or intend to mobilize

public deposits, are now required by the SBP to obtain ratings.

THE FIXED-INCOME MARKET

The fixed-income market in Pakistan can be divided into the government,

semigovernment, and corporate debt markets. Statutory corporations issue

semigovernment debt in the corporate debt market. As of 30 June 1998, the

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volume of outstanding bonds was relatively high, at 42.1 percent of GDP,7

but this figure is misleading since the size of the actively traded bond market

as of that date was about Rs 314.19 billion, or only about 11.39 percent of

GDP.8 The bond market is dominated by the government. T-bills and fed-

eral investment bonds accounted for Rs 287.33 billion, or 91.45 percent of

the bonds outstanding as of 30 June 1998. Statutory corporations contrib-

uted Rs 24.60 billion (7.83 percent) and corporate entities, Rs 2.26 billion

(.72 percent).

Issuers

Government

The government has consistently run large fiscal deficits over the last

two decades. At the end of June 1998, it had an accumulated debt of

Rs 2,518.3 billion, or 91.2 percent of GDP.9 To finance these deficits, the

government has been borrowing from the banking sector through govern-

ment bills (T-bills) and bonds (federal investment bonds, or FIBs). Aside

from the banking sector, the government has also borrowed from the

public, through the national savings schemes. Initially the government

borrowed from state-owned institutions, including financial institutions, at

below-market rates through moral suasion and mandatory reserve re-

quirements.

Table 1 shows the mandatory reserve requirements for financial insti-

tutions in Pakistan.

7State Bank of Pakistan, Annual Report 19971998.8Ibid.9Ibid.

Table 1

Commercial Banks NBFIs

Statutory reserve requirement (SRR) Cash reserve of 5% of Cash reserve of 1% ofdemand and time liabilities demand and time liabilities

Statutory liquidity requirement (SLR) 15% of demand and time 14% of demand and time

liabilities in FIBs/T-bills/ liabilities in FIBs/T-bills/national investment trust NIT units/listed securities

(NIT) units

Total 20% 15%

Mandatory Reserve Requirements for Financial Institutions n

Sources: Khadim Ali Shah Bukhari & Co. Limited, Fixed-Income Monthly, August 1998; State Bank of Pakistan, Annual Report

19961997

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406 CHAPTER 6

National investment trust (NIT) units are units issued by the state-

owned open-ended mutual fund, which is the larger of the two open-

ended funds in Pakistan.

At first, Treasury bills were issued on tap basis for six months at 6

percent per year, while bonds were issued irregularly. The following

changes in T-bill issuance were introduced in April 1991, when the gov-

ernment moved to a market-based system as part of the process of eco-

nomic deregulation, disinvestment, and decentralization:

The American-style auction-based system was introduced.

The primary market was limited to fortnightly auctions, instead of

on tap, allowing for the development of a secondary market.

The market was allowed to determine yields.

Primary dealers were appointed.

The government stopped issuing T-bills on 4 July 1996 and instead

issued short-term federal bonds (STFBs), but reversed that decision on

24 June 1998, when it decided to stop issuing STFBs and reintroduced T-

bills.

While T-bills are short-term instruments, federal investment bonds

(FIBs) are medium to long term. FIBs, with a fixed coupon rate for a

particular tenor, were introduced in 1991. Auctions were held monthly.

As of 30 June 1998, the government had domestic debt outstanding of

Rs 1,151.4 billion (41.72 percent of GDP). 10 Of this amount, permanent

debt11 accounted for Rs 289.70 billion (10.50 percent), floating debt12 for

Rs 473.85 billion (17.17 percent), and unfunded debt13 for Rs 387.90

billion (14.05 percent). As shown in Figure 1, T-bills (through auctions)

represented 21.65 percent of the floating debt, and FIBs, 50.49 percent of

permanent debt.

Besides the auction system, the SBP held the first formal open-market

operation (OMO) sale of government securities in 1995. Although OMOs

were meant to support interest-rate policy, the MOF first used them only

as a borrowing vehicle. The introduction of OMOs was a severe blow to

the secondary market: now the SBP would enter the market at least

seven times a month (three auctions and four OMOs). The move was

10State Bank of Pakistan, Annual Report 19961997.11Medium- and long-term debt.12Short- term debt, normally T-bills.13Completely nonbank debt, normally national savings schemes.

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criticized by market participants as a reversion to the on tap system,

with a change in rates.

Characteristics of T-bills and FIBs. The T-bill is a debt instru-

ment with a maturity of three, six, or twelve months and a face value of

Rs 100, and is issued at a discount. The government guarantees the

face value and the profit. As in the US, T-bills are auctioned by the

central bank and all authorized primary dealers may participate. Figure

2 below presents the auction cut-off yields and amounts accepted for

T-bills/STFBs since 1991.

Figure 1 Breakdown of Domestic Debt, as of 30 June 1998 (Rs million) n

Source: State Bank of Pakistan, Annual Report 19971998

Figure 2 Auction Cut-off Yields for T-Bills/STFBs, 1991 to present n

Source: Khadim Ali Shah Bukhari & Co. Limited (Money Markets)

STFBs as % of Floating Debt = 21.37%

Unfunded Debt311,783

Floating Debt433,83

Permanent Debt296,172

FIBs as % of Permanent Debt = 52.85%

19 91 19 9 2 1 9 93 199 4 1 995 19 96 199 7 1 9980

5,500

11,000

16,500

22,000

27,500

33,000

38,500

44,000 19181716151413121110987

65

STFBs replace T-bills

T-bills replace STFBsAccepted AmountCut-Off Yields

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408 CHAPTER 6

FIBs, part of the governments permanent debt, have three different

maturities with a fixed coupon rate that varies with maturity. The coupon

rate is currently 13 percent per year for three years, 14 percent per year

for five years, and 15 percent per year for ten years, payable semiannu-

ally. FIB auctions follow the same procedure as for T-bills and are held

monthly. The actual yield to the investor depends on the accepted bid

price at each auction. Each bidder at an auction gets the amount at his bid

price (if accepted), as opposed to a single price for all the accepted bids.

Figure 3 shows the amounts accepted in billions of rupees through FIB

auctions from February 1991 to May 1998.

The decreasing amount of accepted FIBs reflects the decreasing bid

amounts in the auctions. It is evident from Figure 2 that the yield on six-

month T-bills currently hovers around 14.00 percent per year, higher than

the yield on three-year FIBs and equal to the yield on five-year FIBs.

Given the current interest-rate structure, it is no surprise that most institu-

tional investors have shifted from longer tenors to shorter ones.

The main participants in the primary market are banks and other fi-

nancial institutions (regardless of their resident status), which are required

to hold these securities as part of their statutory liquidity requirement

(SLR). Individuals and corporate entities also participate in the market,

but nonresident persons or corporations may invest only with foreign ex-

change remitted through official banking channels. The principal and re-

turns on such investments may be repatriated, and exchange risk cover

for up to one year can be obtained from commercial banks.

Figure 3 Amounts Accepted in FIB Auctions, February 1991 to May 1998 (Rs billion) n


19 91 1 9 92 1 9 93 1 9 94 19 95 19 9 6 19 9 7 19 9 80

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

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Primary dealers. Only primary dealers may participate in the auc-

tions and OMOs. There are 77 primary dealers, including all the commer-

cial banks and the NBFIs, as well as a few other institutions.

Settlement. Settlement is normally through book entry, but physical

delivery can be made if necessary. Primary dealers must maintain a cur-

rent account (for cash settlement) and a subsidiary general ledger ac-

count, or SGLA (for book-entry settlement) with the SBP. The positions

of primary dealers are maintained by the SBP in these accounts.

Tax liability. Investors in T-bills and FIBs are subject to a withholding

tax, which is adjusted against their final tax rate. The tax rates are given

in Table 2.

Table 2

Category of Investor Withholding Tax Final Tax Rate

Foreign commercial bank 58% 58%

Local commercial bank 30% 58%

Local (nonexempt) institution 10% 33%

Individual 10% depending on income bracket

Tax Rate of Investors in T-Bills and FIBs n


The yield curves established by the STFBs/T-bills and FIBs were ex-

pected to provide a benchmark for corporate debt. However, the STFBs/

T-bills are used more regularly to price corporate debt, since they are

used to price floating-rate loans.

Secondary market. Both T-bills and FIBs are freely tradable in the

secondary market through over-the-counter transactions. Transactions in

each of these instruments amount to around Rs 45 billion daily with a

bid/offer spread of 2550 basis points (bps), depending on the size of the

transaction, and are carried out through adjustment entries in the SGLA

with the SBP. The average transaction size is around Rs 100 million. Now

operated manually, this system will eventually be computerized.

Repo (repurchase agreement) market. This is the most common

transaction in the interbank market, with a daily turnover normally in ex-

cess of Rs 10 billion. The underlying securities are T-bills and FIBs. The

tenor normally varies from overnight to six months, but could be longer.

Yield curve. The current yield curve in the interbank market is given

in Figure 4.

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410 CHAPTER 6

Discount rate. The SBP has a discounting facility that gives commer-

cial banks access to a one- to three-day repo window at 16.50 percent

per year in a liquidity crunch.

Statutory corporations

This section covers the issuance of debt securities by corporations

that were not incorporated under the Companies Ordinance of 1984

and are therefore not regulated by the CLA. The main entity that has

relied on bond financing is the Water and Power Development Author-

ity (WAPDA), the national power utility company, which has had a large

and growing need for long-term funds. These needs used to be met

from government budgetary allocations, supplemented with government-

guaranteed bank loans. But after the government stopped guaranteeing

bond issues in 1994, WAPDA was forced to raise funds directly from

the market. Since 1988, it has raised Rs 23.699 billion through a series

of issues, as shown in Table 3.

The bonds were issued in Rs 5,000500,000 denominations with re-

turns payable every six months, and are discountable after six months

from the date of sale (except for the sixth issue). They are quoted on the

Karachi and Lahore Stock Exchanges.

The Civil Aviation Authority (CAA) is another public-sector organiza-

tion that has relied on bond financing for its capital expenditures. It has

issued one series, valued at Rs 900 million and with an annual return of

12.5 percent, in 1991. These government-guaranteed bonds were redeem-

able after five years.

Figure 4 Yield Curve in the Secondary Market, as of 31 December 1998 n


O /N 7 -d a y

1 5 -d a y

1 -m o n t h

3 -m o n t h

6 -m o n t h

1 -y e a r

2 -y e a r

3 -y e a r

1 0 -y e a r

1

3

5

7

9

1 1

1 3

1 5

1 7

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Corporate entities

The corporate bond market in Pakistan was established only in 1994,

although corporate bonds, known as TFCs, have been around since 1985.

TFCs are privately placed and hence illiquid, and are, in fact, term loans

provided by banks and DFIs under a different name. The creation of a

corporate bond market has given corporations access to the capital market

and allowed them to diversify their sources of borrowing. They have thus

been able to reduce their dependency on the banking system for funds at a

time of lending restrictions: SBP prudential regulations have set single-cus-

tomer lending limits for each bank and restricted public-sector organiza-

tions from borrowing from banks.

In September 1997, as part of the CMDP, all investors in rated corporate

debt were made tax exempt. Primary yields for corporate debt dropped by

200 bps to take account of the tax advantage, and corporations and public-

sector enterprises rushed to issue TFCs to lock in the low fixed rates.

On 17 March 1998, SRO 171(1)/98 issued by the Central Board of

Revenue (CBR) rescinded the tax-exempt status of all institutions, in-

cluding corporate entities. All companies are now taxed at their normal

tax rates, and only individuals, associations, and provident/pension funds

are still tax exempt. The apparent reason for the measure is to prevent

banks from converting their taxable loan portfolios into tax-exempt TFCs

and earning abnormal profits. The authorities feared a possible misuse of

the facility, which they felt should not have been given in the first place to

the banking sector, the highest tax-paying category in Pakistan.

Table 3 Salient Features of WAPDA Bond Issues n


Term Year Rate Amount Sold

Issue (Years) Issued (%) (Rs billion)

1 5 1988 13.50 3.102 (redeemed)

2 5 1989 13.50 5.631 (redeemed)

3 10 1990 12.50 6.844

4 10 1992 15.00 1.431

5 10 1993 16.00 1.250

6 10 1994 19.00 2.991

Special 5 1995 16.50 2.450

Total 23.699

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412 CHAPTER 6

Trading and settlement. TFCs are tradable on the stock exchanges

as well as over the counter. Since the market players are normally finan-

cial institutions, more than 90 percent of trading takes place over the

counter; the stock exchange is dominated by equity brokers. Over-the-

counter settlement takes place on mutually agreed dates between buyer

and seller, and can also be carried out on the same day. Trades on the

stock exchanges are settled on T+1.

Money and Bond Market Instruments

The main types of instruments available in the money and bond markets

are as follows: those issued by the government and statutory corpora-

tions (Treasury bills, federal investment bonds, special US-dollar bonds,

foreign-exchange bearer certificates, WAPDA bonds, defense savings

certificates, and special savings certificates) and those issued by the

corporate and financial sectors (certificates of investment, term finance

certificates). Treasury bills and federal investment bonds are interbank

instruments normally invested in by banking institutions. Foreign-ex-

change bearer certificates, WAPDA bonds, certificates of investment,

and term finance certificates are held by institutions as well as individu-

als. Provident and pension funds and individuals may invest in defense

savings certificates and special savings certificates, but banks are not

allowed to do so.

The publicly listed issues to date are given in Table 4 below.

Table 4 Listed TFC Issues, as of 30 June 1998 n

Source: Khadim Ali Shah Bukhari & Co. Limited

Packages SSGC Nishat Tek ICI Gatron

Total outstanding Rs 232 million Rs 500 million Rs 250 million Rs 1,000 million Rs 274 million

Issue date 19 Feb. 1995 19 Oct. 1995 16 Jan. 1996 30 Sept. 1996 17 June 1998

Maturity date 19 Feb. 2000 19 Oct. 2000 16 Jan. 1999 30 Sept. 2001 17 June 2003

Tenor 5 yrs 5 yrs 3 yrs 5 yrs 5 yrs

Issue price Rs 100 Rs 100 Rs 100 Rs 100 Rs 100

Denomination Rs 5,000 Rs 5,000 Rs 5,000 Rs 5,000 Rs 5,000

Issue yield 18.50% 18.25% 18.00% 18.70% 18.00%

Profit payable Feb/Aug Oct/Apr Jan/Jul Sept/Mar Jun/Dec

Rating (PACRA) A+ AA A AA- A+

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Instruments issued by the government and statutory

corporations

Treasury bills (T-bills). A T-bill is a debt instrument with a maturity

of three, six, or twelve months. Its short maturity makes it the most liquid

government security in the money market. It is also freely traded and

transferable. T-bills are issued at a discount to their face value of Rs 100

through auctions and OMOs organized by the SBP. The bidder must indi-

cate the total bid amount and the price at which he is willing to buy the T-

bill. The face value is guaranteed by the government and repaid at matu-

rity. T-bills are treated as liquid assets for financial institutions

Federal investment bonds (FIBs). FIBs are issued in maturities of

three years (with a coupon of 13 percent per year), five years (14 percent),

and ten years (15 percent). The coupon is paid every six months. Coupon

payments and redemption of principal are guaranteed by the government.

Issues are made through closed-bid auctions held monthly by the SBP. Bids

are placed through primary dealers at discount, at par, or at a premium to

the face value of Rs 100. FIBs are freely traded in the secondary market

and are treated as liquid assets for financial institutions.

Special US-dollar bonds. These are registered bonds denominated in

US dollars and issued at par with maturities of five, seven, and ten years.

They were introduced in 1998 to induce foreign-currency account (FCA)

holders to convert their holdings into these bonds. Profits, at a rate that varies

between LIBOR and LIBOR + 2 percent, are paid semiannually. Resident

Pakistani FCA holders who purchase these bonds are paid their profits in

rupees at the official exchange rate on the date of accrual of profits. Nonresi-

dent buyers are paid in US dollars. The face value may be cashed in at

maturity in US dollars or rupees. Bonds and proceeds are exempted from

wealth tax for six years, as well as from income tax andzakat.14

Foreign-exchange bearer certificates (FEBCs). First introduced

in 1985, these rupee-denominated certificates are issued at par with a

maturity of three years. FEBCs can be exchanged for cash from the

issuing institution at any time after issue, but with a penalty in terms of

interest payments.

FEBCs may be purchased without limit by Pakistanis and foreigners,

against payment in foreign exchange. The par value of the certificates is

14Islamic tax on wealth, charged at 2.5 percent only on the principal amount at the time of cashing in, except

where a statutory declaration of exemption is filed, and in the case of trusts, funds, and other noncorporate

entities.

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414 CHAPTER 6

paid either in rupees or in foreign currency at the holders discretion, at

the spot rate as of the day of purchase. The holder bears the entire for-

eign-exchange rate risk.

Water and Power Development Authority (WAPDA) bonds.

There have been six issues of WAPDA bonds. The first four issues are

guaranteed by the government, while the others are not. WAPDA bonds

are issued in bearer and registered form in denominations of Rs 5,000,

Rs 10,000, Rs 50,000, Rs 100,000, and Rs 500,000, with a semiannual

coupon. Except for the third issue, the bonds are subject to withholding

and income tax. WAPDA bonds are quoted on the Karachi and Lahore

Stock Exchanges, and are accepted as prime collateral for obtaining bank

advances. They are discountable six months after the date of sale.

Defense savings certificates (DSCs). DSCs are issued with a ma-

turity of ten years. They have a guaranteed rate of return of 42.50 per-

cent at maturity, on the average, based on an internal rate of return of

18.04 percent per year. The profit is entirely tax free. Zakat is payable

only once, at the time the certificates are cashed in. If the principal is not

withdrawn at maturity, it is automatically reinvested.

Special savings certificates (SSCs). SSCs have a three-year matu-

rity and are registered. Their yield is 16 percent per year for the first 2.5

years and 18 percent per year for the last coupon. The profit is tax-free

for individuals and local authorities, butzakatis payable at the time the

certificates are cashed in.

DSCs and SSCs are the most popular of the national savings schemes

and are operated by the Central Directorate of National Savings under

the Ministry of Finance.

Instruments issued by the corporate and financial sectors

Certificates of investment (COIs). COIs are issued by DFIs, in-

vestment banks, leasing companies, and housing finance companies to

raise deposits from the general public. Their tenor varies from three

months to five years, and determines their rates, which also vary de-

pending on market conditions, the credit of the borrowing institution,

and deposit size. COIs cannot be recalled at the option of the issuer, and

the investor is penalized for cashing them in early. There is no second-

ary market in COIs.

Term finance certificates (TFCs). TFCs are corporate bonds nor-

mally with a tenor of three to five years. They can be listed or unlisted,

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and can be issued by listed or unlisted companies. Rating is mandatory for

listing. The structure of the TFC is similar to that of a zero-coupon bond:

the issuer and the investor agree on its sale and repurchase. The issuer

must create a redemption reserve to repay the TFC and appoint a trustee

for each issue. Individuals, associations, and pension/provident funds en-

joy complete tax exemption on rated TFCs. All other institutions, includ-

ing corporate entities, must pay tax on TFCs, based on their normal tax

rates. Listed TFCs are exempt from capital gains tax.

Interest Rate Structure

Table 5 shows the structure of interest rates in Pakistan.

Table 5 Interest Rate Structure, as of 4 January 1999 n

Sources: Khadim Ali Shah Bukhari & Co. Limited (Money Markets); Pakistan and Gulf Economist

Annual Yield Annual Yield

Instrument (%) Instrument (%)

Federal Government Financial Institution COIs3-month T-bill 9.50 1 year 12.5017.006-month T-bill 11.94 3 years 13.5018.0012-month T-bill 12.99 5 years 15.0019.503-year FIB 13.005-year FIB 14.0010-year FIB 15.00

WAPDA Bonds TFCs: Primary IssuesSixth issue (10 years) 19.00 Packages Limited (5 years) 18.50Fifth issue (10 years) 16.00 Sui Southern Gas Co. Ltd.

(5 years) 18.25Fourth issue (10 years) 15.00 Nishat Tek Limited (3 years) 18.00Third issue (10 years) 12.50 ICI (5 years) 18.70Second issue (5 years) 13.50 Gatron (5 years) 18.00

National Savings Schemes TFCs: Secondary MarketDefense savings certificates 18.04 Packages Limited 16.34Special savings certificates 16.27 Sui Southern Gas Co. Ltd. 17.68FEBCs 14.60 Nishat Tek Limited 16.92

ICI 16.26

Gatron 17.82

Annual Yield Annual Yield

Banking Sector Assets (%) Banking Sector Liabilities (%)

Bank Advances Bank DepositsRunning finance 16.0020.00 1 month 9.2012.68Term loans (35 years) T-bill + 2.00 to 3 months 9.5013.91

T-bill + 5.00 6 months 10.7014.591 year 11.3015.003 years 12.4017.00

5 years 14.0019.00

Investors

Table 6 shows the various categories of investors in Pakistan.

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Table

6

CategoryofInvestor

Nu

mber

Comments

Commercia

lBanks

46

Largestpoolofinvesta

blefunds,whichshouldbeusedinnormal

bankingoperationsbu

thavebeendivertedtoT-billsbecauseof

relativelyhighyieldso

nshort-term

governmentpaperandscarcity

ofgoodcredit.

Totalassetsofbankingsystem:Rs1,5

87.5

9billion(30J

une1998).a

NBFIs

Investme

ntbanks

15

NormallyinvestinFIB

s.

CanuselisteddebttosatisfySLR.

DFIs

10

NormallyinvestinFIB

s.

CanuselisteddebttosatisfySLR.

Leasingcompanies

33

Earningahighgrossreturnofover24%f

rom

coreleasingactivities.

Havelittleincentiveto

participateindebtsecuritiesyield

inglower

returns,unlessusedtosatisfySLR.

Institutiona

lInvestors

Insuranc

ecompanies

62

Potentiallylargesourc

eoffunds.

Fixed-incomeinvestmentsideal

forthiscategory.

Larg

estplayerisStateLifeInsuranceCorporation

(SLIC),whosetotalinvestmentportfolioasof30June1998was

Rs52billion.b

Mutualfunds

39clo

sed-end

26of39closed-endfundswerefloatedbyInvestmentC

orporation

2op

en-end

ofPakistan(ICP),ag

overnment-controlledorganization.

Asof

30June1998,cm

arke

tcapitalizationofthesefundswas

Rs2.8

9

billionasagainstpaid-

upcapitalofRs4.1

2billion.

Amongtheopen-

endfunds,

NationalIn

vestmentTrust(NIT)isagovernm

ent

institution;theotheris

private-sector.NITsinvestmentportfolioas

of30June1998wasRs25.0

0billion.dM

utualfundscou

ldbecome

largeplayersinfixed-incomemarket.

Fixedincomeinvestm

entsofmutualfundsaretaxexem

ptifat

least90%o

ffundsin

comeisdistributed.

InvestorCategoriesinPakistan

n

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Employe

esOldAgeBenefitInstitution(EO

BI)

1

Governmentinstitution

withlargeinvestmentportfoliowo

rth

Rs23.1

0billion.eE

OB

Iinvestsmainlyingovernmentse

curitiesbut

alsohassmallinvestm

entsincorporatedebt.

Employe

esprovidentfunds(private)

Providentfundsofcorporationsandgovernment-sectororganizations

potentiallyform

hugepoolofinvestablefunds.

Previously,only

optionavailablewasg

overnmentsecurities.

Butamendedrules

allow

investmentinlisteddebtsecurities,andsomefunds

have

invested.

Largelyuntappedsector.

FederalEmployeesBenevolentandGroup

InsuranceFund(FEBGIF)

1

Estimatedinvestment

portfolioofFEBGIF:Rs2.7

7billio

nf (net

assetvalue).Bulkofportfolio(80%)isingovernmentse

curities,

but

investmentinotherde

btsecuritiesnotprohibitedbyinvestment

guidelines.

Corporations

State-ownedcorporatio

nsusedtoinvestexcessliquidityingovern-

mentsecuritiesbutha

vebeendivestingoflate,

because

ofsevere

liquiditycrunchonmoststate-ownedinstitutions.

RetailInve

stors

Sizeofmarketcanbe

estimatedbythesizeofthenation

alsavings

schemeswhichiscurrentlyatRs458.9

5billionasofJune

1998g

(provisional).

Anotherclassofpotentialretailinvestors:in

dividuals

withsavingsandfixed

depositaccountsincommercialba

nks.

Total

amountofsuchaccountsaboutRs.

727.0

1billionasof31December

1997.hR

eturnsare310%l

owerthanoncorporatedebtin

struments.

Largelyuntappedmarket,butrequiresinvestoreducation,especially

ifindividualsaretosw

itchfrom

governmenttonongovern

mentpaper.

aStateBankofP

akistan,AnnualReport1996

1997

bStateLifeInsuranceCorporation

cKhadimAliShahBukhari&Co.

Limited(Research)

dNationalInves

tmentTrust

eEmployeesOldAgeBenefitInstitution

fFederalEmployeesBenevolentandGroupInsuranceFund

gStateBankofP

akistan,AnnualReport1996

1997

hIbid.

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418 CHAPTER 6

Obstacles to the Development of theFixed-Income Securities Market

INTRODUCTION

Pakistans large fiscal deficits in the past decade and a widening savings-

investment gap have added to the countrys external debt burden, and

have forced the government to borrow heavily from domestic sources.

At the expense of crowding out the private sector, it has borrowed from

domestic institutional investors through T-bills and FIBs, and from retail

investors through its national savings schemes.

The private-sector bond market, specifically the TFC market, began in

1994 when the government allowed the private sector to issue redeem-

able capital to the public. The government then dealt with anomalies on

the supply and demand side to stimulate this market; reduced stamp du-

ties and brought these in line with stamp duties on equities; initiated the

formation of credit-rating agencies; allowed provident funds and foreign-

ers to invest; and, most recently, granted tax exemptions to individuals.

On the demand side, the investor base broadened, as provident funds

were allowed to invest up to 20 percent of their fund size (from the previ-

ous limit of 10 percent), foreign investors could obtain forward risk cover

of up to one year on currency, NBFIs could use TFCs for their statutory

liquidity requirement, and foreign commercial banks could invest.

However, the government, with its high rates of return on government

borrowings from the institutional and retail sector, continues to crowd out

the private sector. Because of the scarcity of good credit in the market,

most banking sector funds flow into high-yielding, short-dated govern-

ment paper. Retail investors, on the other hand, are generally wary of

private-sector investments, and their participation has been constrained

by low awareness of the relatively new market, inconsistent government

policies, and lack of liquidity. Whereas a formal exchange exists to pro-

vide liquidity in the equity market, the nominated discount houses have

failed to provide liquidity for the larger investors in TFCs and especially

semigovernment bonds.

On the regulatory front, little if anything needs to be done for govern-

ment securities other than the possible lengthening of tenor and the intro-

duction of innovative structures and instruments. Since government secu-

rities already have high acceptability, the responsibility for developing fixed-

income instruments should rest with the government rather than the pri-

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vate sector. The corporate debt market, however, needs regulatory in-

centives to develop further. The tax exemption granted to rated corporate

debt in September 1997 stirred up hectic activity in the corporate debt

market, as issuers clamored to issue and investors stood in line to invest.

Six months later, in March 1998, the exemption was revoked (only provi-

dent funds and individuals remained tax-exempt), ostensibly to prevent

banks (the highest tax-paying category) from converting their taxable

loan portfolio into tax-exempt TFCs. The banking sector holds most of

the assets in Pakistan, and investment by commercial banks in the TFC

market not only provides depth but also lends credibility to the issues and

reassures small investors who are fearful of investing in private debt.

Several measures are suggested in this section to forestall the conver-

sion of bank loan portfolios while retaining the tax exemption for institu-

tions. Among the suggested measures is a time-bound tax exemption for

debt of at least five years tenor.

With respect to mortgage-backed securities (MBSs), their issuance

through specially created special-purpose vehicles (SPVs) is not feasible

in Pakistan, which has unclear laws relating to asset securitization. How-

ever, housing finance companies (HFCs) can raise funds from the capital

markets by issuing debt securities backed by mortgages they hold on the

fixed assets of borrowers. This matter is discussed in more detail in this

section.

The MBSs market, too, would be hampered by competition from the

government securities market and lack of investor awareness, especially

since the corporate debt market is relatively new. Most MBSs would

have a longer tenor than government bonds, whose longest tenor is only

ten years. Investors poor perception of the performance of HFCs as

well as their lack of rating sensitivity are other concerns that must be

addressed.

The most important legal issue surrounding MBSs is enforceability of

foreclosure laws. Unless the laws are enforced more effectively, the in-

vestor confidence required to develop this market would not exist.

INSTITUTIONAL OBSTACLES, TAXES, AND TRANSACTION COSTS

Pakistan has been facing large fiscal deficits for more than a decade

and has financed these deficits by borrowing from both institutional and

retail investors through the interbank market (T-bills and FIBs) and na-

tional savings schemes (NSSs). The already scarce domestic resources

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420 CHAPTER 6

available for investment in the capital market, including investment in

TFCs, have thus been further depleted.

From 1976 to 1995, gross investment in Pakistan averaged 17.9 per-

cent of GNP,15 lower than in most other Asian countries except

Bangladesh. But even this low level of capital formation could not be

financed solely with domestic savings, which averaged 11 percent of GNP

over the same period. Sizeable increases in savings from abroad, as well

as substantial inflows of workers remittances, were also needed.

The government has introduced several measures since 1994 to boost

the TFC market.

Government Incentives for the TFC Market

The measures announced by the government to stimulate the market for

TFCs deal with anomalies and problems on both the supply and the de-

mand side.

Supply-side measures

Issuance of redeemable capital by the private sector. Before

1994, bank loans were the main source of funds for the private sector.

The build-up of bad debts by the banking sector and the resultant credit

crunch, however, forced the private sector to look for other funding sources.

The most important obstacle to the development of the private-sector

bond market was removed when the government allowed companies to

access the capital markets by issuing TFCs.

Lower stamp duties. The government in 1994 reduced the stamp

duty from 4.5 percent to 0.15 percent on issuance and 0.1 percent on

subsequent transfer of TFCs, in line with the stamp duties on equities.

The drastic reduction in issue cost made TFCs a viable financing option

for companies looking for long-term sources of finance.

Formation of credit-rating agencies. The establishment in 1994 of

PACRA, the first credit-rating agency, gave companies with good credit

histories an incentive to use rated TFC issues as a funding source. Good

credit ratings gave these companies a better chance of attracting a wider

range of investors.

Permission granted to provident funds to invest in TFCs. In

1995, provident funds were finally allowed to invest in listed TFCs. Po-

15Andrew T. Hook, Savings in Pakistan, Practice and Policy (1981-1996).

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tential issuers were drawn to TFCs, as an alternative to bank financing,

because of their increasing and diverse investor base.

Permission granted to foreign investors to invest in TFCs. For-

eign investors were given permission to invest in listed TFCs in 1995,

through the Special Convertible Rupee Account (SCRA). They may also

invest in listed shares and government securities through this account. All

these investments are tax exempt for foreign investors.

Tax exemption for individuals from September 1997 onward.

Investments by individuals and provident/pension funds in future TFC

issues were made tax exempt in September 1997. This exemption made

TFCs much more attractive to potential issuers, who could now market

their instruments to nontraditional funding sources and become less de-

pendent on bank lending.

Demand-side measures

Wider investor base. The permission granted to provident funds and

foreigners to invest in TFCs broadened the investor base for these secu-

rities. Provident funds were allowed to invest up to 20 percent of their

portfolios in TFCs. Foreign investors could obtain forward cover for up to

one year from the open market on their investments through the SCRA.

NBFIs could now treat TFCs as liquid assets for their SLR requirements,

and foreign commercial banks could also invest in listed securities.

Remaining Obstacles for the TFC Market

Inconsistent government policies. On 17 March 1998, the govern-

ment reversed its decision made six months earlier to grant total tax exemp-

tion to all investors in rated corporate debt. Only pension and provident

funds and individuals remained exempt. As a result, demand from institu-

tional investors has been adversely affected and a severe blow has been

dealt to the budding TFC market in the country. This lack of consistency

causes loss of credibility, and will hamper response to future reforms.

Government dominance of the fixed-income market. The market

for fixed-income securities in Pakistan is still dominated by the government,

at both the retail and the institutional level. At the retail level, national savings

schemes (NSSs) offer guaranteed rates of return to investors, as well as

exemptions from taxes andzakat. The yield on NSSs, net of tax andzakat,

varies between 15.66 percent and 17.79 percent yearly, as shown in Table 7.

The table gives a comparison of the net yields on NSSs and issued TFCs.

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422 CHAPTER 6

Table 7 Net Yields to Individual Investors in National Savings Schemes and TFCs n


Instrument/Issuer Remaining Tenor Net Yield (%)

Nishat Tek 3 months 11.51

Packages 1.5 years 14.81

SSGC 2 years 17.57

SSC 3 years 15.59

ICI 3 years 14.87

Gatron 5 years 18.35

DSC 10 years 17.79

Even though the net yield on SSCs is 1.98 percentage points lower

than the net yield on the TFCs issued by Sui Southern Gas Company

Limited (SSGC), for instance, investors still prefer SSCs. Investors in

general seem to be extremely wary about any investment scheme linked

to the private sector, partly because of recent bitter experiences with

cooperative scams in which millions of rupees worth of life savings were

embezzled by unscrupulous individuals. The co-ops promised returns in

excess of 18 percent per year, which in the 80s was too good an oppor-

tunity to pass up. But after raking in the investments, the co-op owners

simply closed down their offices and disappeared. The true identity of the

culprits is still unknown.

At the institutional level, T-bills and FIBs with their attractive rates of

return and highly liquid secondary markets attract the lions share of insti-

tutional funds. Recent yields on 12-month T-bills, for instance, were around

13.00 percent per year. The fact that the government guarantees their

face value also makes T-bills more viable investments than TFCs for

institutions, including commercial banks and NBFIs. TFCs may offer a

premium of 12 percent over T-bills, but bear no government guarantee

and are three to four years longer in tenor. TFCs also use per-party cor-

porate limits which are regulated by the SBP.

Lack of investor awareness. Lack of education and awareness also

partly explains the lukewarm response of retail investors to TFCs. Since

TFC issues are relatively new in the market, investors need to be informed

about their nature and structure, and the benefits of investing in them. Semi-

nars and conferences on fixed-income securities for retail investors can be

sponsored by prospective issuers of TFCs or by brokerage houses that

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trade in them. Khadim Ali Shah Bukhari & Co. Limited (KASB), a broker-

age house, has held several such programs for the general public, drawing

participants through invitations and newspaper advertisements.

Lack of investor sensitivity to credit ratings. Investors also do

not appreciate the value of ratings and often invest on the basis of per-

ceptions or preconceived notions about certain companies. They need to

be acquainted with the objectives and usefulness of credit-rating agen-

cies and the effect of ratings on corporate fund-raising schemes.

The yields-to-maturity and credit ratings of the TFCs issued as of 30

June 1998 are compared in Table 8.

Table 8 Yields-to-Maturity and Credit Ratings of Listed TFCs n

Source: Khadim Ali Shah Bukhari & Co. Limited

Issue Rating Remaining Tenor Yield-to-Maturity (%)

ICI AA- 3 years 16.94

SSGC AA 2 years 18.02

Packages A+ 1.5 years 17.48

Nishat Tek A 4 months Closed

Gatron A+ 4.75 years 17.82

As shown in the table, ICI and SSGC have similar ratings. But the

yield-to-maturity on ICIs TFC is 0.57 percent lower than that on SSGCs,

which is shorter in tenor by a year, mostly because of negative investor

perceptions of public-sector companies.

Lack of depth and liquidity. The TFC market lacks depth and liquid-

ity. Despite the offer of tax exemptions, retail investors have not been

attracted in droves to purchase TFCs. Commercial banks and other insti-

tutional investors, on the other hand, were enticed by the prospect of

higher tax exemptions (than those for retail investors), and showed rela-

tively more interest in TFCs before the government rescinded the tax

exemption on 17 March 1998.

Undercapitalized market-makers and discount houses. Broker-

age houses that have been assigned market-making roles do not have

enough capital to be effective market-makers. Table 9 shows the paid-up

capital of listed brokerage houses in Pakistan as of June 30 1998.

These brokerage houses handle millions of rupees worth of transac-

tions in the equity market everyday, and therefore need additional credit

lines and repo facilities to operate in the TFC market. One suggestion is

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424 CHAPTER 6

that brokerage houses should be allowed to issue short-term COIs to

raise funds for market making. All these funding sources might not have

any effect on the market-making abilities of brokerage houses, however,

if their cost of funding remains at the present level of around 18.50 per-

cent. Since the yield on TFCs is typically around 17 percent, brokerage

houses have little incentive to purchase TFCs and hold them for sale in

the future.

Table 9 Paid-up Capital of Listed Brokerage Houses n

Source: Khadim Ali Shah Bukhari & Co. Limited (Research)

Brokerage House (Listed) Paid-up Capital (Rs million)

Al-Mal Securities and Services Ltd. 50.00

First Capital Securities Corporation 213.40

JOV and Company 40.00

Jehangir Siddiqui and Company Ltd. 120.00

KASB and Company Ltd. 111.19

Trust Securities and Brokerage 40.00

The situation is not helped by the fact that the two discount houses for

TFCs, National Discounting Services Limited (NDSL) and Prudential Dis-

count House Limited, have performed well below expectations. They have

either limited themselves to investing in COIs or been hindered by lack of

capital from effectively performing their discounting function. Moreover,

efforts to tap the capital market for extra funds have not borne fruit.

Absence of a trading floor for TFCs. The absence of a separate

exchange or trading floor has also adversely affected the secondary mar-

ket for TFCs. All listed TFC issues are listed on the stock exchanges,

whose listing requirements are geared solely to the needs of the equity

market and are not applicable to fixed-income securities. This listing pro-

cedure is cumbersome and time consuming. The OTC Exchange that is

being developed under the ADB-sponsored CMDP should help improve

liquidity in the TFC market.

Scarcity of good credit. The lack of good credit on the issue side

continues to hinder the development of the TFC market. The situation is

worsened by the fact that many companies operating in the country have

been declared in default by the SBP. Latest estimates put the total amount

of defaulted loans at between Rs 140 billion and Rs 210 billion,of which

only Rs 10 billion has been pledged back by the defaulters. Unless a

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solution is found, many companies will be excluded from the capital mar-

kets for lack of investor interest. The top-tier companies, on the other

hand, can easily obtain cheaper funds from the banking system, which

has the funds but is starved for good credit.

Obstacles Relating to the Market for Statutory Corporation

Bonds

Investor wariness. Investor wariness is also a major problem in the

market for WAPDA and Civil Aviation Authority (CAA) bonds. The fi-

nancial malaise afflicting these organizations, especially WAPDA, and

the negative publicity in the media are major disincentives to investment.

The problem has been compounded by the removal of government guar-

antees on the fifth and future issues of WAPDA bonds. Negative inves-

tor perceptions of these corporations show in their investment decisions.

Problems in the secondary market. The Federal Credit and Dis-

count Corporation (FCDC) was established in 1989 as a discount house

for WAPDA bonds, but has been hampered throughout its life by lack of

capital. For the four bond issues for which the FCDC was formally as-

signed discounting responsibility, WAPDA committed to provide funds to

FCDC equal to 10 percent of each bond issue. The committed amount

was never made available in full. The two private-sector discount houses

have also been allowed to discount WAPDA bonds. However, for the

reasons mentioned above in the case of TFCs, these houses have failed

to perform their discounting roles. The ineffectiveness of discount houses

is one of the main obstacles to the creation of an active secondary market

for WAPDA bonds.

The Market for Mortgage-Backed Securities (MBSs)

Uncertainty about laws applicable to asset securitization makes it unfea-

sible to issue mortgage-backed securities (MBSs) in the traditional way,

that is, through a specially formed special-purpose vehicle (SPV). (This

issue will be dealt with in more detail in later sections.) Housing finance

companies (HFCs) can, however, raise funds from the capital market by

issuing debt securities (TFCs), backed by the mortgages that they hold on

the fixed assets of borrowers. According to current practice, a security

(mortgage) is created in favor of a trustee to be governed by the terms

and conditions of a security trust deed executed by the issuer of the debt

security and the trustee. The trustee agrees to hold the mortgage for the

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426 CHAPTER 6

benefit of the holders of the debt security, which is usually issued in the

form of TFCs. The benefit of the mortgage created in favor of the trustee

is transferred when the debt security is transferred. The difficulties and

implications applicable to the sale or transfer of mortgage loans do not

apply to these securities, if structured in the usual manner in Pakistan.

Institutional Obstacles Hindering the Development of the

MBSs Market

There are a few obstacles to the development of a market for MBSs

issued in the traditional way.

Competition from government securities and TFCs. Government

securities and TFCs would provide competition for MBSs and crowd

them out of the market. Also, most MBSs would be longer term, whereas

the longest government security is for ten years only.

Investor perception. As with TFCs and statutory company bonds,

investor perception is also likely to be an obstacle to the development of

an MBSs market. The general view of the performance of HFCs, espe-

cially in the public sector, and the quality of their assets is not very en-

couraging. This perception is likely to be reflected in investment decisions

regarding MBSs.

Lack of rating sensitivity among MBSs investors. Potential in-

vestors in MBSs are also likely to lack sensitivity to credit ratings and to

rely instead on their preconceived notions about the riskiness of investing

in the housing finance market. In fact, the problem is expected to be more

serious than in the case of TFCs.

Lack of investor awareness of MBSs. The lack of rating sensitivity

is likely to follow from a lack of awareness among investors about the

nature and structure of MBSs and about the concept of securitization itself.

Concepts such as assigning mortgage loans to an SPV and issuing securi-

ties backed by those loans are new to Pakistan. There is thus a consider-

able need for an investor education and awareness campaign. Otherwise,

investors may perceive the security to be too complex to invest in.

LEGAL AND REGULATORY OBSTACLES AFFECTING THE

FIXED-INCOME SECURITIES MARKET

There is little need to develop the government securities market further.

If anything, the government should try to lengthen the maturity of its debt

profile by offering 15- and 20-year bonds, which would encourage corpo-

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rations to follow suit. At the same time, the government should offer

differently structured securities, given the accessibility and high accep-

tance level of government debt.

The corporate debt market, however, needs regulatory changes to

develop. Unless it develops, all other types of fixed-income securities

will find it difficult to gain acceptance with the general public. The TFC

market should therefore be given the requisite incentives. As mentioned

earlier, a major catalyst for the development of this market was the tax

exemption provided in September last year. In the three years up to that

time, there were only four listed issues in the market. After September,

there were over 15 listed issues, mostly underwritten, reflecting the

increase in demand and supply. Yields on the TFCs had fallen by over

200 bps.

In March 1998, the exemption was removed to forestall the conversion

by commercial banks (the highest tax-paying category) of their taxable

loan portfolio into tax-exempt TFCs. Since the corporate debt market is

still in its infancy, and the banking sector holds most of the assets in

Pakistan, investment by commercial banks in TFCs would have lent cred-

ibility to the issues and provided comfort to small-time investors fearful of

shifting their money away from government programs.

To prevent banks from converting their loan portfolio while at the same

time allowing them tax exemption, it has been variously suggested that

the exemption be limited to:

Rated and listed debt.

The difference between the coupon rate and the funding rate.

Debt of more than five years. Over 80 percent of bank loans in

Pakistan are under one year, while less than 2 percent are over five

years. Giving banks a tax incentive for long-term lending in the form

of corporate debt will not only jump-start the corporate debt market

but also encourage longer-term lending, the lack of which has been a

constant complaint of the central bank.

A predefined period, to be withdrawn once there is investor depth in

the market.

On the legal front, an issue that must be addressed is the absence of a mas-

ter repo agreement. This agreement has to do with the ownership of securi-

ties used as collateral when raising money in the repo market. The absence

of such an agreement creates uncertainties regarding ownership which can

have legal as well as tax implications for both the lender and the borrower.

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428 CHAPTER 6

Legal Obstacles Affecting the MBSs Market

MBSs, in the traditional sense of the word, are a special case because

they represent the secondary market for residential mortgage loans. As

such, demand for them would depend on the quality of the mortgage loans

and on the confidence of investors.

One of the most important factors determining mortgage loan quality

is the default ratio of HFCs and ease of foreclosure. Although foreclo-

sure laws have been in place ever since the country was created, en-

forcement has been a problem. Section 67 of the Transfer of Property

Act of 1882 entitles the mortgagee to file a suit for foreclosure or a suit

for sale at any time after the mortgage falls due and before a decree for

redemption of the mortgaged property is issued or the mortgage money

is paid or deposited. Foreclosure enforcement has, however, been a

problem because of corruption and inefficiency in the judicial system in

Pakistan. Many of those who default on their loans are influential people

who do not hesitate to use their influence to stop foreclosure proceed-

ings. Unless foreclosure laws are enforced more effectively, the devel-

opment of the MBSs market would be hampered by lack of investor

confidence.

A noteworthy development in this regard is the inclusion of a new set

of foreclosure rules in the Banking Companies (Recovery of Loans, Ad-

vances, Credits and Finances) Act of 1997, with which the government

hopes to remove or at least reduce bottlenecks in the enforcement of

foreclosure procedures.

Other legal problems that could affect the MBSs market in Pakistan

will be discussed in later sections after a detailed description of the con-

cept of asset securitization.

State of Residential Mortgage Financing

INTRODUCTION

After 50 years of existence Pakistan still faces the problem of rising

shortage of housing. The cumulative shortfall in supply equals 7 million

units according to current estimates and is expected to reach the 10 mil-

lion figure by the year 2020. This alarming state of affairs basically stems

from a widening gap between the demand for housing and the ability of

the formal or regulated housing finance market to meet this demand. The

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formal market has so far met only 20 percent of the needs of the national

housing finance market; the informal sector takes care of the rest.

The government has always struggled to keep its budget deficit down

and its problems have become even more acute as a result of the sanctions

imposed on the country because of its nuclear stance. Its ability to provide

funds for the housing finance market is therefore extremely limited.

The government has, however, encouraged and facilitated the con-

struction of houses in the lower and lower-middle income groups. Until

the early 1990s it assigned this task to the House Building Finance Corpo-

ration (HBFC), the lone public-sector housing finance company in

Pakistan and also the largest, with cumulative loans totaling Rs 27.6 bil-

lion as of 30 June 1998. HBFCs operations used to be financed by the

SBP. Since 1994, however, it has had to rely on its own loan recoveries to

finance additional lending. Its excessively high default ratio of 2530 per-

cent is not helping things. The corporation has recently launched a new

loan recovery drive and has warned defaulters to repay before HBFC is

forced to use other legal options. But this latest campaign is not expected

to be any more successful than previous ones, which failed to recover

substantial amounts from defaulters for reasons given later in this section.

The International Housing Finance Company (IHFC), the only private

housing finance company, is facing funding shortages of its own. It has

recently increased the maximum mark-up on its loans from 22 percent to 24

percent yearly and is trying to bring their tenor down from the current aver-

age of nine years, to comply with its asset-liability ratio. The increased con-

servatism of IHFC does not augur well for the countrys housing market.

IHFC has so far issued loans worth Rs 396 million, at an average

mark-up of 22 percent per year. The quality of IHFCs loan portfolio, with

a default ratio of just 1 percent, is much better than that of HBFC, making

IHFC a very suitable candidate for any securitization issue, provided that

the right legal and regulatory environment for asset securitization exists.

This is the subject of the next section.

Although commercial banks are required to invest 1 percent of their loan

portfolio in the housing finance market, they have always been reluctant to

lend for housing finance mainly because of the higher, safer, and more

attractive returns on shorter-term instruments issued by the government.

It is therefore clear that the gap between housing demand and supply

will continue to widen unless the government takes concrete steps to

remove the major funding obstacles faced by housing finance companies

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430 CHAPTER 6

1621st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing

Finance, (1997).17Eighth Five-Year Plan (19931998).

Table 10 Household Patterns, 19801998 n

Sources: Population and Housing Census, 1998 (provisional results); 21st Century Consultancy and Management Services

(Pvt.) Ltd., Draft Final Report of Study on Housing Finance, 1997

1980 1989 1998

U rba n R ur al Total U rb an R ur al Total Ur ban Rur al Total

No. of households (millions) 3.55 9.03 12.59 5.24 11.14 16.38 6.25 13.45 19.70

No. of house-owners (millions) 2.41 7.46 9.87 4.14 10.15 14.29

Ratio of house-ownersto households (%) 67.70 82.60 78.38 79.00 91.10 87.00

and devises a rational strategy for involving other financial institutions,

such as commercial banks, in housing finance schemes. Moreover, any

new strategy, law, or policy will have be implemented properly and in its

complete spirit for it to succeed.

THE HOUSING MARKET

According to the provisional results of the latest population and housing

census carried out by the government in March 1998, the total population

of Pakistan is 130.58 million and is growing at 2.61 percent yearly. This

puts Pakistan among the ten most populous countries in the world.

Its large population and high population growth rate have saddled

Pakistan with a severe housing shortage throughout its brief history. The

problem is more acute in urban areas because of constant migration from

villages and the influx of illegal immigrants into the country. The informal

(unregulated) sector has taken over the task of providing for the housing

needs of these migrants, the vast majority of whom are housed in slum

dwellings or shanty towns called kutchi abadis.

The housing shortfall in Karachi alone is estimated at more than 580,000

units. For the entire country, the shortfall is over 7 million units, despite the

fact that in real terms the housing stock has grown at an average rate of

about 4.8 percent yearly for the last 15 years.16 By the year 2020 the

shortfall is expected to reach 10 million units.17

Table 10 gives a comparison of the household patterns in Pakistan

from 1980 to 1998. Details of the breakdown of house ownership pat-

terns in the country are expected to become available once the full results

of the 1998 population and housing census are published in 1999.

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The total number of housing units increased by about 57 percent over

the 18-year period. From 1981 to 1989, the number of house-owners as a

percentage of the total units went up by 8.62 percent.

To meet the demand for housing, an estimated 600,000 units would

have to be built every year for the next 20 years. The government

cannot possibly achieve this target on its own because of its ballooning

budget deficit and its debt service and defense commitments. Private-

sector housing finance companies will have to play a major role in meet-

ing this shortfall.

Table 11 shows the floor area of urban and rural houses. Urban dwell-

ings are larger on the average than village dwellings. However, for the

vast number of city dwellers living in semi-pucca or kutcha (shanty)

houses, the covered area is smaller than that in the villages.

Table 11 Floor Area of Urban and Rural Houses n

Source: 21st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing Finance, 1997

Average Dwelling Size Average Room SizeDomain (square meters) (square meters)

Pakistan 37.98 15.30

Urban 41.04 16.47

Pucca (brick house) 45.00 18.09

Semi-pucca 31.68 12.69

Kutcha (shanty) 29.07 11.70

Rural 36.63 14.76

Pucca 41.49 16.74

Semi-pucca 36.00 14.49

Kutcha 34.83 14.04

HOUSING POLICY OF THE GOVERNMENT

Background

To reduce the gap between housing demand and supply, the government

has always stressed the provision of houses to the lower and lower-middle

income groups.18 However, the lone public-sector housing finance com-

pany, HBFC, has not had a very encouraging record in this respect. Ac-

cording to a study made by a local consulting firm, almost 77 percent of

HBFCs housing loans have gone to influential people in the upper or

18This study assumes the following income ranges: lower (up to Rs 2,750); lower-middle (Rs 2,7514,000);

upper-middle (Rs 4,0017,000); and upper (over Rs 7,000).

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432 CHAPTER 6

upper-middle income groups, and only 23 percent have gone to the lower

and lower-middle income groups.19

Experience has also shown that the lower and lower-middle income

groups have received little housing assistance from other concerned gov-

ernment agencies such as development authorities in major cities of the

country.

National Housing Policy

In 1992, the government approved a National Housing Policy as part of the

eighth five-year economic development plan (19881993). The aim of the

policy was to encourage the active participation of the private sector in

developing a market-based housing finance system and increasing the number

of primary market lenders in the country. The role of the public sector was

restricted to providing a facilitating environment for the system.

Under the new policy the SBP allowed the establishment of private

housing finance companies to add breadth and depth to the financial struc-

ture of the housing market and to improve the capacity of the market to

mobilize resources for its long-term financial development. These com-

panies face the challenge of running viable financial institutions while

trying to manage the mismatch between their relatively short-term funds

and long-term loans.

REGULATORY SET-UP

Housing finance companies in the country are defined as nonbanking

financial institutions for regulatory purposes, and are therefore super-

vised by the SBP. The SBP in turn reports to the Internal Wing of the

Ministry of Finance as the ultimate regulatory authority for housing fi-

nance companies in the country. Only two HFCs now operate in the

market.

HBFC was created by a separate act of Parliament called the House

Building Finance Corporation Act of 1952. IHFC was incorporated in

1990 as a public limited company (unlisted) under the Companies Act

1984 and started operations after obtaining its license from the Ministry

of Finance. Its statutory monitoring authorities are the CLA and SBP. It

reports to the latter by submitting periodic returns.

1921st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing

Finance, 1997.

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PRIMARY MARKET LENDERS

HBFC was the only primary market lender in the formal (regulated) hous-

ing finance market until the early 1990s, when three private-sector hous-

ing finance companies were set up. Citibank Housing Finance Company

(CHFC) began its operations in the early 1990s but later suspended them,

in accordance with its global strategy. A housing finance company was

also established by the LTV Group of Companies in 19931994, but has

since closed.

IHFC is the only private housing finance company still operating as a

primary market lender. It is owned jointly by the International Finance

Corporation, Commonwealth Development Corporation, Pakistan Indus-

trial Credit and Investment Corporation, and Cresbank. Its share of the

outstanding loan portfolio of private-sector housing finance companies is

around 45 percent. However, it accounts for only 1.5 percent of the total

formal sector lending to datevery small compared with HBFCs share

of over 95 percent. Together, IHFC and HBFC have a mere 20 percent

of the housing finance market.

Table 12 shows mortgage loans as a percentage of bank loans, assets,

and GDP from 1994 to 1997.

Table 12 Size of the Mortgage Loan Market, 19941997 (%) n

Sources: SBP, Annual Report 199697; HBFC; IHFC

Ratio of Mortgage Ratio of Mortgage Ratio of Mortgage

Year Financing to Bank Loans Financing to Assets Financing to GDP

1994 6.30 1.59 1.45

1995 5.61 1.45 1.27

1996 5.31 1.33 1.17

1997 4.85 1.26 1.07

The ratios of mortgage financing to GDP and to total commercial bank

assets are extremely low considering the high demand for housing in the

country and the importance that the housing sector should enjoy in any

economy.

The informal sector supplies the remaining 80 percent of financing in

the housing sector. Personal savings, including remittances from abroad,

reportedly account for over 73 percent of total house financing. Lower-

income groups obtain around 80 percent of their financing from savings,

liquidated assets, and loans from relatives.

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434 CHAPTER 6

FUNDING SOURCES OF PRIMARY MARKET LENDERS

From 1953, when it began its operations, until 1979, HBFC received

funds from the SBP at market lending rates. After 1979 the funding

arrangement became a profit/loss-sharing agreement between HBFC

and the SBP, in accordance with the Islamic mode of financing.20 Fund-

ing from the SBP started dwindling in 19901991, however, and was

completely closed down at the end of fiscal year 1994. Henceforth,

HBFC was expected to become self-sustaining. It now derives its funding

solely from a revolving fund replenished with the loan repayments of

borrowers.

IHFC, on the other hand, has derived its funding, in the form of equity

and debt capital, predominantly from sponsors. The company has sub-

scribed and paid-up capital of Rs 125 million. In addition, it has received

seven-year foreign-currency loans from two of its sponsors, the Interna-

tional Finance Corporation (690 million) and the Commonwealth Devel-

opment Corporation (2 million). IHFC raised about Rs 6 million, much

less than expected, from its first COI issue in May 1998.21 Bad timing

explained the lukewarm response: investor confidence and morale had been

severely dented by the nuclear tests carried out by India and Pakistan.

Housing finance institutions have five main funding sources.

Equity capital

Debt capital. Housing finance companies usually borrow at com-

mercial lending rates of up to 1718 percent per year, which they

cannot pass on to most borrowers, as mortgage loans appear to dry

up at a mark-up of around 1718 percent per year. HFCs can also

issue TFCs, but the yields on these instruments are likely to be even

higher than their borrowing rates. Another alternative, to issue 30-

day to 10-year COIs, cannot be a primary funding source for HFCs

because of the resulting asset-liability mismatch (most investors pre-

fer shorter investments).

Repayments by borrowers. This happens to be HBFCs sole fund-

ing source at the moment.

Local-currency savings accounts. In addition to equity and debt

capital, HFCs are also allowed to accept local-currency savings ac-

counts. However, depositor mistrust of private-sector savings cum

20HBFC reports that it has so far paid the SBP Rs 6.5 billion in profits under the arrangement.21International Housing Finance Corporation.

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investment companies (following the earlier cooperative scams) have

made it impossible for HFCs to raise funds in this manner.

Housing refinance facility. To provide short-term liquidity to pri-

vate-sector housing finance companies, USAID, in December 1994,

granted a US$15-million housing guarantee loan to the SBP, which

later opened a housing refinance window for the companies.22 But

the refinancing facility has never been used in all the three years that

it has been open, mainly because of the high interest rate that would

have to be paid to the SBP. Although the funds have been provided to

the government of Pakistan at a mark-up of 7.75 percent per year,

the proposed cost of these funds to HFCs is 19.63 percent per year

(as of April 1997).23 This total cost is broken up as follows:

22Under the facility, an HFC that issues at least Rs 10 million in mortgage loans can package these loans

Documents

6 Pakistan