IMF Flags Dangerous Risks in Govt’s Growing Dependence on Banks, SBP for Liquidity

The International Monetary Fund (IMF) has warned about the “complex tripartite relationship” between the federal government, commercial banks and the State Bank of Pakistan (SBP). The lender in its latest report “2024 Article IV Consultation and Request for an Extended Arrangement under The Extended Fund Facility” said Pakistan’s growing financial connection between the government, central bank, and commercial banks is hurting the economy. This sovereign-bank nexus can lead to policy conflicts, regulatory challenges, and economic instability. With limited access to external funding government debt has increasingly been taken up by the banking sector and, as a result, banks’ holdings of domestic government debt have surged to around 60 percent of their assets, i.e., more than three times the average for Emerging Market Economies. With a limited depositor base, the banks have mainly financed the government’s additional demand for funds through liquidity provided by the State Bank of Pakistan (SBP) via Open Market Operations (OMOs). With government credit more attractive than private lending, this has significantly crowded out the latter. Moreover, the balance sheets of the three parties, the sovereign (government), commercial banks, and the central bank have become highly interconnected. This complex tripartite relationship means that developments or actions in one domain (e.g., fiscal, monetary policy, and the banking sector) can have wide-ranging effects across the economy. It also significantly affects the strength of monetary policy transmission by impinging the relationship between policy rates, private credit, and, private investment and consumption decisions. IMF said there are multiple actions to limit this nexus. Addressing the fiscal imbalances is key to first containing and then start unwinding the complicated interdependences. Cash and debt management should make better use of idle public sector cash balances and strike a balance between the banks’ investment preferences and the government’s strategic medium-term objectives. In particular, the authorities should closely monitor the health of the banking sector and prepare a contingency plan in case of a downside risk scenario. In the medium term, the structural impediments to the financial sector and capital market development, including the extent of the informal economy should be addressed.