BR Research Newsletter

Inside this:
All eyes on Islamic banking industry Is dollarization of Pak-Afghan trade a good idea? Strengthening the regulatory framework Global food prices stay high

ANALYSES & COMMENTS BY

BR RESEARCH
BR Research is the research wing of Pakistans premier financial newspaper, the daily Business Recorder.

DISCLAIMER: All information and data used are from reliable source(s) and subjected to extensive research after diligent and reasonable efforts to determine the soundness of the source(s). This analysis is not for the benefit of or discredit to any person, scrip or tradable instrument. The content(s) of this analysis shall not be construed as an advice or recommendation to trade. No relationship of client will be created between Business Recorder and user of this information. Professional advice must be taken by the reader before making investment/trading decisions. BR disclaims any liability for investment(s) made or liability accrued on basis of this analysis. The content(s) including all opinion(s), statement(s) and information are subject to change without prior notice and/or intimation.

FIND US: www.brecorder.com/br_research.html | Comments & Feedback at: research@br-mail.com | https://www.facebook.com/BRResearch | https://twitter.com/BRResearch09

Friday, January 17, 2014| BR Research Newsletter |

BR Research Newsletter

All eyes on Islamic banking industry

If I can meet all my financial needs in a religious manner and without an albatross of usury (interest) around my neck, why would I go to a conventional bank? This is the mentality of most of the Muslims across the globe and Pakistan is no exception, a regional Islamic banking head of a multinational bank told BR Research. The desire to capitalize on this frame of mind has not only triggered Islamic banks but also given impetus to conventional banks to come up with a more refined Shariahcompliant banking model and fill in the gap that prevails in the financial industry.

Islamic banking industry has grown at an average of 30 percent in the past five years. In 3QCY13 alone, the Islamic banking assets touted a phenomenal growth of 25 percent year-on-year with an infection ratio of just 3 percent vis--vis asset growth of 7.1 percent and infection ratio of 14.3 percent for the entire banking industry. As new players are stepping into the religious banking realm by the day, the existing contenders are flexing their muscles to stay competitive and attractive to the customers. One such stride is made by MCB whereby it has decided to unfasten its conventional and Islamic banking operations so as to gain more customer confidence, said Rashid Jahangir, Head of Strategic Planning, MCB. As per a KSE notice released yesterday, MCB has been granted NOC by the SBP to

Those holding the reins of the banking industry (SBP and MoF) are also geared up to fully support the growth of Islamic banking industry by offering sufficient asset deployment avenues to the banks.

establish a fully-owned Islamic banking subsidiary which will take up the existing network of 27 Islamic branches. Delving into the details, MCB currently has an Islamic asset size of Rs14.7 billion on its

Asset deployment is the Achilles heel of the Islamic industry, hampering its growth. But the regulators are hitting the nail right in the head by reportedly planning to finance its development and infrastructure projects by issuing Islamic product of Sukuk of varying nature and maturity. The commitment shown on the regulators front has fur ther triggered the banking sector to unleash the largely untapped banking avenue. A cursory look at the numbers reveals that the Islamic banking industry has witnessed a lot of resilience in the recent years. From just over 4 percent of the banking industry assets in 2007, the Shariah-compliant banking in Pakistan boasts an asset-size of Rs926 billion as of 3QCY13, representing 9.5 percent of the industry assets.

books which constitutes a skimpy 1.6 percent of the total domestic Islamic industry assets. However, Jahangir believes that the new subsidiary would enhance their Islamic banking brand as Islamic divisions of conventional banks are perceived to be treacherous by the customers and hence MCB couldnt fully cash in on the Shariah industry by relying on its Islamic divisions. Jahangir further highlighted that MCB would differentiate itself from other Islamic industry players on the basis of its technological innovation and product suite. With a plan to open 25 new branches next year, MCB plans to grow its Islamic subsidiary to a mid-sized bank in next five years with an asset-base of over Rs200 billion.

2 | BR Research Newsletter | Friday, January 17, 2014

BR Research Newsletter
As no other big bank, so far, has taken such initiative, MCB would have first mover advantage in the sphere whereby it would capitalize on its long established brand name to grab the market share from its opponents. Besides the initiative undertaken by the MCB, the decision of Summit Bank to turnaround its entire conventional banking operations into Islamic banking is another interesting move. With an outlook of reaching a size of 20 percent of the banking industry assets by 2020, there is more to it than meets the eye for Islamic banking industry.

3 | BR Research Newsletter | Friday, January 17, 2014

BR Research Newsletter

Is dollarization of Pak-Afghan trade a good idea?

While the latest numbers for Pak-Afghan trade are unavailable from the Pakistan Bureau of Statistics, the numbers for FY11 and FY12 show that Pakistan ran a trade surplus of $2.16 billion and $2.04 billion, respectively. The trade surplus reported by the SBP, however, was $1.85 billion and $1.36 billion for those two years. Even if we assume that the whole of the difference between PBS and SBP data (See graph) is equal to trade denominated in Pak Rupee, the net realisable dollars from the move to dollarize Pak-Afghan trade might be between $300-$700 million per annum, which is a sizable number for Pakistans habitual forex predicaments. But thats just one side of the story. In order to fully appreciate the situation, one has to realise that the reason why Pak-Afghan trade was allowed to be denominated in Pak rupee was because Afghanistans banking system was weak, if not nonexistent. Even now, Afghanistans banking system is anything but. Stakeholders - like Daroo Khan, board member of Pak-Afghan Joint Chamber of Commerce and Industry (PAJCCI), and Ali Salman, Executive Director of Islamabadbased think tank called Prime agree that while the move makes sense in principle, there are some concerns about the nature of Afghanistans banking system and th at their trade financing system needs to evolve.

The decision to dollarize Pak-Afghan trade from mid-March looks like a quick and easy move to increase the supply of dollars in Pakistan. Pakistan has been running a constant trade surplus with Afghanistan and if the bilateral trade is denominated in dollars instead of Pak rupee then it only means more dollars flowing into the economy, which is what Pakistan desperately needs. Here is the ballpark maths behind the move.

Given this backdrop, its quite surprising that nobody has raised the red flag over this decision yet not even the Afghan consulate, which, sources in the consulate say, is still waiting for a briefing from Kabul. Of course, there are those who argue that why should Pakistan allow Afghanistan to import in Pak rupee, when in fact its trade with most other countries is transacted in dollars. Well, they have a point, but consider this:

4 | BR Research Newsletter | Friday, January 17, 2014

BR Research Newsletter
According to data by Central Statistics Organization (CSO) of Afghanistan, Pakistan was Afghanistans single biggest trade partner in the Afghan fiscal year 2011 -12. Afghan imports from Pakistan were 14 percent of its total imports that year. This means that any decision to dollarize Pak-Afghan trade will directly affect Afghan reserves, and therefore, there is a need to think twice before making any move. And speaking of Afghan reserves, might one also remind that Afghan reserves can be expected to witness a drop as annual aid inflows drop following the NATO withdrawal from the country. Policymakers might also like to consider the trade diversion thesis. Recent reports suggest that Iran has been chipping away at Pakistans share in Afghan imports (cement being one such example), which is why Pakistani exports to Afghanistan have recently dropped on year-on-year basis. Also note that most of the Afghan-Iran trade is being conducted in Iranian currency, according to Haji Hameedullah, PAJCCI board member, who is also the President of Clearing Agents Association, Chaman. In a telephone conversation with BR Research, Maiwand Mangal, at Afghanistan Investment Support Agency asserted the view that due to weak banking structure in Afghanistan and availability of alternatives such as Iran and Central Asia, the move will compel Afghan importers to divert their trade away from Pakistan. In short, the likely shortage of dollar supply in Afghanistan, and the absence of adequate banking system in the country, can potentially divert trade to Iran, at a time when Afghan transit trade is already diverting to Iran from Pakistan. Can Pakistan afford to risk this trade diversion to Iran? The desperation for dollar

may demand a yes to that question, but the need to improve trade and investment ties with Afghanistan and boost Pakistan exports may demand a no. Let the debate begin.

5 | BR Research Newsletter | Friday, January 17, 2014

BR Research Newsletter

Strengthening the regulatory framework

With the resumption of long-stalled privatisation process, there are chances that lossmaking state-owned enterprises (SOEs) will be seeing revival over time. Transparency is the buzz word these days, invoked every time one mentions privatisation. The focus on having a robust transparency mechanism is well-placed, but there is also a need to focus on strengthening the regulatory framework in the context of privatisation.

The perception of regulatory bodies is generally bad. As per BR Researchs Economic Perception Survey conducted in Aug-Sep last year with 50 respondents from top local and multinational firms only SBP, SECP and CCP were rated positively for independence and competence. Other regulatory bodies like Nepra, Ogra and NTC were rated poorly on those two perimeters. It would be nave to expect the government to be self-motivated to change this status quo. Pressure has to come from the civil society. Those parliamentarians who are opposing privatisation have a great opportunity here: they can peg their support with a roadmap for improvements in regulatory frameworks. Parliament as a whole can pass laws mandating government to seek its

SOEs operate in a number of sectors and impact the citizens in various ways. After the private sector takes the reins of some of the SOEs on that long privatisation list, the role of regulators will assume greater importance. Regulators will have to be especially cautious with the mixed-ownership SOEs (majority-owned by government but managed by private sector), which often flout rules of the game and get away with it. The government has signaled that it will improve regulatory frameworks in conjunction with the privatisation process. However, there is no word on how and when that exercise will take place. Informed observers suggest that regulatory laws are in place, but their lack of implementation is hurting the market and consumers. They cite politically motivated hiring and firing of the heads of the regulatory bodies as the main problem that gives rise to other problems in areas such as regulatory capacity, oversight mechanism, enforcement and litigation.

confirmation for appointment of chairpersons of the regulatory bodies, with the objective of having only the qualified, competent and conflict-of-interest-free people to serve. Granted that the current political economy will not allow that to happen but then, who else will bell the cat, if not the elected people? Pakistans checkered history of economic reforms demands that things be done right this time. One suggests that the government use the privatisation process as a tool for the larger goal of market development where market players are competitively efficient and where regulators are vigilant. For that, a strong sector-based regulatory framework is needed.

6 | BR Research Newsletter | Friday, January 17, 2014

BR Research Newsletter

Global food prices stay high

The FAOs annual Food Price Index has averaged 209.9 points for 2013. While that marked a 1.6-percent drop from the 2012 level, it was still the third highest value on record. The full-year results came after prices remained virtually flat in December, though visible volatility in different sectors was already on the rise, with increases in dairy products and meat balancing out drops in worldwide process for rice and other cereals, sugars, and oils and fats For the year, an increase in supplies pushed grain prices lower, though rice prices fell less than corn and wheat. Dairy and meat prices hit all-time highs in 2013. Sugar prices, a minor component in the overall index, slid dramatically in December, around 5 percent lower than in November its third consecutive monthly decline. The main factors remained strong harvests in China and Thailand. On the whole, a deeper look into the data and commodity market shows that gains in food costs around the world have slowed as record harvests from India to the US expanded supply, sending corn, soybeans, wheat, sugar and coffee into bear markets. The world's food-import bill slid 3.2 percent in 2013 to $1.15 trillion, the United Nations estimates. Not only that but global costs are down 13 percent from an all-time high in February 2011, when floods and drought ruined crops and sparked protests in Africa and the Middle East, toppling leaders in Tunisia and Egypt. The International Monetary Fund has already predicted that prices will drop 6 percent this year.

Standard & Poor's GSCI Agriculture Index of eight crops has also tumbled 22 percent last year, the biggest annual drop since 1981. Additionally Morgan Stanley and Rabobank International have also cut their outlooks for farm goods in December, and costs are easing for buyers including Panera Bread and General Mills. But as the world prepares for a gener al slowdown in prices, things arent as hunky dory close to home. Higher commodity costs automatically have a disproportionate effect on poorer countries, where people spend more of their wages on meals. Ponder this comparison: US shoppers spend about 6.6 percent of their income on food, the lowest of any country, while people in Pakistan spend almost half of their wages to eat, according to the USDA. Additionally, coming off the back of incessant speculation, food prices at home might climb even higher this year as millions are made off the soft commodity market by parties who are blamed by many to be the biggest forces behind price hikes in the market despite the presence of sizable physical inventories of some commodities. This issue was raised by a groundbreaking research report presented by Oxfam last year which practically had the entire global agriculture commodity financing community running around like headless chickens, trying to prove their pure intentions. A recent World Bank study also attempts to nullify Oxfams findings in that vein, showing that increases in agricultural commodity prices can be mainly attributed to changes in crude oil prices. The report on the whole concludes that most of the price increases in sensitive nations like Pakistan are accounted for by crude oil prices (more than 50 percent), followed by stock-to-use ratios and exchange rate

7 | BR Research Newsletter | Friday, January 17, 2014

BR Research Newsletter
movements, which are estimated at about 15 percent each. Crude oil prices mattered most during the recent boom period because they experienced the largest increase, the report suggests.

8 | BR Research Newsletter | Friday, January 17, 2014