South Asia: Financial development – comparing nations

Pakistan needs to focus on improving financial depth and asset quality ratios

KARACHI:

The imposition of 0.6% withholding tax on banking transactions, as part of the Finance Bill, sparked country-wide protests by the business community and forced the government to halve it till the end of September.

Although the tax is an easy way to improve government revenues, it comes at a huge cost since it creates incentives for financial disintermediation. Financial intermediation plays a crucial role in improving information asymmetries and facilitating transactions, thus boosting economic growth of a country.



The role of finance in boosting economic growth has been age-old. Although economic literature offers views about finance “overstressing the economy”, there has been concrete evidence that financial intermediaries and markets play a positive role in the growth process.

Presence of financial intermediation leads to better accumulation of savings which can then be channelled towards productive investments leading to long-term growth. Empirical evidence has found this relationship to be true even after considering the differences in economic and political factors across countries.

Emphasising the role of finance in growth, the term financial development has been coined which encompasses policies, factors and institutions that lead to efficient intermediation and well-functioning financial markets.

Research has also pointed to the role of financial development in reducing inequality through broadening access to finance for the poor and disadvantaged groups.

However, empirical evidence has found that financial development can only benefit up to a certain threshold after which it causes instability and introduces volatility in the economy. Economists have pointed to the benefit of financial development to an economy being dependent on its initial level of development; a small benefit has been seen in advanced economies with developed financial systems while a large positive effect has been seen in countries with intermediate levels of development.

But the question arises, how do we measure financial development and how does Pakistan fare compared to other countries in South Asia? This article delves into three broad dimensions of financial development; depth, efficiency and stability and compares Pakistan to other economies in the South Asian region – India and Bangladesh.

The case of Pakistan

For the sake of analysis, I have used the global financial development data compiled by the World Bank. This data ranges from 1960 to the latest update available till 2011. This huge dataset has time series of all three variables of interest used in the measurement of financial development.

Firstly, the financial depth variable captures the size of the financial sector relative to the economy. Using bank deposits relative to GDP, Pakistan’s financial depth stands at 27.5% relative to Bangladesh’s 49.5% and India’s 62%. Using another indicator of domestic credit to private sector to GDP, presents a similar picture with Pakistan at the bottom among the three countries.

Efficiency is used as another indicator to measure financial development. Efficiency can generally be defined as the ability to produce a result with minimum resources.

In terms of banking efficiency, it can be defined as how cost-effective banks are in performing their fundamental activities of deposit-taking and loan disbursement.

Net interest margin and overhead costs as a percentage of total assets are some of the indicators used to capture efficiency. Pakistan stands out at the top with the highest net interest margin standing at 5.7% with India at 3% and Bangladesh at 4.3%.

However, in terms of efficiency pertaining to overhead costs as a percentage of total assets, the country fares slightly worse than India and Bangladesh.

Lastly, financial development is also measured through stability. Capital adequacy ratios, asset quality ratios and liquidity ratios are all used as indicators to measure this criterion.

Pakistan presents a mixed picture. Although the capital adequacy ratios are comparable to India, the country fares quite poorly in terms of asset quality in the region.

According to the latest financial compendium compiled by the State Bank, non-performing loans as a percentage of gross loans stand at 12.8% in March 2015. This ratio stands at a mere 4.6% for India. This is definitely something that Pakistan needs to work on in order to strengthen financial development.

Pakistan fares well in terms of efficiency and capital adequacy ratios but efforts need to be focused on improving financial depth and asset quality ratios. Financial development is crucial for long-term growth of a country as it results in capital accumulation and technological progress by increasing savings, facilitating investment and optimising capital allocation.

The government needs to play a positive role in bolstering the financial sector through a favourable political and macroeconomic environment and strengthening the legal and information structure.

The writer is an economist and ex-central banker 

Published in The Express Tribune, August 3^rd,  2015.

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