KARACHI - State Bank of Pakistan has predicted that the governments dependence on commercial banks to meet its budget deficit needs would increase further in 2011 and beyond mainly due to continuation of IMF-supported Stand By Arrangement Programme and the expected implementation of SBP Amendment Bill 2010 in the country. The said bill restricts SBP not to give direct or indirect credit to the federal and provincial governments or to any other public agency or state-owned entity with the exception of intra-day credits to ensure the smooth functioning of the payment system. According to Financial Stability Review 2009-10 released by SBP on Tuesday, the emphasis on monetary tightening in a period of rising inflation by the economic and financial managers can have a potentially detrimental impact on banks NPLs. Moreover, it could have negative implications for banks financial health and financial stability in time to come. The report, which presents an assessment of financial stability for 2009 (CY09) and the first half of 2010 (H1-CY10), is based on the theme of Role of Government in the Financial Sector and assesses the governments developmental role in enhancing the financial development in the country. The report revealed that current stock of market related treasury bills (MRTBs) stood at Rs1,347.2 billion during the first half of current calendar year. It said that the pace of deterioration in the quality of advances slowed down considerably as in CY09 Non Performing Loans (NPLs) increased by 24.2 percent to Rs 432 billion and further by 6.4 percent to Rs 460 billion by end-June CY10. The continued presence of the government with an insatiable appetite for banking system resources jeopardise prospects of long-term growth and investment, said report adding that the monetisation of the fiscal deficit dilutes the monetary policy stance, as has been the case in Pakistan where the impact of monetary tightening in controlling inflation has only been partially successful given governments heavy reliance on borrowing from the State Bank of Pakistan (SBP). Such financing thus endangers monetary stability. It said that in recognition of the negative consequences of borrowing from the central bank for both monetary and financial stability and given the need for compliance with the IMF-SBAs structural performance criteria which limits net quarterly borrowing from the central bank to zero, the government then looks to meet its funding needs from commercial banks through T-Bills and PIBs auctions and borrowing for commodity operations, in addition to quasi-fiscal borrowing by Public Sector Enterprises (PSEs). It pointed out that such borrowing carries implications for banks incentives to undertake risky ventures when profitability can still be maintained, or even enhanced, by investing in govt securities or lending to the public sector, especially where such lending is backed by government guarantees. This is particularly true for banks looking to consolidate their risk profile given the rising stock of NPLs in the last two years. It showed that the financial system stability seems to have improved in CY09 and H1-CY10, simply because of the shift in banks focus from the riskier private sector to investments in government securities, lending to public sector agencies and quasi-fiscal financing. It also said this shift in focus has had a favorable impact on banks Capital Adequacy Ratio (CAR) due to growth in low risk-weighted assets. However, it is exactly this shift and the reallocation of banks loanable pool of funds, which is the underlying potential source of financial instability. Notably, share of the public sector in outstanding advances has increased from 9.4 percent in December 2003 to 18.4 percent by June 2010, whereas the share of private sector loans has decreased from 90.6 percent in December 2003 to 81.6 percent in June 2010 - a trend with an inherent element of potential instability, if not reversed. Pakistans financial system size, in terms of assets, increased to Rs 9.2 trillion by end-June 2010 showing a robust growth of 20 percent from December 2008 level of Rs 7.71 trillion. The report said that stability of the financial system is largely derived from the pre-dominant position of the banking sector, as other components of the financial system continue to grow at a more gradual pace. Domestic banking sector assets constitute 73.2 percent of total financial system assets, the report added. It said the bank deposits, which have a key contribution in maintaining financial stability, grew by 13.5 percent in CY09, and 8.2 percent in H1-CY10, bringing the total deposit of the banking system to Rs 5.1 trillion by end-June CY10. This bodes well for enhancing prospects of financial stability, especially keeping in view the slowdown in deposits growth in CY08, the report added. The deposit growth is largely driven by the growth in home remittances of 23.9 percent (in US dollar terms), gradual economic recovery, and the substantial increase in government borrowing, a portion of which flows back into the banking system in the form of deposits, it added. The report opined that healthy deposit growth is indicative of banks resilience to the competition from the National Savings Schemes (NSS), which generally offer a higher rate of return than bank deposits. It pointed out that the banks exposure to the government increased significantly during 2009 and in the first half of 2010, with particular concentration in the power sector due to the ongoing issue of circular debt, and continued increase in lending to public sector enterprises and commodity finance in general. Finding the government to be a captive client, banks behaviour to lend more to the government and to public sector agencies impedes the process of productive activity in the economy, it said. In the current circumstances, while it may be prudent for banks to allocate their loan and investment portfolio in favour of public sector to maximise profits in the short run and minimise risks, a long term strategy requires an allocation of their portfolio in favour of the private sector, which is the main engine of growth and productivity, the report added. Referring to other components of the financial system, the report said that the dormant element of funding risk in case of Non-Bank Financial Institutions (NBFIs), which emerged as a strong threat to their commercial viability in CY08, continues to be a source of systemic risk. Whereas, insurance sector, on the other hand, continues to provide requisite support to the economy, despite its small size and low penetration. With regard to financial markets, the report said that in contrast to the volatility in global financial markets since the inception of the global financial crisis, financial markets in Pakistan have continued to strengthen, primarily due to the low level of integration with global financial markets, and in response to the ongoing reform process, domestic financial markets continue to provide requisite support to the financial system in performing its function of financial intermediation.