5.1 Overview

While the seeds of the monetary accommodation during FY02 lie in the macroeconomic discipline witnessed during the previous fiscal year, FY02 saw important structural shifts that considerably enhanced the SBP's ability to implement this monetary easing, and underpinned the phenomenal 14.8 percent rise in M2.

On the whole, interest rates fell dramatically in FY02, with the benchmark weighted-average 6-month T-bill yields falling by 6.6 percentage points, on the back of a 5.0 percentage point drop in the SBP discount rate during the period. The monetary easing should have a salutary short-term impact on the economy, but the high M2 growth (the strongest for the last 5 years), when seen in conjunction with the prevailing low GDP growth, could become a source of concern with respect to the build-up of inflationary pressures in the economy.

It must be noted that the tighter monetary posture witnessed in FY01 stemmed from both, the relative instability of the exchange rate during the year, as well as stringent IMF conditionality, including tight limits on the SBP NDA. The fact that interest rates were raised even as a continuing decline in the domestic inflation rate drove up the real interest rates, serves to highlight the role of the exchange rate in the FY01 tightening as well as in the subsequent easing. In fact, as soon as FY02 ushered in a degree of stability in the exchange rate, SBP promptly moved to cut the discount rate by a percentage point in July 2001, reversing the corresponding June 2001 increase. Then, in the face of the continuing stability in the exchange rate, it quickly followed up with yet another one percentage point cut in the discount rate in August 2001, before pausing to assess the impact (see Figure 5.1).

However, the macroeconomic environment changed dramatically in the second quarter. Specifically, September 11 shocks were ever berating in the domestic economy by October 2001,  with a sharp drop in the already low net credit growth, and a very uncertain export outlook. The SBP responded to this crisis by lowering the discount rate by an unusual 2.0 percentage points, taking it to an all-time low of 10.0 percent. It then waited to gauge the impact of the earlier discount rate reductions before implementing a final 1 -percentage point cut to take it to a new all-time low of 9.0 percent in response to an apparently continuing weakness in net credit demand by the private sector. The absence of further rate cuts during FY02 simply reflects (1) the end of the seasonal credit off-take period, (2) a significant drop in the weighted average lending rate, and (3) the concerns that an excessive reduction in interest rates over too short a period could de-stabilize the financial system. The impact of the easier monetary stance on net private sector credit is discussed in Section 5.6.

Over the last few years, while monetary policy gained a degree of independence from fiscal policy, it remained captive to the exchange rate considerations. Interestingly, these shackles persisted through the whole ofFY02 despite the current account surpluses seen post-September 2001, which led to a considerable appreciation of the Rupee.' However, the focus changed dramatically during the year as the emphasis shifted from preventing a depreciation of the Rupee, to avoiding a very abrupt appreciation.

As rising foreign currency inflows swamped the foreign currency markets, the SBP quickly increased its foreign currency purchases from the inter bank market.2 This served two purposes:

Thus, by the end-FY02 SBP's net foreign currency purchases totaled US$ 3.9 billion. This represented a 273.7 percent rise over the corresponding figure for the previous year as well as a Rupee liquidity injection of Rs.. 234.2 billion into the domestic economy. The latter substantially added to the free liquidity of the banking sector during a period of relatively weak growth in net private sector credit.

This excess liquidity with the banking system was a key determinant of a shift in the structure of domestic public debt that saw the government's borrowings from scheduled banks rise sharply at the expense of borrowings from the SBP, without the generation of upward pressure on interest rates.

The credit plan for FY02 (see Table 5.1), formulated in the beginning of the year, anticipated a monetary expansion of Rs.. 146.0 billion (9.7 percent) in accordance with the projected nominal GDP growth of 9 percent. This expansion was to be achieved through an increase in the credit expansion to the private sector, and higher growth in Net Foreign Assets, and a retirement of government borrowings from the banking system.

These were projected on the basis of sound macroeconomic fundamentals reflected in the targeted reduction in the fiscal deficit, a current account surplus and a relatively stable exchange rate. This credit plan, however, was revised to factor in the post-September 11 developments. Although the overall growth in M2 was revised marginally downwards to 9.5 percent, in terms of its composition between NFA and NDA, the revised credit plan had major changes.

In anticipation of the foreign exchange inflows in the form of cash assistance or rescheduling, the NFA target was revised upwards from Rs. 55.0 billion to Rs. 75.4 billion. The compensating factor to neutralize this proposed expansion was the target for government credit retirement, which was increased from Rs. 20.0 billion to Rs. 54.0 billion. This revision in government credit retirement was done on two grounds: (1) the external inflows would enable the government to make expenditures with these resources, thereby reducing its borrowing needs from the banking system for budgetary support, and (2) a shifting of commodity operations to the private sector would allow the government

to retire borrowings under this head.3 Credit allocation for the non-government sector was increased from Rs. 111.0 billion to Rs. 124.2 billion in the revised plan. The revised and the original credit plan targets are given in Table 5.1.

Table 5.1: Credit Plan and Actual Outcome

Source: Economic Policy Department, SBP

During FY02, the government borrowed Rs. 12.5 billion for budgetary support from the banking system. On face value, this was in breach of net retirement targets set in both, the FY02 credit plan (Rs. 19.0 billion) and the IMF projections (Rs. 6.9 billion). However, taking into account the waiver given by the IMF on account of KESC re-capitalization and the tax

Table 5.2: Net Budgetary Borrowing

refunds to banks, the government borrowing remains well within the target (see Table 5.2 and Section 5.5 for details).

A number of elements are of particular interest in this performance:

• Although the government's borrowings were initially quite consistent with historical trends, this changed dramatically by October 2002 as: (1) the government received a US$ 600 million grant from the US and (2) the Rupee liquidity jumped amidst heavy SBP purchases in the inter bank market.4 The former significantly depressed cumulative net government borrowings, while the latter helped the government to substitute its SBP borrowings with borrowings from commercial banks.

• Given that the increase in Rupee liquidity resulted from higher growth in the BP NFA (through market purchases); and that a portion of this increased market liquidity was being channeled to the government (via rising net sales of government securities); and that the government, in turn, was retiring its SBP borrowings (reducing the SBP NDA), it can be seen that the rise in SBP NFA was sterilized by the fall in the SBP NDA (See Table 5.3 and Figure 5.2). Thus, reserve money growth was held down to 9.6 percent.

• More interestingly, the sterilization of SBP NFA brought an extraordinary change in the structure of the government borrowings from the banking system, with a sharp 50.3 percent retirement of SBP debt, which is offset by a jump in the borrowings from scheduled banks (see Section 8.2 for details).

Table 5.3: Sterilization

• The timing of the increased availability of external financing was also fortuitous, helping keep interest rates down precisely during the period of peak seasonal demand.

• Finally, the share of the government's bank borrowings in financing the overall budgetary deficit/e// during FY02, even though the borrowings increased in absolute terms. This was because (1) large one-off increase in external financing; and (2) increased availability of non-bank borrowings due to rising inflows into the NSS, and high PIB sales to non-banks.

At first look, government borrowing for commodity operations seems to have risen considerably. However, this Rs. 5.3 billion rise does not reflect an increase in the government's commodity operations:

• The level of retirement during FY02 was lower than that seen in FY01 1. The heavy FY01 retirement of commodity finance reflects exceptionally high commodity financing in the previous year (FY00). Similarly, the relatively low FY0 1 wheat purchases (which accounts for most of the credit off-take under commodity operations) meant that the FY02 retirement was lower (see Figure 5.3).

• The government's actual wheat purchases during FY02 have probably been slightly lower than in FY0 1, as it already holds stocks purchased in the previous year.

Developments during FY02 make the trend in borrowings by autonomous bodies quite different from FY01, especially after October 2001.

• First, the list of autonomous bodies changed. SSGC and SNGPL were excluded, and PIA and Pak Steel were classified as autonomous bodies.

• Second, a usual sharp surge in borrowings at the end of the year was not visible inFY02. This was because autonomous bodies, other than WAPDA, were restricted from borrowing. This head usually witnesses an overall retirement trend during most of the fiscal year and, with a sudden borrowing jump in the month of June when these autonomous bodies borrow heavily to keep their credit lines intact. This year a surge in borrowing is evident after October 2001, with sharp decline in May 2002

• PIA borrowed Rs. 1.7 billion in October 2001 and KESC borrowed Rs. 4.9

billion in November that led to a sharp increase in net credit during October and November 2001.

• During May 2002, KESC was re-capitalized, with Rs. 30.0 billion, by the government to bring it to the point of sale. For this purpose, Rs. 22.0 billion owed to the commercial banks were retired by issuing T-bills to them.

The net credit to the private sector grew by Rs. 44.1 billion in FY02 against a growth of Rs. 54.7 billion seen in FY01 which, taken at face value, represents a 19.4 percent year-on-year decline. However, as explained below, the FY02 figures are not comparable with the statistics of earlier years.

• Following the 2nd review under PRGF in May 2002, SBP and IMF agreed to scrutinize the data on Public Sector Enterprises (PSEs). As a result, out of some 143 PSEs, 94 were reclassified as private corporations;5 two autonomous bodies6 were reclassified as private corporations; and two PSEs were included in autonomous bodies.7

• Further, the merger of two non-bank financial institutions, NDFC and Faisal Investment Bank, with commercial banks (NBP and Faisal Bank Limited) inflated the FY02 figures for credit to private sector.

Unfortunately, data constraints make it impossible to disentangle the various impacts of these shifts into specific categories. Thus, in order to analyze the FY02 trends in relation to FY01 developments, one is forced to rely on the aggregate net credit figures, i.e. the net credit extended by commercial banks to (1) autonomous bodies, (2) PSEs and (3) the private sector.

Aggregate net credit expansion by commercial banks was Rs. 28.3 billion against Rs. 78.6 billion in FY01 and the revised credit plan

figure of Rs. 116.1 billion (see Figure 5.5). It is important to note that the actual expansion in FY02

becomes even lower if we adjust these figures for the merger of two non-banks with commercial

banks. Up to end-March 2002, while the net credit growth was Rs. 29.5 billion year-on-year, gross disbursement figures registered an increase of Rs. 136.1 billion over the corresponding FY01 figure (see Table 5.4).

It is also worth noting that the gross disbursement figures in FY02 remained higher

Table 5.4 : Gross Net Credit Disbursement (Cumulative)

than FY0 1 through out the year, except for November and June. While this difference between the net and gross figures probably includes an element of re-pricing of loans, this would have impacted the disbursements only after December 2002, when weighted average lending rates began to decline. The earlier shift thus suggests that higher fresh disbursements were also masked by rising retirements.

If we net off export finance from net aggregate credit figures, the credit extended by commercial banks turn out to be slightly higher in the first and third quarter ofFY02 (see Figure 5.6). A rather steep decline in the last quarter is mainly attributable to (1) ban by SBP on borrowing of PSEs/ Autonomous bodies after March (as a precautionary step to avoid any breach of performance criterion target for PSEs) and (2) retirement of Rs. 22.0 billion KESC debt to commercial banks. In FY0 1, autonomous bodies and PSEs together had borrowed Rs. 30 billion in the last quarter. If we take into account these two major factors, the credit expansion curves almost overlap each other.

Thus it can be argued that in overall terms, barring September 11 events, the private sector in FY02 may have been better off than FY0 1 in terms of (1) market liquidity and availability of funds,8 (2) lower input prices, (3) lower mark-up rates (4) higher CBR refunds and (5) increasing quantum of foreign currency loans. A detailed assessment of the relative availability of funds to the nongovernment sector is presented in (see Section 6.3.2).9

Data for manufacturing, and for exports, also indicates that the private sector has borne the brunt of external shocks rather well, which would not have been possible if its funding requirements had gone unmet.

Export finance figures are reflective of the behavior of exporters. The outstanding volume of export finance, which was 75.1 billion in FY00 and Rs. 75.4 billion in FY01, came down sharply to Rs. 59.3 billion in FY02 (see Figure 5.7). This suggests that exporters had earlier been taking advantage of this concessionary scheme and delaying repatriation of export proceeds in order to gain from the customary depreciation of the Rupee. If this was the case, once expectations for a Rupee appreciation gained strength, the outstanding export receipts would have been expected to decline sharply. This is exactly what has happened. In fact, anecdotal evidence suggests that exporters even resorted to discounting their existing export bills.

While retirements under export finance are mainly attributable to appreciation of Rupee, the increase in gross disbursements, especially in the 3rd quarter, seems inspired mainly due to re-pricing. Earlier, SBP linked the mark up rates on EFS scheme with 6-month T-bills rates, but prior to December 2002, these had been adjusted only on a quarterly basis.

However, with effect from December 2001, to give exporters the full benefit of the FY02 cuts in interest rates, SBP began adjusting EFS rates on a monthly basis. As a result Q3-FY02 witnessed unprecedented disbursements of Rs. 103.0 billion and almost matching retirement of Rs. 96.6 billion (see Figure 5.7). The fact that this situation calmed down after SBP issued the directives that the outstanding existing loans would also be priced at new rates, lends support to our view that EFS loans were being re-priced during this period.

It is worth noting that, over the years, there had been a substantial difference in the market rates and EFS rate, distorting the overall interest rate structure. By linking the EFS rate to the 6-month T-bills rate this differential has been substantially reduced (see Figure 5.8).10

5.8 Net Foreign Assets

As explained earlier, ballooning net foreign assets (NFA) of the banking system were the key drivers of the exceptionally strong M2 growth during FY02.

The initial sharp increase in NFA in November 2001 represents inflow of US$ 600 million from USA, and later inflows of US$ 300 million for logistic support in the second quarter and US$ 640 million from the World Bank in the fourth quarter, contributed to bulk increases during the year (see Table 5.5). These were supported by the sustained surge in remittances October 2001 onwards.

Table 5.5: Sources of Increase in NFA - FY02

Other than the sheer extent of the increase, there are two major differences between NFA growth in FY02 and FY01 (see Figure 5.9):

• While rising remittances pushed up the NFA of Scheduled banks in FY02, heavy SBP inter bank purchases dampened the resulting increase by substituting these with Rupee assets. As a result, contrary to past trends, the NFA growth of the SBP far outstripped the rise in the NFA of scheduled banks. • In net terms, therefore, the growth in NFA of scheduled banks owed more to a decline in liabilities (i.e. a fall in non-residents foreign currency deposits) than to an increase in assets (see Table 5.6).

The unusual monetary developments during Y02 are reflected in the M2 components Q2-FY02 onwards (see Figure 5.10). Initially, during Q 1 -FY02, the pattern was similar to the normal seasonal developments, but it changed abruptly by September 2001, with a sharp jump in currency holdings at the expense of deposits growth, possibly reflecting the considerable increase in economic and political uncertainty during the period." By December 2001, however, the growth in cash holdings tapered off, and the M2 growth impetus reverted back to deposits,12 which began recording large net increases (see Section 6.3.1 for details). However, due to the initial jump, the currency in circulation (CC) contributed heavily to M2 growth for most of the year.

The structure of this increase in deposits during FY02 is also note worthy:

• In sharp contrast to past trends only Rupee deposits saw appreciable growth.13

• The growth rate for demand deposits (DD) is well below the historic average (the 5-year average is 15.6 percent).

Table 5.6: Growth in Net Foreign Assets

• On the other hand time deposits (TD) grew at a phenomenal 19.1 percent, far out tripping the 5-year average of 12.1 percent. This meant that time deposits provided half of the total M2 growth in FY02 (see Table 5.7). A consequence of the see-saw increases in deposits and currency in circulation during FY02 is that the currency deposit ratio (CDR), which initially increased during the year, ended at 3 percent by end Jun-02 - the same as in FY01 (see Figure 5.11). This is a welcome development.

The overall CDR has been climbing steadily after reaching a low of 29 percent in FY98, reflecting the dis-intermediary role of the freeze on foreign currency deposits (RFCDs). While the cash to Rupee deposits ratio had continued to decline at that time, by FY00 this too had begun to rise, signaling an increasing dis-intermediation (see Figure 5.11). Interestingly, the preference for liquid assets is mirroring the same consolidation around FY01 levels as visible in the CDR. The ratio between Ml/ M2 that reflects the preference for liquidity had been on the rise since May-98 until it stabilized at approximately 50 percent over the last 3 years (see Figure 5.12).

The domestic money markets felt the impact of substantial structural and policy changes in FY02. The most important of these was the significant improvement in the macroeconomic environment that enabled the SBP to ease its monetary stance while remaining comfortably within the parameters of the IMF program. Despite increased liquidity injections in the money market through a pro-active liquidity management by SBP, volatility in overnight rates did not decline significantly. This was partly due to mis-reading of signals by the market participants, and to a certain extent, a significant change in investment behavior of banks towards speculative bidding in auctions.

The tight monetary discipline visible in FY01 was perceptibly eased in FY02. The benchmark 6-month T-bill yield witnessed a steady decline through the fiscal year, as the SBP signaled an easier monetary stance through four successive cuts in the discount rate; the cumulative 500 basis point reduction took the rate to an all-time low of 9 percent. However, as discussed in the overview of the chapter, the SBP objectives for the discount rate changes varied significantly through the period, and this is reflected in the inter bank market.

Table 5.7 : M2 Component

The initial easing of monetary policy began well before the spillover effects of September 11 became visible in the form of substantially increased market liquidity. Q 1 -FY02 saw two successive adjustments in the discount rate, but in the T-bill auctions during this period, the government's net borrowings increased from both, the SBP and commercial banks.

In the subsequent quarters (and especially Q2 FY02) the SBP's monetary stance became even more accommodative as it strove to mitigate economic shocks. In particular, the liquidity injections resulting from SBP's foreign currency purchases from the inter bank market were very substantial. Given that net private sector credit demand from the commercial banks remained depressed, and that banks too were apparently unwilling to aggressively pursue credit, interest in government securities increased dramatically (see Figure 5.16).

As a result there was a visible shift in the government's borrowings patterns after October 2001. Each successive auction saw increasing reduction in the government's borrowings from the SBP with a corresponding increase in commercial bank borrowings (see Section 5.3). The fact that interest rates declined even as the government's borrowings from commercial banks increased is a telling indicator of the increase in liquidity and banks' investment preferences.

There is even an argument that bank's expectations of interest rate declines may have been, at least partially, self-fulfilling. A cursory look at the financing of the fiscal deficit shows that the larger contribution was from external and non-bank sources, i.e. the government's increased borrowings from commercial banks simply reflected increased demand for government securities, rather than an increased supply due to budgetary financing needs. The easing of the monetary stance in FY02 is reflected well in the downward shifting yield curves (see Figure 5.13). At the same time, the shape of the yield curves became steeper, depicting a greater return at the longer end of the curve, i.e. although the long-term benchmark rates - PIB coupon rates - were also reduced; this decrease was lower than the decline in discount rate and T-bill rates. However, it must be noted that despite the smaller change in the yield of the long tenor security, the impact on its market price was proportionately larger. Thus, not surprisingly, as expectations of declining interest rates strengthened, interest in the longer tenor instruments soared; 10-year PIBs in particular, were in considerable demand and traded at high premiums.

The fixed schedule of fortnightly OMOs was dismantled in July 2001 to give the SBP more flexibility in managing market liquidity. In conjunction with the FY01 shortening of the OMO tenor structure, the move underlined the OMO's primary role as a liquidity management tool, rather than an indicator of the SBP's monetary stance.14

The changes in inter bank market interventions are clearly visible in Table 5.8; SBP interventions have distinctly increased in both number and scale during FY02, and are more evenly dispersed over the year, as well as among weekdays.15 Importantly, the nature of the interventions also changed dramatically in FY02, with a net injection of Rs. 185.1 billion as compared to the net absorption of Rs. 57.6 billion in FY01. The latter is explainable by the strict IMF targets for NDA last year that compelled a squeeze on banks' liquidity as well as a need to defend the Rupee in the inter bank market. The need for the FY02 injections, however, is less obvious as, in theory, weak net private sector credit demand and the increased use of external finance by the government to finance the deficit should have left ample liquidity within the banking system. The answer to the apparent anomaly lies in the change in the investment preference of the banks, which opted to overbid aggressively in government security auctions to lock-in investments amidst expectations of a continuing decline in interest rates.

Indeed, there is a possibility that the SBP pro active liquidity management may have inadvertently encouraged this trend by creating a moral hazard. As evident from Figure 5.14, unlike in previous years, the SBP interventions were more numerous and took place on all weekdays. In other words a bank could place speculative bids in auctions secure in the knowledge that auction acceptances in excess of market liquidity would probably result in an early OMO by the central bank. Since (1) the liquidity offered in OMOs was clearly cheaper than resort to the discount window and (2) banks no longer had to wait until a scheduled OMO for relief, the effective cost of overbidding would have certainly decreased.

Apart from a few episodes of discounting, the money market remained fairly liquid during FY02 (see Figure 5.15). In the first quarter discounting was due to higher acceptance vis-a-vis maturities in primary auctions of government securities while in second quarter due to seasonal net credit off-take (although low) and Eid outflows that showed in an increase in currency in circulation. The discounting episodes in the second half of the year resulted mainly due to the over-bidding by banks in auctions (this is discussed in detail in the next section).

Table5.8 : Open Market Operations

Source : Exchange and Debt Management Department, SBP

Table 5.9 : Table 5.9: Activities and Discount Window

Source : Exchange and Debt Management Department, SBP

Comparing FY02 with the previous year, the amount of discounting and number of visits were visibly lower (see Table 5.9). More specifically, banks discounted Rs. 828.4 billion worth of government securities against Rs. 1,556.7 billion last year. The liquidity comfort this year represents the injections from improvements in NFA, and the rising deposits of banks; whereas the crunch faced in the last year was a reflection of the effective use of money market to ease off pressures on the foreign exchange market.

Figure 5.16 reveals a steady easing of monetary stance. In effect, the 6-month T-bill yield has declined from 12.5 percent at the end-June 2001 to 6.4 percent at the end-June 2002 (an all time low). In order to signal an easy monetary stance, the discount rate was cut on four occasions, i.e., one-percentage point in July, August and January respectively; and by two-percentage point in October.

In overall terms, banks offered Rs. 565.9 billion compared with Rs. 269.2 billion in the preceding year, of which SBP accepted 54.5 percent and 48.4 percent of the offered amount, respectively. An interesting observation here is that despite the declining interest rates the banks were offering heavy amounts while in FY0 1 rising interest rates failed to attract more funds.

This difference in FY02 was the result of: (1) ample liquidity in the banking system, (1) low net private sector credit demand (3) self-fulfilling expectations of banks regarding further decline in interest rate in coming auctions. By contrast, in FY01, rising interest rates had failed to attract more funds due to severe liquidity problems that mply; (1) a lack of funds, (2) profitable nvestment opportunities in short-term repo market, and (3) banks' expectation of a further iquidity squeeze, especially at respective quarter ends.16

It is also interesting to note that secondary market activity (see Figure 5.17) in T-bills suggests that market expectations of a decline in interest rates took greater hold during the latter half of the fiscal year. This is evident in a sharp drop in activity in the shorter tenors, and the rise in activity in the longer tenor T- bill. This is also mirrored in the T-bill auction data (see Table 5.10).

Occurrence of multiple spikes in the graphs shows, (1) sudden shift in trading towards longer tenors (this is also visible in PIB secondary market data, see Figure 5.20) reflecting a higher degree of volatility and uncertainty amongst market players regarding interest rate expectations, and (2) a

greater degree of interest in longer-term securities, one can easily identify periods where activity in 3 month is negligible.

The analysis of individual auctions is also quite revealing. In first eight auctions the market behavior was consistent with SBP view of interest rates as the rates declined only after the discount rate cuts and remained stable otherwise (see Figure 5.16). In next five auctions, between third and fourth discount rate cut, the banks offered heavy amounts at cheaper rates in anticipation of a further easing of monetary policy. This expectation is evident from the term repo rates, the tenor-wise break up of banks' offers in T-bill auctions, as well as secondary market trading volumes.

Figure 5.19 shows the daily trends in term repo rates, which clearly depicts the declining trend in these rates much before the discount rate cut. Furthermore, one can easily see the rates crashed before the February 7, 2002 auction. To further reinforce our view of these self-fulfilling expectations, the break-up of funds offered in different tenors and secondary market trading in different instruments shows a higher interest in longer tenors during the period when these expectations were prevailing in the market (see Figure 5.17 and 5.18).

As discussed in the SBP Third Quarterly Report for FY02, these expectations were eventually quashed in February 7, 2002

Table 5.10: Trading Volume ( Face Value) - FY02

auction. Afterwards, in all remaining auctions (except the last auction) the T-bill rate remained stagnant closely aligned with SBP's view of interest rates. However, the budget speech in mid-June, 2001 re-ignited banks' expectations of another round of rate cut as evident in the last auction ofFY02.

In aggregate, the government mobilized Rs. 77.1 billion in 11 regular PIB auctions and a further Rs. 30.5 billion through special PIB sales during FY02, against an aggregate target of 83.0 billion (see Table 5.11).17 In particular, the ten-year bond stands out as a clear success with mobilizations greater than the combined receipts of the other two tenors.

The role ofPDs in development of a robust secondary market for PIBs, however, is still a matter of concern.

Firstly, so far, the PDs have failed to judge the extent of market demand, which is reflected in oversubscription in most of the auctions through out the year. SBP, on its part, has adhered to auction targets, which is clearly reflected in the target to acceptance ratio of 93 percent.

Secondly, the PDs have failed to quote two way pricing that is essential for market making.

Thirdly, anecdotal evidence suggests that, apart from allowed short-selling of 5 percent, pass-through bids are also excessively used, thus implying a reluctance on part of PDs to take PIBs on their books. This is supported by the higher than average trading evident on PIB auction settlement dates, especially in the case of 3 and 5-year bonds (see Figure 5.20).

Another problem for the long-term market, as already discussed in SBP Quarterly Reports, is that most institutional investors appear to lack proper professional skill and infrastructure to gauge market sentiments. This makes it difficult for institutional investors to quote appropriate prices. The PDs responsibility, here, is two-pronged, as they have to: (1) act as "market makers" and (2) help their clients make intelligent investment decisions. The SBP is therefore looking to improve the PD system to strengthen PIB primary and secondary market.18

The secondary market activity ofPIBs reveals an increase in activity in periods when the interest rate decline expectations were prevalent in the market. A few spikes are also visible on auction dates, especially for 3 and 5 year bonds, this is presumably due to pass through bids and/or short selling (see Figure 5.20).

Figure 5.21 depicts excessive interest of banks, especially the private banks in holding PIBs in relation to their respective demand and time liabilities (DTL). As discussed in the SBP Third Quarterly Report, FY02 banks' holdings of PIB are still greater than non-bank holdings.

Although it is not a desirable development, the excessive interest is understandable in a scenario of declining interest rates.

Table 5.11: PIB Auctions (Summary of Results) - FY02 billion Rupees