Academic journal article The Lahore Journal of Economics

Corporate Financial Leverage, Asset Utilization and Nonperforming Loans in Pakistan

Academic journal article The Lahore Journal of Economics

Corporate Financial Leverage, Asset Utilization and Nonperforming Loans in Pakistan

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1.An Overview of Nonperforming Loans in Pakistan

Although the volume of nonperforming loans (NPLs) as a share of gross advances in Pakistan has declined from a peak of 16.2 percent in 2011, this ratio remains higher than the regional and world averages - 12.5 percent in 2014 compared to 7.0 percent for South Asia and 4.5 percent globally (Figures 1 and 2). The State Bank of Pakistan reveals that lending to the corporate sector alone accounts for almost 65.6 percent of gross advances for investment in noncurrent assets, working capital and trade financing. The corporate sector's contribution to the total volume of NPLs was alarmingly high at almost 70 percent in 2014 (Table 1). More than 94 percent of all bank credit is channeled to urban areas. The share of rural areas has never been more than 6 percent (Table 2).

Motivated by the negative or very low real interest rate (RIR), which has never exceeded 4 percent, the nonfinancial corporate sector has borrowed on a large scale, significantly raising its debt-equity ratio (DER) and financial burden during the period 2006-10. This borrowing was used to expand the asset base - primarily noncurrent assets such as machinery and equipment - and to invest in speculative or nonproductive assets such as real estate (see Figure A1 in the Appendix).1

However, several factors have led to a sharp decline in asset turnover (corporate asset utilization), especially during 2006-10 (Figures 3a-h). These include severe energy shortfalls (Pakistan having been unable to expand its capacity to generate enough electricity and gas), expansions in the asset base, the global financial crisis, an adverse local macroeconomic environment, and poor law and order.2

The corporate sector's noncurrent and total assets increased at a cumulative growth rate of 23.2 and 19.0 percent, respectively, while sales grew by only 13.0 percent during this period (Table 3). Greater financial leverage in terms of a larger financial burden and poor asset utilization has caused average bank asset quality to deteriorate, resulting in a sharp rise in NPLs, especially during 2006-10. Figure 4 shows that textiles, cement, electronics, automobiles and shoes/leather garments account for the highest NPLs. The incidence of loan defaulting in cement and automobiles - despite extensive construction activity and high demand for vehicles - is indicative of the moral hazard resulting from weak law enforcement in Pakistan.3

Figure 5 illustrates the gravity of the situation. For the Industrial Development Bank of Pakistan (IDBP) and HSBC Bank Middle East, NPLs account for 100 percent of gross advances. SME Bank and KASB Bank follow, with a corresponding share of 68 and 35 percent, respectively. The Bank of Punjab, NIB Bank and the Punjab Provincial Cooperative Bank account for 28, 25 and 24 percent. Clearly, specialized and public banks in Pakistan tend to have the highest NPL levels, while Islamic banks have among the lowest.

Larger banks appear to contribute more to the sector's total stock of NPLs than smaller banks (Figure 6). While Pakistan's macroeconomic recovery 2011 onward has improved the asset turnover of the corporate sector, this ratio is still far below its pre-2006 level. The NPL level has also fallen, but even this percentage is still excessive (see Figures 1-3).

A high NPL level can potentially deepen the severity and duration of a financial crisis and complicate macroeconomic management (Woo, 2000). It can also shatter investors' confidence in the banking system (Adhikary, 2006) and prevent economic recovery by cutting into profit margins and, therefore, the capital base for further lending (Bernanke & Lown, 1991). Combined with weak law enforcement, this is likely to drive out bona fide borrowers through a contagious financial malaise - 'bad' borrowers will have a negative impact on 'good' borrowers by inducing the latter to prolong their payments (Adhikary, 2006). …

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