NOTE stood at 51% as of June

NOTE ON PAKISTAN’SSME MARKET, POTENTIAL and CHALLANGES FOR CGF SME Finance in Pakistan The economyof Pakistan is the 24th largest in the world in terms of purchasing power parity (PPP) and 42nd largest in terms of nominal gross domestic product. Pakistan has apopulation of over 207 million1 (theworld’s 5th largest), giving it a nominal GDP per capita of $1,629,2 whichranks 147thin the world for 2016.However, Pakistan’s undocumented economy is estimated to be 36% of its overalleconomy, which is not taken into consideration when calculating per capitaincome3. Primaryexport commodities include textiles, leather goods, sports goods, chemicals,carpets/rugs and medical instruments. The country’s economy achieved aGDP Growth rate of 5.28% with a Nominal GDP of $304 billion in 20174. There are 34 Commercial Banks withmore than 13,0005branches and 11 Microfinance Banks with 2,4006 branchesoperating in Pakistan presently. The Advances to Deposits Ratio (ADR) ofPakistan’s banking industry stood at 51% as of June 30, 2017.

 Pakistan has one of the highest andmost diverse populations of Small & Medium Enterprises (SMEs) in the region(estimated at more than 3,000,000 businesses) and yet the country’s SME Marketremains fundamentally under-banked and underserved, particularly for the “S”segment. Fewer than 200,0007 SMEscurrently borrow from banks and less than 40% have any form of bankingrelationship.  Historically, the favourablemacroeconomic and investment conditions in Pakistan began to deteriorate from2008. Not only the global financial crisis triggered an uncertainty, but thegrowing security concerns and widening energy imbalances in the country alsostrongly dented domestic business prospects. During this time, overall SMEsector suffered from the spill over impact of sluggishness in the largercorporate sector. SMEs could not address their cash flow constraints byborrowing from banks due to high interest rates and banks’ reluctance to lendto SMEs due to rising bad debts. An additional factor of high fiscal burdensignificantly increased government’s appetite for funds from the banking systemleaving little or no liquidity and appetite for the high-risk SME lending.

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8 This primarily explains the prevailingrisk aversion of banks to SME lending and their preference to stay distancedfrom the SME development agenda.  From 2013 and onwards, overallmacroeconomic conditions started improving and with the reduction in the policyrate from 12% p.a. in 2012 to 6% p.

a. in 2017, the situation started favouringSMEs in conjunction with the support of State Bank of Pakistan (SBP)’sfacilitative role to enhance access to credit including:·        Introduction of a separate set of PrudentialRegulations for SME Financing in 2003 with a revision in 2013 wherein SmallEnterprises (SEs) and Medium Enterprises (MEs) were separately defined and morespecific and simpler regulations for SEs and MEs were prescribed. ·        Facilitation in the approval of “The FinancialInstitutions (Secured Transactions) Act, 2016” from the Parliament tofacilitate SMEs and agri borrowers to access credit from banking sector byusing their movable assets as collateral. ·        Allocation of SME financing targets to banks for thefirst time in 2016 in order to enhance the flow of credit to the SME sector. ·        Introduction of different risk coverage and refinanceschemes for SME Financing aimed at risk-sharing and reducing the cost ofborrowing by SMEs.Though these efforts have broughtimprovement in SME financing portfolio of banks, however, a large number ofSMEs, particularly Micro and Small Enterprises, are still financially excluded.In order to address this issue and enhance access to credit to SME sector, SBPhas prepared an ambitious policy for promotion of SME finance with the followingkey benchmarks to be achieved by 2020: ·        Increase SME share from existing 8% private sectorcredit to 17%·        Increase number of borrowers from existing 174,000 to500,000  Despite the policy level work doneso far to create an enabling environment for SME lending, only a handful ofbanks (HBL, UBL, Bank AlFalah, and Meezan Bank) have undertaken SME Bankingprojects through IFC’s Bank Advisory Services over the past 5 years and havebeen successful in increasing their SME Financing portfolios with considerablylow NPLs.

 Main reasons behind the reluctanceof banks to lend to SMEs include lack of strategic focus on part of banks, ahigh industry-wide NPL ratio for SME loans (21%9), corporatefinance mindset, lengthy and cumbersome foreclosure process, lack of financialdisclosure by SMEs, lack of definition for non-borrowing SMEs, weak technologyplatforms including absence of Client Relationship Management (CRM) and LoanOrigination System (LOS) software, absence of SME-specific risk managementfunction and framework, lack of SME R&D and product programmes, and HRcapacity constraints.  By and large, banks in Pakistanstill do not see SME Banking as a unique and profitable business function inaddition to and separate from the Corporate and Consumer banking shops. Despitethe various policy level initiatives taken by SBP including the CreditGuarantee Scheme and Refinance Facilities, off-take under these has remainedlow. On the one hand, banks feel that the Credit Guarantee Schemes introducedby SBP have a cumbersome process coupled with an uncertain favourable outcomefor banks in case of defaults by borrowers, and on the other, the RefinanceFacilities that are aimed at providing low-cost liquidity to banks for SMElending, have little or no demand due to reduction in policy rate coupled withsurplus liquidity available across the banking industry. Furthermore, all theseschemes except one, are targeted at SMEs engaged in the manufacturing businessand given that only 22% of all SMEs fall into this category, utilizationremains low.   Challenges faced by SMEs andpotential solutions Main challenges and constraints tobusiness growth faced by SMEs, particularly Micro and Small Enterprises,include historically high interest rates, requirement of collateral forsecuring loans (access to financing), long turn-around-time of banks for SMEloans (avg. 90 days), scarcity of financial solutions and conservatism ofbanks, uncertain economic policy, macro-economic instability, taxadministration, and tax rates.

 In terms of way forward,considerable work needs to be done by banks in the country including thefollowing to enable them to undertake SME lending in a profitable and scalablemanner:·        Investment in Technology (Application Scorecards,Collections, Loan Origination System, and Client  Relationship Management software)·        Definition of non-borrowing SMEs·        Simplification and automation of Credit Process toreduce Turn-Around-Time·        Target Market Identification and Cluster-basedApproach for Programs supported by segment-specific Risk Acceptance Criteria(RACs)·        Development of Supply Chain Financing programs andother cash flow based products ·        Re-alignment of the existing Delivery Channelincluding the use of Alternate Delivery Channels (Internet Banking, ATMs, andBranchless Banking platforms) for SME lending Opportunities for otherstakeholders consist of:·        SME Lending and SME Banking Advisory for banks·        Development of customized training programs for SMEloan officers and SME credit and risk staff·        Introduction of Credit Guarantee / Risk Sharingfacilities directly with partnering banks and financial institutions·        Introduction of Venture Capital funds for SMEs Challengesand mitigating measures for Credit Guarantee FundsThe biggest challenge for aprivate credit guarantee fund would be the regulatory approval by SBP to allowtreatment of a private credit guarantee at par with guarantees issued byfinancial institutions and multilateral agencies in case the fund partnersdirectly with banks, particularly, if the fund is not set up as a Non-BankingFinance Company (NBFC). Other challenges including optimal utilisation andminimizing unnecessary loan losses, could addressed through a combination ofthe following: 1.      Partnering with banks that already have sizable SMEportfolios or are desirous of increasing their market share (would stronglysuggest the first round with private sector conventional and Islamic banks,microfinance banks, and leasing companies only).2.      Partnering “directly” with banks either for across theboard new SME lending or for launching or increasing outreach under product /program lending. Any credit guarantee that is launched through SBP dilutes theinterest immediately as the decision to reimburse the bank in case of defaultrests solely with SBP and banks are paid after SBP’s audit.

No claims are paidif SBP decides that the loan was not granted according to its guidelines andbanks cannot argue with the regulator!3.      Providing on-ground and hands-on support in clientselection and credit decisions at least for the first 3 years. This periodcould be very effectively used for knowledge transfer and capacity buildingwithin the partner banks. One way of doing this could be to control the creditautonomy during the first year with a higher loss coverage (say 75%); allowjoint credit decisions with a reduced coverage of say 50% during the secondyear, and limit yourself to an oversight of decisions made by the bank’s staffwith say 25% coverage.4.      Encouraging and helping banks to introduce cash-flowbased and preferably collateral-free lending for Micro and Small Enterpriseswith a comparatively higher coverage that collateralised loans. Despite all the challenges, the attractivenessof Pakistan’s SME market is high with ample opportunities for growthparticularly with the anticipated economic upturn associated with the ChinaPakistan Economic Corridor (CPEC) initiative.

1CENSUS – 2017 PAKISTAN (PDF). Pakistan Bureau of Statistics.August 2017.2Ministry of Finance, Government ofPakistan3″TheSecret Strength of Pakistan’s Economy”. Bloomberg.4″MACROECONOMIC INDICATORS” (PDF). Pakistan Bureau of Statistics.

5BankingSector Statistics June 2017. State Bank of Pakistan.6Pakistan Microfinance Review 2016. Pakistan Microfinance Network.7SMEFinance Annual Review 2016. State Bank of Pakistan.

8Policyfor Promotion of SME Finance 2017. State Bank of Pakistan.9 SME Finance Quarterly Review June 2017.State Bank of Pakistan.

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