THE DEVELOPMENT OF DEBT SECURITIES MARKET

COUNTRY EXPERIENCE OF PAKISTAN

PRESENTED BY

MS. UZMA KHALIL

STATE BANK OF PAKISTAN

 SEACEN-WORLD BANK SEMINAR ON STRENGTHENING THE

DEVELOPMENT OF DEBT SECURITES MARKET

JUNE 08-JUNE 10, 2004

Introduction

The bond market in Pakistan is comprised of debt and debt like securities issued by a) the

Government; b) statutory corporations; and c) corporate entities. As of June 30th, 2003,

the size of the Pakistan’s bond market was approximately Rs. 1,892 billion equivalent to

USD 33billion. The bond market is clearly dominated by the Government, which

accounted for Rs.1,852 billion (or 98%) of total bonds outstanding as of June 30 th, 2003

followed by corporate entities Rs. 25 billion (1.32%) and statutory bodies Rs.15billion

(0.79%).

The following table shows the outstanding position of bond market during the period

June 30th, 2003 as compared to June 30th, 1996.

Debt Instruments FY2003 FY1996

Amt Rs. in mn USD in mn Amt Rs. in mn USD in mn
Government Debt 1,852,391 31,938 901,402 15,541
Permanent Debt 427,908 223,788

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Floating Debt 516,268 421,742
Un funded Debt 908,215 252,902
Corporate Debt 25,000 431.03 1,000 17.241
Statutory Corporation 15,000 258.62 13,400 231.03

The secondary market trading volume in the Government bond market as measured by

average daily turnover is approximately Rs. 20 bn which is 5% of the total outstanding

debt.

Government Debt Securities

The Government of Pakistan has run large fiscal deficits over the last two decades. This

has lead to the accumulation of a large domestic debt of Rs. 1,852 billion as at end June,

2003. Of this amount, permanent debt accounted for Rs. 427.908 bn (23 %), floating debt

for Rs. 516.268 bn (28%) and un funded debt (the various saving schemes) for Rs.

908.215 bn.(49%)

The large portion of floating and permanent debt has been raised through the auctions of

short term Government of Pakistan Market Treasury Bills (MTBs) and long term

Pakistan Investment Bonds (PIBs).

Characteristics of MTBs and PIBs

Market Treasury Bills (MTBs) are short-term instruments of Government borrowing

having the following features:

• Zero Coupon bonds sold at a discount to their face values

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 • Issued in three tenors of 3-month, 6-month and 12-months maturity

• Purchased by individuals, institutions and corporate bodies including banks

irrespective of their residential status.

• Can be traded freely in the country’s secondary market. The settlement is

normally through a book entry system through Subsidiary General Ledger

Accounts (SGLA) maintained by banks with State Bank of Pakistan (SBP).

Physical delivery could be affected if required.

• Profit is taxable at 20%

As at end June 2003, outstanding amount in MTBs was Rs 516.268 bn (USD 8.901bn)

including MTBs created for replenishment of Govt. cash balances with SBP.

Pakistan Investment Bonds

After the suspension of auctions of the long term Federal Investment Bonds (FIBs) in

June 1998, there was no long term marketable government security that could meet the

investment needs of institutional investors. Therefore, in order to develop the longer end

of the Government debt market for creating a benchmark yield curve and to boost the

corporate debt market, the Government decided to launch Pakistan Investment Bonds in

December 2000. These bonds have the following features:

• Issued in five tenors of 3, 5, 10, 15 and 20-years maturity.

• Script less security managed through SGLA

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 • Purchased by individuals, institutions and corporate bodies including banks

irrespective of their residential status.

• Coupon and target amount announced by SBP in consultation with Ministry of

Finance

• Payment of Profit on semiannual basis. Profit is taxable @10%.

As at end June, 2003 outstanding amount under PIB was Rs. 228.665 bn. Equivalent to

USD 3.94 bn.

Auction Mechanism

SBP is acting as an agent on behalf of the government for raising short term and long

term funds from the market. The MTBs and PIBs are sold by SBP to eleven approved

Primary Dealers through multiple price sealed bids auction.

 The Auction for MTBs is held under a fixed schedule on fortnightly basis.

 The Auction for PIB is held on quarterly basis. Since September 2003, the sale of

PIBs is done under Jumbo issuance mechanism under which the previous issues

are reopened in order to enhance the liquidity in the secondary market.

Corporate Bond Market

Pakistan’s bond market has seen increased corporate issuances following the

rationalization of interest rate structure of National Saving Schemes (various government

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scheme to raise funds from non banks sources) in FY00. In addition to this, Government

has also barred institutional investors from investment in National Saving Schemes in

March 2000, which has substantially benefited the corporate debt market.

As a result of these measures, 48 new issues were launch during FY01 to FY03 whereas

previously only 13 issues were launched during the period FY95-FY00.

The size of Corporate bond market as at end June, 2003 was approximately Rs. 25bn

(USD 0.431 bn)

Role of Credit Rating Agencies

The Pakistan Credit Rating Agency (PACRA) was established prior to the first public

issue of Term Finance Certificate (TFCs). This agency was incorporated in August 1994

by IFC in collaboration with Fitch-IBCA Inc of UK and Lahore Stock Exchange, while

the second credit rating agency DCR-VIS Credit rating Co. Ltd was set up in 1997 to

improve transparency in capital market.

Recent Developments in Domestic Securities Market

Primary Dealer System

• As a prerequisite for launching long term bonds, Primary Dealer System was

introduced in FY00 and seven banks were chosen by SBP on the basis of their

treasury expertise and infrastructure, past performance as market makers and

capital adequacy. Based on the experience with the Primary Dealers the Primary

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 Dealers rules were revised in FY03 in which the minimum paid up capital

requirements were relaxed to allow brokerage houses to act as primary dealers.

The Primary Dealers (PDs) are given explicit responsibility of developing an

active secondary market by supplying non-PDs and institutional investors with

PIBs.

• In order to allow an effective price discovery mechanism each PD is allowed to

short sell 5% of the target amount before the auction.

• Non competitive bidding upto 10% of the target amount in PIB was introduced in

FY03 in order to diversify the investor base and encourage participation from

retail investors.

• With the view to enhance secondary market liquidity in long term bond market,

Jumbo issuance mechanism for the sale of PIB was introduced in September

2003. This step is expected to lessen the segregation in Government bond market

arising out of too many issues of different sizes and coupon rates trading in the

market. Also the announcement of quarterly sale target, helps market participants

in forming expectations about long term Government borrowing requirements.

• In January 2004, PIBs of 15-year and 20-year maturity were introduced to provide

long term yield curve for corporate sector, housing finance and infrastructure

projects.

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Corporate Bond Market

• In order to develop the corporate bond market, several initiatives have been taken

by the Government to remove the anomalies in interest rate structures for

government saving schemes. In this respect, the rates on Government National

Saving Schemes (NSS) been linked with the yields on market based instrument

i.e. PIB of different maturities.

• In addition, the Govt. has also barred institutional investors from investment in

NSS in March 2000, which has substantially benefited the corporate debt market.

• On the investment side, commercial and investment banks are main investors in

private sector TFC’s. In 1997, listed TFC’s became “ approved securities” for the

purpose of meeting statutory liquidity requirement (SLR) for NBFI’s.

• As an important step, Government has progressively liberalized the investment

restrictions on institutional investors. According to the new Insurance Ordinance

the minimum requirement of investible funds of life insurance companies in

Government securities has been lowered to 40%. Immediately prior to the

promulgation of the ordinance, the minimum requirement was 50% while in 1997

the requirement was 60%.

• The investment cap was raised for provident funds to invest in stocks and listed

fixed income securities from 10% to 30%.

• Furthermore the Government has reduced stamp duties and taxation including

withholding tax on profits of TFCs.

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Implementation of Monetary Policy.

The financial sector reforms initiated in late 1980’s started to reform the financial

markets rapidly from FY91. One of the objectives of these reforms was the reorientation

of Monetary Policy away from direct controls towards indirect controls through market-

based instruments. This reorientation triggered two important changes. First is the

increasing assertiveness of the SBP in initiating and implementing its monetary policy,

albeit within the framework of Annual Credit Plans, and second is the significant

alteration in monetary policy transformation mechanism.

With respect to the monetary transmission mechanism, prior to reforms it was largely

determined by the instruments of direct control such as high SLR, bank-by-bank credit

controls and directed lending. After the initiation of reforms following indirect instrument

are relied upon for the successful implementation of monetary policy.

Open Market Operations (OMOs)

After the abolishment of Credit to Deposit ratio in 1995, OMOs are being used as a major

tool for the conduct of Monetary Policy. Regular OMOs are being conducted since

January 1995. Effective from July, 2001 OMOs are conducted under a flexible schedule

on as and when required by market conditions prior to that OMOs were conducted under

a fixed schedule. The Government Market Treasury Bills created for replenishment of

Govt. accounts are used as instruments.

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SBP 3-day Repo Facility

The 3-day Repo facility is one of the main instrument of SBP. Changes in it shows the

direction and stance of monetary policy. Cash accommodation is usually provided for

overnight, however transaction period can be extended to 3-days or more to cover

occasionally long week ends.

Cash Reserve Requirements

All scheduled banks in Pakistan are required to maintain a balance-non-remunerated with

SBP upto 5% of their demand and time liabilities. Effective from July 26, 1997 banks

were advised to maintain average balance of 5% of DTL on weekly basis with a

minimum of 4% on daily basis.

Swap Desk

The Foreign Exchange Swap Desk was established in September 2001 to manage the

liquidity in both the FX and Money Market.

Coordination between Monetary and Fiscal Policy

The SBP is managing the public debt on behalf of the Government. There exists a close

coordination between Ministry of Finance and SBP as a result of which fiscal and

monetary policy are closely coordinated to achieve the objective of high sustainable

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growth rate and low and stable inflation rate. To achieve this task the National Credit

Consultative Council meet annually to formulate the Credit Plan for the year which is

reviewed on semiannual basis.

Key Challenges facing the Development of Debt Securities Market

Enhancing Secondary Market Liquidity

This is obviously the most critical area for improving the efficiency of secondary market.

In this respect the Primary Dealers have to play a more effective role in enhancing their

market making abilities by quoting two-way prices for large volumes.

In addition to reduce fragmentation in the long term bond market, Jumbo issuance

mechanism has been introduced in September, 2003 to by which previous benchmark

issues are reopened to provide greater liquidity to the market. Further efforts are

underway to introduce Coupon stripping in long term bonds.

Diversifying the Investor base

Presently, in the long term bonds are largely held by the banking system. As on April 30,

2004 banks held 59.65% of total outstanding PIBs whereas Non-banks held 40.35%. The

high percentage of holdings by banks is exposing them to interest rate risk as their

liabilities are short term whereas assets are long term. To help diversify the investor base

SBP is maintaining close liaison with banks and recently guidelines on Risk Management

are issued so as to guide the banking system in their efforts to develop effective Risk

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management system. In addition to encourage retail participation in long term bonds,

non-competitive bidding upto 10% of the target amount was introduced in 2003.

Creating Awareness among Investors

One of the problems in long term bond market is that most institutional investors appear

to lack proper professional skills and infrastructure to gauge market sentiments. This

makes it difficult for institutional investors to quote prices and thus most of them have

adopted a buy and hold strategy. In this respect SBP has held several joint meetings with

Primary Dealers and institutional investors to assess the problems faced by institutional

investors and have encourage Primary Dealers to hold seminars for creating awareness

among institutional and individual investors.

The international bond market has greatly expanded in

recent years because of the readily available information
provided over the Internet, and more deregulation in
financial markets throughout the world. There is greater
opportunity to not only diversify a portfolio, but to also

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earn higher yields. Furthermore, new financial instruments,
such as interest rate swaps and currency swaps, allow
issuers of bonds to take advantage of foreign markets, and
to pay out lower rates than would otherwise be possible.

However, there are 2 additional risks in holding

international bonds that are not found in domestic bonds:

sovereign risk and foreign-exchange risk. Sovereign

risk (synonyms: country risk, political risk) is the

risk associated with the laws of the country, or to events
that may occur there. Particular events that can hurt a
bond are the restriction of the flow of capital, taxation, and

the nationalization of the issuer. Foreign exchange

risk is the possibility that the foreign currency will

depreciate against the domestic currency. Currency
exchange rates are changing all of the time, so if the bond
currency depreciates against the investor’s domestic
currency during the term of the bond, then the investor will
either lose money or not make as much profit.

The world of bonds can be subdivided based on domicile of

the issuer and the buyers, and currency denomination.

Domestic bonds are issued by a company or bank

within a country, in the country’s currency, and traded

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within the country, and are subject to that country’s rules
and regulations.

Foreign bonds are issued by a foreign entity, but are

underwritten and sold in a domestic market.

Eurobonds are underwritten by an international

syndicate to be sold primarily outside the domestic market,
which does not necessarily include Europe, but usually
does.

Global bonds are underwritten by an international

syndicate to be sold both domestically and internationally.

Another way to classify international bonds is whether they

pay in United States dollars (USD) or a foreign currency.

U.S.-pay bonds are sensitive to interest rates in the

United States, while foreign-pay bonds are sensitive to

the interest rates of the currency’s country of origin. With
the exception of the emerging market debt, U.S.-pay bonds
have a risk profile similar to domestic U.S. bonds. With
foreign-pay bonds, however, the investor must consider
currency exchange risk, trading hours and procedures, the
laws of the country (for instance, what happens if a
company goes bankrupt?), and especially taxation.

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U.S.-Pay International Bonds

U.S.-pay bonds are bonds that are from issuers domiciled

in other countries, but that are denominated and pay in
USD. Foreign pay bonds pay in foreign currency, and so
there is a foreign exchange risk with these bonds. If the
dollar strengthens against the bond’s currency, then the
value of the bond will decline; but if the dollar declines,
then the bond’s value increases.

Yankee Bonds

Because the United States market is large and safe, many

foreign companies and banks choose to issue bonds in this

country to raise capital. Yankee bonds are issued in the

United States by foreign companies and banks, but are
underwritten by a United States syndicate, and are sold in
the United States and pay interest semi-annually in U.S.
dollars. They are also registered with the Securities and
Exchange Commission (SEC), so they are much like
domestic bonds. Many Yankee bonds are sovereign or
sovereign-guaranteed issues, so they are of high credit
quality. Supranational agencies and Canadian companies
and agencies have been the major issuers of Yankee
bonds. The size of the Yankee bond market increased

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 substantially after the abolition of the interest

equalization tax (effective 1963-1974), which taxed

U.S. buyers of foreign securities.

Eurodollar Bonds

Eurodollar bonds are usually issued, mostly by sovereigns,

supranational agencies, such as the World Bank,
corporations, and banks, outside of the United States, and
are mostly traded in foreign markets, in the so-called

Eurobond market—the major trading center is London.

Eurodollar bonds are usually of high quality, many are
sovereign or sovereign-guaranteed issues, but they are not
registered with the SEC. Eurodollar bonds constitute most
of the Eurobond market and are denominated in United
States dollars. They are bearer bonds, which are
unregistered—like cash, possessing them is owning them.
They are underwritten by an international syndicate and
marketed in many different countries.

Because they are not registered with the SEC, new issues
cannot be sold in the United States. Thus, Eurodollar bonds
can only be purchased in the secondary market after they

have been seasoned—SEC Regulation S arbitrarily

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 defines seasoned as a security that’s been on the market
for 40 days (recently reduced from 90 days).

The Euro medium-term note is similar to the

Eurodollar bond, but is issued in different currencies and
maturities under a single agreement.

Emerging Market Debt: Brady bonds and Aztec bonds

In the 1980’s, Latin America was experiencing a debt crisis.

Mexico suspended debt payments in 1982, and other Latin
American countries soon followed. Because United States
banks held much of the debt, various solutions were
considered to restructure the debt.

Aztec bonds were issued by J.P. Morgan in February,

1988 to restructure Mexican debt. Shortly thereafter,
Treasury Secretary Nicholas Brady initiated a similar plan,

subsequently called the Brady Plan, to restructure the

debt involving other banks and other countries that had
defaulted on their bank loans. This restructuring involved
agreements among the debtor countries and the lending
banks, whereby the debtor country would issue bonds,

subsequently called Brady bonds, in exchange for the

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debt obligation. Thus, the banks could trade their
nonperforming loans for Brady bonds.

Most Brady bonds were denominated in United States

dollars, although some were denominated in other
currencies. The interest rate can be fixed, floating (usually a
percentage above the LIBOR rate), or step-up (interest rate increases
according to a schedule), and is paid semi-annually. To
guarantee principal, most Brady bonds are collateralized
with U.S. Treasury zero-coupon bonds, purchased by the
creditor country, with a maturity date equal to the maturity
date of the Brady bond, and held in escrow at the Federal
Reserve, and also have a rolling interest guarantee,
collateralized with cash or money market instruments, for
6, 12, 14, or 18 months of interest payments. However,
not all Brady bonds were collateralized. The first Brady
agreement was reached with Mexico and the bonds were
first issued in March, 1990.

The Brady bond market is now the largest and most

actively traded emerging market asset class. Although
retail investors can buy Brady bonds, a round lot is
$2,000,000.

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Foreign-Pay International Bonds

For a United States investor, foreign-pay international

bonds are bonds that pay in any currency other than the
United States dollar. Consequently, a major risk with these
bonds is the foreign-exchange risk. And because
information about issuers is usually less than for issuers
domiciled in the United States, and because standards
throughout the world are frequently lower than in the
United States, these bonds are more volatile.

These bonds, like the U.S.-pay bonds, are classified

according to the country of the issuer, the domain of the
trading market, and the bond’s currency.

One class of bonds is the foreign domestic bond, which are

bonds issued in single countries other than the United
States, trade within that country, and are denominated in
that country’s currency.

The foreign bond market involves bonds issued in 1

country and in that country’s currency by a foreign issuer.
For instance, the Yankee bond is a bond issued in the
United States by a foreign issuer and denominated in USD.

Other specific foreign bond markets are the Samurai

market where bonds, issued by foreign issuers, in Japan

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and in Japanese yen are traded, and the Bulldog

market, where bonds issued in Great Britain by foreign

issuers are traded in the local market in British pounds.

Bonds issued in the international market in major

currencies, but outside of the currency’s domestic market,

are called Eurobonds. Generally underwritten by

international syndicates, these bonds are sold in a number
of major markets concurrently. Most Eurobonds are
denominated in Euros. Other major markets include the
Eurodollar, Eurosterling, and Euroyen markets.

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