ASIAN DEVELOPMENT BANK RRP: PAK 33271 REPORT · PDF fileFINANCIAL (NONBANK) ... KSE –...

ASIAN DEVELOPMENT BANK RRP: PAK 33271

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON

PROPOSED LOANS

AND GUARANTEES

FOR THE

FINANCIAL (NONBANK) MARKETS AND GOVERNANCE PROGRAM

IN THE

ISLAMIC REPUBLIC OF PAKISTAN

November 2002

CURRENCY EQUIVALENTS

(as of 4 November 2002)

Currency Unit – Pakistan rupee/s (PRe/PRs) PRe1.00 = $0.0170

$1.00 = PRs58.84

ABBREVIATIONS

ADB – Asian Development Bank CDNS – Central Directorate of National Savings CGP – coguarantee program CMDP – Capital Market Development Program CP – commercial paper CSP – Country Strategy and Program DFI – development finance institution EOBI – Employee's Old-Age Benefits Institution FMG – Financial (Nonbank) Markets and Governance GDP – gross domestic product IA – implementing agency IAS – International Accounting Standards ICP – Investment Corporation of Pakistan IDBP – Industrial Development Bank of Pakistan IMF – International Monetary Fund KSE – Karachi Stock Exchange LIBOR – London interbank offer rate MOF – Ministry of Finance MRPA – master risk participation agreement NBFI – nonbank financial institution NIT – National Investment Trust NPL – Nonperforming loan NSS – National Savings Scheme PFI – participatory financial intermediary PIB – Pakistan investment bond PRCL – Pakistan Reinsurance Company Limited PRG – political risk guarantee PRGF – Poverty Reduction Growth Facility PRI – political risk insurance SBP – State Bank of Pakistan SECP – Securities and Exchange Commission of Pakistan SLIC – State Life Insurance Corporation TA – technical assistance TB – treasury bill TFC – term finance certificate US – United States WTO – World Trade Organization

NOTES (i) The fiscal year (FY) of the Government ends on 30 June. FY before a calendar year

denotes the year in which the fiscal year ends, e.g., FY2002 began on 1 July 2001 and ended on 30 June 2002.

(ii) In this report, “$” refers to US dollars.

This Report was prepared by a team consisting of W. Liepach (Team Leader), V.V. Subramanian, M. Good and M. Endelman.

CONTENTS CONTENTS i PROGRAM, LOAN, GUARANTEE, AND INVESTMENT SUMMARY ii I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1 III. THE SECTOR 3

A. Sector Description and Performance 3 B. Opportunities and Issues 6

IV. THE PROPOSED PROGRAM 10 A. Objectives and Scope 10 B. Policy Framework and Actions 11 C. Important Features 15 D. Financing Plan 15 E. Implementation Arrangements 16

V. TECHNICAL ASSISTANCE LOANS 17 VI. NONLENDING ASSISTANCE 18

A. Political Risk Guarantee Facility for Enhancing Pakistan's Integration with International Capital Markets 18

B. Political Risk Guarantee Facility for Enhancing Access to Cover for Selected Violence-Related Risks 19

VII. PROGRAM BENEFITS, IMPACTS, AND RISKS 19 VIII. ASSURANCES 22

A. Specific Assurances 22 B. Conditions for Loan Effectiveness 22 C. Conditions for PRG Effectiveness 22

IX. RECOMMENDATION 23 APPENDIXES 1. Sector Analysis 25 2. Processing Approach, Background Studies and Chronology 33 3. External Assistance 34 4. Program Framework 36 5. Development Policy Letter and Policy Matrix 39 6. Estimate of Program Adjustment Cost 48 7. Ineligible Items 50 8. Technical Assistance for Strengthening Pension, Insurance, and Savings Systems 51 9. Technical Assistance for Strengthening Regulation, Enforcement, and Governance of Nonbank Financial Markets 56 10. Political Risk Guarantee Facility for Enhancing Pakistan's Integration with International Capital Markets 61 11. Political Risk Guarantee Facility for Enhancing Access to Cover for Selected Violence-Related Risks 66 12. Summary Poverty Reduction and Social Strategy and Poverty Impact Assessment 71 SUPPLEMENTARY APPENDIX (available upon request) A. Poverty Impact Assessment

PROGRAM, LOAN, GUARANTEE, AND INVESTMENT SUMMARY

Borrower

Islamic Republic of Pakistan

The Proposal

Support for the Government’s Financial (Nonbank) Markets and Governance (FMG) Program, comprising (i) a program loan for FMG policy reforms; (ii) two technical assistance (TA) loans: one for strengthening pension, insurance, and savings systems; and one for strengthening regulation, enforcement, and governance of nonbank financial markets; and (iii) two political risk guarantees (PRGs) with counterindemnity by the Islamic Republic of Pakistan: one for enhancing Pakistan’s integration with international capital markets; and one for enhancing access to cover for selected violence-related risks following the terrorist attacks on 11 September 2001 in the United States (US).

The Program Rationale

To finance the expansion of its economic base and generate employment, Pakistan requires a wide range of financial services and instruments beyond what can be provided by the banking sector. Broadening and deepening of the financial system through development of nonbank financial products and services is also required to reduce financial sector vulnerabilities and systemic risks associated with a banking crisis, the impacts of which are often most severe for the poor. Nonbank financial markets, in particular capital markets, are needed for sustainable mobilization of long-term savings and investment. This is closely linked to the development of life insurance and pension systems, which fulfill an important social role in old-age protection, as well as general insurance to protect against a variety of risks that can undermine economic development. Institutional investors also play an important role in improving corporate governance and information disclosure. The Asian Crisis, in particular, has highlighted the importance of good corporate governance and sound financial risk management for sustainable economic growth. Pakistan has since the mid–1990s embarked on comprehensive financial sector reforms. The Capital Markets Development Program, implemented successfully over 1997–2001 with Asian Development Bank (ADB) support, established a necessary foundation for the sustainable development of nonbank financial markets. Yet, despite good progress in particular on the regulatory and infrastructure side, Pakistan’s nonbank financial markets remain narrow and lack depth, as investors have so far not realized their full market potential. Further initiatives and reforms are required in particular to strengthen investor confidence in the integrity and robustness of markets, and bring about a lasting economic impact.

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Objectives and Scope

The overall goal of the Program is to facilitate private sector-led productivity growth as well as social protection. It thus aims to contribute to poverty reduction indirectly. The purpose of the Program is to support the Government’s financial sector reform agenda, and development of capital markets and other nonbank financial services. The immediate objectives of the Program are to (i) strengthen investor confidence through improved governance, transparency, and investor protection; (ii) increase the depth and diversity of financial intermediation through new capital market issues for saving and investment; (iii) improve operational efficiency and risk management of intermediaries; and (iv) reduce financial sector vulnerabilities. The reform agenda is structured around five components: (i) improvement in the fiscal, interest rate, and investment policy environment; (ii) improvement in governance of market participants and transparency in information disclosure; (iii) increase in supply of financial instruments and improvements in market infrastructure; (iv) increase in demand for financial instruments through development of contractual savings and institutional investment; and (v) development of related financial services and institutions. The Program's reform agenda is supported by two TA loans: one for strengthening of pension, insurance, and savings systems; and one for strengthening regulation, enforcement, and governance of nonbank financial markets. The Program is complemented further through non-lending initiatives including ADB’s guarantee products to enhance integration of Pakistan’s financial markets with international capital flows; and to ensure continued access to cover for selected noncommercial risks, which was withdrawn by the international insurance industry following the terrorist events in the US on 11 September 2001.

Poverty Classification Thematic Classification Environmental Classification

Other Good Governance; Private Sector Development Category C

The Program Loan

Amount and Terms

A loan of $260 million from ADB’s ordinary capital resources will be provided under ADB’s London interbank offered rate (LIBOR)-based lending facility. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB’s LIBOR-based lending facility; a front-end fee of 1.0%, a commitment charge of 0.75% per annum; conversion options that may

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be exercised in accordance with the terms and conditions set forth in the Loan Agreement, the Loan Regulations, and ADB’s Conversion Guidelines; and other terms and conditions set forth in the Loan Agreement.

Program Period and Tranching

The FMG Program period extends to December 2005. The Government will be able to withdraw funds from the loan account for a period of about 3 years starting from loan effectiveness up to 31 December 2005. The loan will be disbursed in tranches based on performance in meeting specified tranche release conditions. The first tranche, equivalent to $100 million, will be made available upon loan effectiveness following up-front compliance with specified conditions. The second tranche will be released upon satisfactory compliance with 18 specified conditions, as well as continued compliance with all previous tranche conditions. To provide an incentive for early compliance, an incentive release of $80 million under the second tranche can be made as soon as any nine of the second tranche release conditions have been met, expected by November 2003. The final release of the second tranche of $80 million will take place upon satisfactory compliance with the remaining conditions, expected by November 2004.

Executing Agency

The Ministry of Finance (MOF) will be the Executing Agency. It will monitor and facilitate overall implementation of the FMG Program and administer the utilization of loan proceeds. MOF will also ensure compliance with all policy-related conditions. The Securities and Exchange Commission of Pakistan (SECP) will be the implementing agency, with full responsibility for implementation of all conditions within its regulatory and development mandate. MOF and SECP will ensure effective coordination through existing mechanisms with other concerned agencies, including the Ministry of Commerce, Ministry of Labor, Privatization Commission, State Bank of Pakistan, and the private sector as appropriate.

Procurement The loan will finance the full foreign exchange costs (excluding local duties and taxes) of imports procured in and from the ADB’s member countries, other than those specified in the list of ineligible items and those items financed by other multilateral and bilateral official sources. The Borrower will certify that the value of eligible imports exceeds the amount of ADB’s projected disbursements under the program loan in a given period. ADB will have the right to audit the use of loan proceeds and to verify the accuracy of the Borrower’s certification.

Counterpart Funds

The counterpart funds, to be generated out of the loan proceeds, will be used to finance the cost of structural adjustment, including the establishment of funds and facilities under the FMG Program, and to finance high priority social and human development projects, including social protection for the poor.

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Technical Assistance Loans

Strengthening Pension, Insurance, and Saving Systems

Strengthening Regulation, Enforcement, and Governance of Nonbank Financial Markets

Two TA loans, for a total of $6 million equivalent, will be provided for capacity building associated with the FMG Program from ADB’s Special Funds resources. The loans will have a term of 32 years, including a grace period of 8 years; an interest rate of 1.0% per annum during the grace period and 1.5% per annum thereafter; and such other terms and conditions as are substantially in accordance with those set forth in the TA Loan Agreements. This TA will develop solutions to improve Pakistan’s pension system and strengthen the capacity of key government institutions in the mobilization and management of contractual savings. The TA will comprise five components, including (i) establishment of an overall framework for pension provision; (ii) financial assessment of civil and military pension schemes; (iii) institutional reform and strengthening of the Employee’s Old-age Benefits Institution; (iv) capacity building for investment management in the State Life Insurance Corporation; and (v) institutional reform and strengthening of the Central Directorate of National Savings. The total cost of the TA is estimated to be $4.5 million equivalent, comprising $2.4 million in foreign exchange costs and $2.1 million equivalent in local currency costs. ADB will finance $3 million equivalent comprising the full foreign exchange costs and $0.6 million equivalent in local currency costs. This TA will ensure sustainable development of nonbank financial markets and protection of investors and policy holders. It will comprise four components: (i) further improvement of legal and regulatory frameworks; (ii) capacity building of SECP with particular attention to its enlarged mandate for regulation and supervision of nonbank financial institutions, insurance, and pensions; (iii) support for restructuring of stock exchanges; and (iv) establishment of sustainable mechanisms for skills development and training. The total cost of the TA is estimated to be $4.4 million equivalent, comprising foreign exchange costs of $2.4 million and local currency costs of $2.0 million equivalent. ADB will finance $3 million equivalent comprising the entire foreign exchange costs and $0.6 million equivalent in local currency costs.

Political Risk Guarantee Facilities

Two revolving facilities will be established that provide PRGs to enhance Pakistan’s access to international capital flows and promote soundness of investment and financial markets, for a total guarantee volume of up to $200 million equivalent. The PRG facilities will be promoted in conjunction with the other FMG Program initiatives. All PRGs issued under the facilities will be counterguaranteed and indemnified by the Islamic Republic of Pakistan. The PRGs may be administered on behalf of ADB through facility agents selected according to normal commercial procedures. The facilities will be available for a period of 4 years from their effective date, during which new PRGs may be issued to replace those that are canceled or have expired. Each PRG issued under the facility may have a maximum term of up to 10 years.

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Enhancing Pakistan’s Integration with International Capital Markets

Enhancing Access to Cover for Selected Violence-related Risks

ADB will charge a one-time front-end fee of up to 1% percent for each PRG issued, in line with ADB’s guarantee policies and payable on the nominal amount of each guarantee issued. ADB will also charge a PRG fee of 0.4% per annum on the aggregate value of all liabilities outstanding under each PRG, calculated on a daily basis and collected periodically. Each beneficiary of a PRG will pay a market-based fee, as a percentage per annum of the guaranteed amount, which will be determined prior to the PRGs becoming available and which may be changed from time to time. Any surplus generated by the facilities, after deduction of all expenses for establishment and operation, will be capitalized to build up a claims reserve or otherwise utilized as agreed upon between ADB and the Government. To enhance integration of Pakistan’s financial markets with international capital flows, ADB will guarantee to international investors payment of proceeds from eligible investments if that payment is not made as a result of a guaranteed risk, including restriction on foreign exchange convertibility and transferability blockage. The PRG facility will, however, not cover any risks that affect the value of the investment itself. The maximum aggregate liability under the PRG facility covered by ADB at any time will not exceed $25 million equivalent. The PRG facility may be enhanced through private sector political risk insurance providers under ADB’s coguarantee program. To ensure availability of insurance cover for selected violence-related risks that is not readily available in the commercial market following the terrorist attacks in the US on 11 September 2001, and thus to protect economic and financial sector soundness, ADB will guarantee payment of a certain amount to a guaranteed party in case terrorism or other political violence risk as specified under the PRG policy occurs. The maximum aggregate liability under the PRG facility covered by ADB at any time will not exceed $175 million equivalent, but the PRG facility may be enhanced through coguarantee and commercial reinsurance arrangements.

Program Benefits and Beneficiaries

The overall outcome of the Program will be a vibrant, diversified, efficient, and sustainable financial market offering a wide range of nonbank products and instruments for saving and investment in a well-regulated sector environment. This will contribute to productivity growth, employment generation, and strengthening of social safety nets, as well as fiscal and financial sector stability. Specifically, the following benefits will accrue: (i) improved resource mobilization and access to financing of economic expansion from domestic and foreign sources; (ii) wider choice of funding and saving instruments accessible to the corporate sector and general public, at more competitive pricing that does not penalize for inefficiencies in the banking sector; (iii) greater flexibility and improved risk management for institutional investors; (iv) increased investment skills and better advisory service to benefit the general public; (v) increased

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transparency, information disclosure, and investor protection; (vi) diversification and deepening of the financial sector with less reliance on the banking sector, reducing vulnerability to financial sector crisis, which often has its most severe impact on the poor; (vii) enhanced social protection through a wider range of insurance and old-age protection products, with greater client orientation and outreach including to the poor on a sustainable basis; and (viii) improved public finances through increased tax revenue in the medium to long term as a result of increased saving and investment, as well as a defined mechanism to deal with selected violence-related risks that can no longer be covered commercially.

Risks and Safeguards

Implementation of the FMG Program is facing a number of key risks, for which mitigating measures have been put in place as appropriate. � High short-term adjustment costs, causing fiscal disruption. Adjustment cost has been reflected in the revenue targets agreed upon with the International Monetary Fund under the Poverty Reduction and Growth Facility, conservative collection targets for tax revenue from financial instruments have been applied, and incentives for tax benefits have been capped. � Change of government policies and reversal of reform process. Implementation of the reform agenda will to a large extent rely on the private sector, which strongly supports and has been involved in formulation of the Program. Wide stakeholder consultation during processing sought to ensure awareness and broad-based ownership for the reforms. In September 2002, the State Bank of Pakistan was made a constitutional body with independence for monetary policies shielded from government interference. � Political interference into regulatory matters. The regulator has been given a transparent governance framework with strong legal protection from direct government interference. � Insufficient capacity and integrity of the regulator. TA support will be provided under the Program to further upgrade skills; financial autonomy will allow the regulator to attract and retain competent staff. � Slow progress in reforming key institutions, including Employees Old-Age Benefits Institution and State Life Insurance Corporation. TA support for institutional development will be provided under the Program; continued dialogue with ADB will support proreform forces. � Inadequate implementation of governance and risk management standards due to vested interests. The private sector and a wide range of stakeholders will be involved in program implementation to lessen dependence on a single lobbying group; the establishment of a private sector-driven corporate governance center will raise governance standards and awareness. � Macroeconomic outlook worsening due to external global or regional developments. As elsewhere, this will affect the performance of Pakistan's financial markets, but reform measures under the Program will increase financial sector resilience and lessen the impact of external shocks.

I. THE PROPOSAL 1. I submit for your approval the following Report and Recommendation to support the Financial (Nonbank) Markets and Governance (FMG) Program in the Islamic Republic of Pakistan. Asian Development Bank (ADB) support will comprise (i) a program loan for FMG policy reforms; (ii) two technical assistance (TA) loans: one for strengthening of pension, insurance, and savings systems; and one for strengthening regulation, enforcement, and governance of nonbank financial markets; and (iii) two political risk guarantee (PRG) facilities with counterindemnity by the Islamic Republic of Pakistan: one to enhance Pakistan’s integration with international capital markets, and one to enhance access to cover for selected violence-related risks following the terrorist attacks on 11 September 2001 in the United States (US).

II. THE MACROECONOMIC CONTEXT 2. Challenging Internal and External Environment. After a difficult period for Pakistan’s economy and frequent change in Government during much of the 1990s, the comprehensive structural reforms initiated and accelerated in particular over the past 2 years at various levels have now started to pay-off, and the macroeconomic situation has gradually stabilized.1 The events following the terrorist attacks in the US on 11 September 2001 have created a further challenge for Pakistan with far-reaching economic, social, and political implications. On the economic front, this has included a fall in industrial production, cancellation of export orders, declining international demand and prices, and reduced availability and rising cost of insurance. 3. Macroeconomic Stability Maintained. The Government has responded skillfully to the considerable challenges it has been facing, and macro indicators reflect this: growth for fiscal year (FY) 2002 was 3.6%, only slightly below the 3.7% originally targeted, and inflation continued to be under control at below 3%. The budget deficit was 7.1% of gross domestic product (GDP), higher than originally projected.2 Exports reached $9.1 billion, which is well short of the goal of $10.1 billion, but a larger fall in imports helped contain the trade deficit for FY2002 at about $1.2 billion and within target. Fuelled by increased remittances from abroad, an unexpectedly large current account surplus of about $2.7 billion could be achieved. Following the successful rescheduling of its bilateral debt obligations and increased inflow of remittances and external aid, gross foreign exchange reserves increased to more than $8 billion by October 2002, the highest amount ever, and the Pakistan rupee has stabilized and even strengthened. Within the current framework, the growth target of 5.2% for FY2003 looks achievable. Recognizing these positive developments, international credit agencies have upgraded their financial risk ratings for Pakistan.3 However, amid continued regional tensions and uncertainties the macroeconomic stabilization has so far failed to attract much investment. Foreign direct investment has remained low, at less than $500 million, and has been directed primarily towards the energy sector. Likewise, international portfolio investment, which has been negative since mid-1998 and declined to less than 3% of market capitalization, has yet to return in an economically significant way. 1 ADB. 2001. Country Economic Review: Pakistan. Manila. State Bank of Pakistan (SBP). 2002. Annual Report. Available: http:// www.sbp.org.pk. 2 The original target was set at 4.9%, but was subsequently revised to 5.3% and then to 5.7%. The larger deficit was

primarily due to a shortfall in customs revenue, one time write-offs, and generally lower economic activity following the events of 11 September 2001. This was only partly offset through spending cuts, including development expenditure. Adjusting for one-time expenditures, the deficit is 5.7%, in line with revised targets.

3 Moody’s Investor Service has raised the rating for Pakistan’s external debt and bank deposits to B3 and CAA1, respectively. Standard & Poor’s has affirmed its rating for foreign currency debt at “B-“ and local debt at “B+”, with “stable” outlook. For further details see http://www.moodys.com and www.ratings.com.

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4. Weak Credit Expansion Despite Easing of Monetary Policy. Strong capital inflows, appreciation of the rupee and low inflation have provided room for easing of monetary policy. The State Bank of Pakistan (SBP) gradually reduced its discount rate from 14% in July 2001 to 9% in early 2002, while treasury bill rates declined sharply and are now hovering around 6-7%, compared with about 13% at the beginning of FY2002. Yet, the banking sector has not been willing or able to fully translate this steep cut in interest rates into lower lending rates, which reflects both inefficiency and lack of competition in the financial sector.4 At the same time, demand for credit has fallen due to lower cotton prices; a fall in working capital requirements, in particular of textile manufacturers; and low investment levels following the uncertainties after 11 September 2001. There has been some sign of a rebound in 2002. Further reduction of interest rates may be problematic, though, as this could trigger downward pressure on the Pakistan rupee. This would also cut into the commercial banks' interest earnings and thus inhibit their ability to build up capital for dealing with their bad loan portfolio, as well as reduce tax revenue for the Government.5 5. Firm Commitment to Reforms. The Government has demonstrated strong commitment for reform to its development partners, including the international finance institutions. For the first time after several attempts, Pakistan was in 2001 able to successfully complete implementation of an agreement with the International Monetary Fund (IMF). IMF subsequently approved, in December 2001, a 3-year Poverty Reduction and Growth Facility (PRGF), for SDR1.03 billion. This provides a framework for further reforms and macroeconomic stabilization, and implementation of the PRGF to date is generally on track.6 6. Poverty Reduction Remains the Key Challenge. Poverty levels in Pakistan have increased since the early 1990s and are strongly correlated with the slowdown in economic growth. At the same time, inequality in income distribution worsened significantly, in particular in urban areas. A large share of employment is in the informal sector, without adequate social protection, and the continued high population growth has put pressure on the labor market that it has been unable to absorb.7 This has given rise to social tensions with far-reaching implications, and is believed to have also fuelled extremist groups. To counter these trends, the Government’s economic policies seek to uplift livelihood and create opportunities for the poor through support for employment-generating activities, more effective social sector spending, and greater participation in decision making at the local level. Pro-poor outlays during FY2002, much of which took place at the provincial and local level, fell short of expectations, however, amid a shortfall in revenues and as local governments became operative only in late 2001. Appropriate measures are required to ensure that macroeconomic stabilization and adjustment programs yield visible benefits for the poor, and to mitigate disproportionate negative impacts that were often associated with reform programs in the past decade. 7. Continued Support Warranted. Despite the considerable external and internal challenges. Pakistan has been able to credibly keep its reform program on track. However, tangible benefits have yet to emerge for a large share of the population. For private sector investors, Pakistan remains a place with both high risks and great opportunities. Therefore, it is

4 Average combined lending rates for all banks fell from 14.4% in July 2001 to only about 12% in February 2002,

albeit with considerable variation among the banks. Foreign banks tend to be more competitive in their rates than the nationalized commercial banks. Average deposit rates declined only marginally, from about 5% to 4.6%.

5 For a more detailed overview of Pakistan's monetary and fiscal policy, see http://www.sbp.org.pk/monetary.htm. 6 Details of the PRGF as well as progress in implementation can be accessed through the IMF website:

http://www.imf.org. 7 For further details on Pakistan labor market and challenges, see International Labor Organization. 2000. Pakistan

Country Employment Policy Review. ILO.

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timely for ADB to further support the reform agenda and address investor concerns to stimulate investment and savings, while ensuring that benefits trickle down to the poor.

III. THE SECTOR 8. ADB’s country strategy program (CSP) for 2002-20048 as well as the Government’s development agenda, articulated in a number of documents,9 give high priority to poverty reduction through private sector-led pro-poor economic growth, social sector development, and improved governance. Within this overall framework, the financial sector has an important role to play to increase resource mobilization, improve efficiency of allocation, enhance access to financial products and services, contribute to the sustainability of social safety nets, and safeguard economic stability. A. Sector Description and Performance 9. Shallow and Narrow. Pakistan’s financial sector is not very large and diversified. Deposits amount to only about 56% of GDP.10 The money (M2) to GDP ratio – which is an indicator for financial sector deepening – at only about 44% suggests that a major portion of the economy is still not monetized.11 10. Heavy Government Involvement. Despite a number of reforms initiated by the Government in the past which have sought to reduce its operational involvement in the financial sector, the Government still plays a predominant role, and much financial intermediation is driven by its financing needs. In 2000, about 65% of deposits were mobilized through government-owned or -controlled institutions, and 51% of credit was allocated to the Government, with an additional 4% to state-owned enterprises, leaving barely 45% for the private sector.12 The government-run National Savings Scheme (NSS), in particular, continues to plays a significant role in mobilizing savings from the general public and channeling those directly to the Ministry of Finance (MOF) to meet Government expenditures rather than financing productive assets. Savings mobilization and credit delivery, in particular in rural areas, are still dominated by government-owned institutions. In addition, the country's largest institutional investors, including the State Life Insurance Corporation (SLIC) and the Employees Old-Age Benefits Institution (EOBI), remain government controlled, which raises governance concerns, as most of the funds they are entrusted with belong to private individuals. 11. Prevalent but Inefficient Banking System. Financial intermediation is dominated by the banking system, which accounts for 61% of deposits. About 34% of deposits are with the NSS, and only 5% are mobilized through nonbank financial institutions (NBFIs).13 Nonperforming 8 ADB. 2002. Country Strategy and Program 2002-2004: Pakistan. Manila. 9 Economic Revival Plan (December 1999); Three Year Development Plan 2000-2003; Ten Year Perspective

Development Plan 2001/11; Interim Poverty Reduction Strategy Paper (2000); Poverty Partnership Agreement with ADB (2002); Budget Documents for FY2001, FY2002 and FY2003.

10 This compares to 150% in India, 125% in Malaysia, 53% in the Philippines, and around 50% the US. It should be noted that non-bank financial markets, in particular capital markets, account for a much larger share of savings in all of those countries compared to Pakistan.

11 In Pakistan, M2 comprises currency in circulation and deposits with scheduled banks and SBP. The M2/GDP ratio compares to 58% in India, 64% in the Philippines, and 106% in Malaysia.

12 Allocation to the private sector hovered between 45% and 55% for most of the past decade, and the fall at the end of the 1990s reflects above all a fall in demand due to the generally subdued investment climate.

13 NBFIs are defined in the context of this program as all financial institutions and intermediaries that do not fall under the SBP banking regulations, including insurance, pension funds, development finance institutions, leasing companies, investment banks, and other related services, but excluding microfinance.

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loans (NPLs) average around 24% for all banks, and more than 50% for specialized financial institutions, including development finance institutions (DFIs). Coupled with administrative inefficiencies, this has driven up intermediation costs and the spread between average deposit and lending rates is as high as 8%. The situation is generally better for foreign banks, which tend to be more selective in credit extension. The generally poor access, limited choice, and low quality of financial services and products contribute to explaining the low savings rate that has stagnated at around 13% of GDP. 12. High Fragmentation and Limited Role of NBFIs. Within the financial sector, nonbank products, markets, and services remain relatively little developed and poorly capitalized. This is despite the fact that there is a large number of NBFIs, including 16 investment banks, 16 DFIs and specialized finance institution, 33 leasing companies, 45 modarabas,14 41 investment companies and mutual funds, 420 brokers, 3 discount houses, and 58 insurance companies. Many of the NBFIs posses a very weak institutional base both in terms of assets as well as human resources to respond in an effective manner to the challenges of the economy. In many cases, their establishment was predicated on short-term returns and regulatory arbitrage rather than long-term economic interest. The proliferation has created more problems than it has resolved, in particular by creating supervisory problems and undermining confidence in the sector. To build up genuine competition, confidence, and transparency in the sector, the Government seeks to promote consolidation through mergers or closures by raising the capital requirements for various financial intermediaries. 13. Mixed Performance of Equity Markets. Pakistan’s equity market, which is dominated by the Karachi Stock Exchange (KSE) but also includes exchanges in Lahore and Islamabad, has seen some impressive growth over the past decade: The number of listed companies at the KSE increased to 741 at the end of FY2002 from 628 in 1992, market capitalization increased to more than PRs400 billion from PRs218 billion, and annual trading rose to 68 billion shares, from 1 billion in 1992. Much of this development – except for the increase in trading volume – took place during the first half of the 1990s, and not all of this is good news. Most importantly, the economic impact of the equity market, despite the developments, has been negligible. Market capitalization is still only around 11% of GDP.15 Many companies sought listing primarily for tax advantages without subsequent trading taking place and little interest in investor relations or dividend payouts. Both the issuer and investor base is very narrow, with trading being heavily concentrated on a few scrips only. Trading volume relative to market capitalization is among the highest in the world, reflecting a very strong speculative and short-term interest in a narrow market that makes it highly volatile. The KSE share index has hovered between 1000 and 2000 points for most of the past decade without exhibiting a marked trend. Factoring in the devaluation of the Pakistan rupee and economic uncertainties, as well as the high guaranteed returns offered by the NSS, investing in the stock market has not been a very attractive proposition. All this has deterred long-term and foreign investors, and valuations of some economically sound companies are often very low. This environment is not very attractive for companies with serious economic ambitions to raise capital from the equities market, and there have been only 13 new listings on all three exchanges over the past 5 years. To counter the trend, the Securities and Exchange Commission of Pakistan (SECP) has, since its inception in 1999, and within the framework of the Government’s first Capital Market Development Program (CMDP), taken credible steps to restore investor confidence. In particular, SECP has been improving risk management and is vigorously enforcing compliance with rules and regulations,

14 Modarabas are finance companies that operate according to Islamic principles of finance, not involving interest. 15 This compares with 41% in India, 35% in the Philippines, 154% in Malaysia, and 270% in the US.

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including delisting of defaulting companies. These measures will need to be enhanced further but constitute an important basis for more sustainable market development. 14. Growing Debt Market but Narrow Range of Instruments. Pakistan’s emerging debt market has gained considerable momentum over the past few years. The corporate bond market consists primarily of Term Finance Certificates (TFCs) with 3-5 years maturity. The number of new issues has risen constantly from the first listed issue in 1995. By the end of FY2002, 39 TFCs had been issued for a total volume of more than PRs22 billion, of which the largest share was issued by the leasing industry. The steep rise in particular over the past 2 years was helped through the reforms promoted under the CMDP, including improved tax treatment; streamlined issuance process; ban on institutional investments in NSS; and introduction by the Government of long-term Pakistan Investment Bonds (PIBs) in December 2000 with maturities of 3, 5, and 10 years, which established a much-needed benchmark for pricing. In FY2002, the Government carried out six PIB auctions and raised PRs46 billion. Most of the investors in PIBs are banks, which raises some regulatory and market concerns. The increase in primary issues has yet to translate into an active secondary market for both PIBs and TFCs, for which trading activity is limited. In addition, the range of instruments is still narrow, in particular for companies. Tenors for TFCs are generally not available beyond 5 years, and there is also no short-term corporate paper in the absence of proper guidelines and tax treatment for such. 15. Weak Institutional Investor Base. Institutional investment is key to the development of money and capital markets. In Pakistan it is poorly developed and has not been growing recently. Life insurance premium income amounts to less than 0.3% of GDP, much lower than in the Philippines (0.8%), India (1.8%), Malaysia (2.1%), or the US (4.5%), and has shown little growth over the few past years, unlike in most other emerging Asian economies. Private pension and provident funds lack a proper regulatory framework and are offered by only a few large companies. The largest institutional investors, SLIC and EOBI, with assets in excess of $1.2 billion and $700 million, respectively, are government controlled; and the largest share of their investments is in government debt. The investment process of these institutions is not very transparent. Coupled with high administrative costs, this has resulted in very poor returns. The mutual funds industry was unable to offer attractive alternatives and to reach out to the retail market in a significant way. There are fewer than 100,000 investors in mutual funds in Pakistan, with total assets of about PRs26 billion under management, mostly with the National Investment Trust (NIT). This represents less than 3% of bank deposits, and compares with about 23 million investors in India with assets amounting to 12% of deposits. Under the CMDP, some progress has been made with privatization of the management of the country's two largest mutual funds, NIT and Investment Corporation of Pakistan. Yet, lacking a wider range of instruments and market depth for portfolio diversification and management, the industry has generally focused on equity funds and has consequently been hampered by the inherent problems of the market. International investors showed some interest in Pakistan’s capital markets during the first half of the 1990s, and foreign portfolio investment peaked at about $1.3 billion in 1997. However, it has since virtually all but disappeared, despite generally favorable market valuations, amid continued economic uncertainties, concerns about market governance, and lack of risk management and hedging tools. The temporary imposition of foreign exchange controls after the nuclear testing in May 1998 has also badly shaken investor confidence. 16. Comprehensive Reforms Initiated. Pakistan has since the mid-1990s embarked on comprehensive financial sector reforms. Key reforms include liberalization of the foreign exchange market and interest rates; increased autonomy of the central bank and its focus on monetary policy and banking supervision; establishment of an independent regulator for capital markets and NBFIs; upgrading of legal and regulatory frameworks; reduction of NPLs in the

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banking sector; and restructuring of government-owned financial institutions including privatization, merger, closure, and enhanced management autonomy. Yet, the reform agenda is far from complete, and reforms are ongoing at various levels to further reduce the Government’s involvement in financial sector operations and enhance private sector participation on market-based principles. 17. CMDP Implemented Generally Successfully. A first phase of reforms for capital market development was implemented generally successfully over 1997-2001 under the CMDP, supported by ADB.16 The reforms were carried out under a difficult macroeconomic environment and subdued investor and issuer interest. The main achievement under the CMDP has been the establishment of an effective regulator as well as improvements in the technological market infrastructure. Progress was also made in improving investor protection, governance of the stock exchanges, and development of the primary corporate debt market, as well improving prudential norms for NBFIs. The ambitious reforms have addressed some of the most fundamental problems and established a good basis for further market development. Yet, important areas within Pakistan’s financial sector must be addressed further to bring about the full impact of these reforms. In many ways, the achievements under the CMDP have been necessary but not sufficient. A project completion report detailing the accomplishments under the first CMDP was released in November 2002.17 B. Opportunities and Issues 18. Potential for Growth and Development. Given the underdeveloped state of Pakistan’s nonbank financial markets relative to the size of its economy as well as other emerging markets, and the inefficiencies and structural problems within the banking system to finance the much-needed capacity expansion of the economy, there is good reason and scope for growth. Capital markets, in particular, can play an important role for sustainable investment and mobilization of long-term savings. This is closely linked to the development of contractual savings through life insurance and pension funds, which fulfill an important social role in old-age protection. Direct financial intermediation through markets can improve funding and investment management of companies, and thus their productivity, while offering better return for savers. Broadening of the financial system can further reduce financial sector vulnerabilities and systemic risks associated with a banking crisis, the impacts of which are often most severe for the poor. Further reduction in government involvement in the sector would also stimulate allocation of resources according to market-based principles. 19. Improving Investor Confidence is Key. While a good foundation has been built through the CMDP, functioning of financial markets cannot be mandated by the Government or any other party. Their efficiency and effectiveness depends on building credibility with private sector investors and issuers, which needs to be sustained over time in a dynamic environment. Within this context, strengthening investor confidence through policy consistency, a strong and credible regulator, and effective dialogue among various stakeholders is of paramount importance. This needs to be underpinned by a set of consistent actions to strengthen governance, institutions, risk management, and operations.

16 ADB. 1997. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to

Pakistan for the Capital Market Development Program (CMDP). Manila. ADB. 1997. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to

Pakistan for the Capacity Enhancement of the Securities Market. Manila. 17 ADB. 2002. Project Completion Report on the Capital Market Development Program Loan and Capacity Building of

the Securities Market. Manila.

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20. Increase Corporate Governance and Transparency. The development and sustainability of financial markets will depend highly on the framework of corporate governance adopted and the degree of adherence to the framework in practice. As the market develops, it will in turn play an integral role in promoting principles of good governance by enforcing financial discipline on companies that practice poor corporate governance. Poor governance, wide information asymmetry, and lack of confidence in the integrity of transactions and internal control mechanisms are the biggest investor concerns in Pakistan. Thus, governance frameworks need to be improved and vigorously adhered to at various levels. This concerns corporate issuers who raise funds from the market; intermediaries and related service providers including stock exchanges, brokers, and institutional investors; information providers and advisors, including accounting and auditing firms as well as rating agencies; and the regulator. Key ingredients are adequate information disclosure and the right of key stakeholders to influence behavior or change management according to a set of rules. 21. Building a Level Playing Field by Removing Policy Distortions. Key distortions on the policy level remain, primarily with regard to tax and interest rates. There has been differential tax treatment among financial instruments, which has worked to the advantage of some instruments and investors while discriminating against others.18 Moreover, tax rates and assessment modalities have been changed frequently in the past. This has created confusion among investors and unintended distortions, in addition to an administrative burden in tax assessment and collection. Streamlining tax treatment can stimulate financial market activity. This would also generate higher tax returns over the medium to long term to offset any short-term adjustment cost. In addition, interest rates remain administered in an ad-hoc manner for the NSS, and their high level in real terms holds back the development of alternative instruments. Good progress in reforming the NSS was made under the CMDP by excluding institutional investments, and lowering their rates of return. However, to tap into the important retail market for capital market development, NSS rates should be adjusted following a systematic market-based mechanism to levels that are below a comparable benchmark for wholesale securities. 22. Streamline Policy Making, Regulation and Supervision. The integration of financial markets witnessed globally has only been partly matched with institutional responses in Pakistan. Policy making remains fragmented, involving diverse ministries, in particular with regards to contractual savings and institutional investments,19 which are poorly developed and government dominated. In such an environment, policy consistency is less likely to be achieved, and coordination administratively more cumbersome. Similarly, there has been some degree of overlap between SBP and SECP on the regulation of nonbank financial products and services, such as leasing or investment banking. Further clarification and a strong mandate to key institutions in line with international best practices are needed to provide a clear perspective to investors. 18 For example, until FY2003 tax rates on dividend income by insurance companies were depending on ownership

structure and were different than for other corporate institutions; tax rates for some instruments differed for households or institutions, such as withholding tax for bank deposits, which was treated as a final liability for households, but was adjustable against final settlement for institutions; dividends were subject to double taxation if the investment was made through a mutual fund or other contractual savings instruments rather than directly; and tax rates differed for instruments with similar characteristics, e.g. withholding tax was higher on T-bills than for NSS or TFCs and PIBs. Many of the inconsistencies have been removed through the Finance Ordinance, 2002.

19 Life insurance and pension systems are under the Ministry of Commerce and Ministry of Labor, respectively.

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23. Tap into Retail Markets through Contractual Savings. Strong intermediaries are required to make capital markets accessible to the general public on a retail level. While the range of investment instruments has been limited, the dominance of a few government-controlled institutions, in particular SLIC and NIT, and preferential treatment given to them, has further inhibited competition and innovation. The development of pension funds has been largely neglected, or has received bad press through inefficient operation in a poorly regulated environment. In addition, tax treatment has not been supportive; and mutual funds have, in the absence of liquid debt markets, focused on volatile equity funds. Most retail markets elsewhere have developed through introduction first of low-risk money market funds that can favorably compete with bank deposits, and later expansion through debt funds into equity. There is a huge potential in Pakistan to tap into this segment, which would allow fund managers to develop a critical mass needed to invest in staff and research. Equally important for the development of retail products is a strong and credible regulator to protect the public, as well as adequate skills of fund managers. The availability of the latter could particularly benefit from the introduction of foreign partners in the market. The mobilization of funds from the retail level, in turn, will provide much needed liquidity for the development of new instruments. Development of the retail market through institutional investment is thus crucial for the development of Pakistan's financial markets. Further consideration should also be given to converting the NSS into a funded scheme and to lower its administrative costs while increasing its operational efficiency. Reduction of administrative overheads, and professionalism of investment management are also required for the other large government-controlled intermediaries; and private sector participation, subject to strict accountability, may increase efficiencies. 24. Develop Wider Range of Instruments and Deepen Markets. Institutional investors need a wide range of instruments with sufficient depth and secondary market activity to effectively manage their investment portfolios. The introduction of short-term commercial paper in particular could yield significant benefits, as corporates could fund their working capital requirements and improve treasury management without being penalized for the inefficiencies of the banking sector. It would also allow them to free up collateral to finance longer term capacity expansion, while offering better short-term returns than currently available. Furthermore, there is a need to deepen markets through increase in debt and equity issues as well as secondary trading in more securities, to allow institutional investors to effectively manage and diversify their investment portfolios. The equities market, in particular, could both benefit from and provide a credible avenue for privatization of blue-chip state-owned companies, as well as a source for capital expansion by medium-sized enterprises that have not been utilized in the past. This needs to be complemented through a wider range of hedging and credit enhancement tools. The successful introduction of new issues and deepening of the market is closely linked to further reform of NSS rates as well as tax treatment. 25. Upgrade Market Structure and Infrastructure. Few areas are more affected by the rapid advancements in information technology than financial markets. While a good technological base has been established under the CMDP with automation of trading and creation of central securities deposit, clearing, and settlement systems, the development of Internet-based technology in particular has created new opportunities and challenges to increase the access to capital markets by retail investors. Further systems are needed to accommodate new instruments and market segments. This requires institutional responses by the stock exchanges, in particular. There is increasing competition and integration among international exchanges, and Pakistan must respond to those trends to offer an attractive and competitive market-place. Integration of the domestic exchanges into a national market, demutualization of exchanges, as well as introduction of new over-the-counter market segments will be required.

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26. Improve Risk Management and Enforcement. The increasing sophistication of financial markets carries high inherent risks that must be adequately addressed. There is an increasing awareness internationally that concept of self-regulation need to be complemented through strong regulatory regimes and credible enforcement as well as adequate risk management systems and tools. This must also include mechanisms of investor compensation and market stabilization during times of stress on markets. 27. Improve Efficiency of Related Financial Products and Services. An effective and resilient financial sector requires a range of services for risk management and outreach to diverse client needs. A strong insurance sector in particular complements financial markets by mitigating risks that could undermine the economic system. The development and efficiency of the insurance industry are closely linked to the functioning of financial markets, in turn playing a major role in developing financial markets and governance through institutional investment. These aspects have not yet been sufficiently developed in Pakistan, and a large portion of the insurance market remains under direct government control. Likewise, most of the specialized DFIs remain under government control. They have in the past generally failed to efficiently channel long-term funds into productive investments. The Government has embarked on an ambitious program for further consolidation and restructuring of DFIs. This is a costly exercise with significant fiscal implications that requires the assistance of international financing institutions, but further privatization or consolidation will shift incentive structures that are likely to result in greater product innovation and support for market-determined financing mechanisms. There is also considerable scope to increase the efficiency of other NBFIs, in particular to provide longer term finance, including the leasing industry, through mergers and better capitalization. 28. Upgrade Skills. Modern financial systems require adequate skills and capacity to deal with increasingly complex issues at various levels. Pakistan has a good but very small skills base that must be enhanced and broadened considerably, covering both the private and public sector. Externally funded capacity-building measures will be required to address the most urgent needs, but must be complemented by internally generated mechanisms to raise professional standards in a sustainable manner. This should entail the development of standards and curricula at the international level applicable to the Pakistan context, and professional training institutes set up with the private sector to offer options for sustainable skills development. 29. Dealing with External Challenges. Pakistan’s financial sector is facing international as well as religious trends, in particular with respect to its membership in the World Trade Organization (WTO) and the decision of the Supreme Court on Islamization of the economy and financial system. In addition, the events following the terrorist attacks on 11 September 2001 in the US have long-lasting implications for Pakistan’s financial sector. The Government is responding to these challenges in a flexible and pragmatic manner. As a WTO member, Pakistan welcomes participation of qualified international investors and service providers to strengthen its financial sector. There remain only a few restrictions, primarily in the insurance sector. In response to the Supreme Court decision to put in place a financial system based on Islamic principles, the Government is working on a credible proposal that would allow a dual system as practiced, e.g., in Malaysia, with encouragement to financial institutions to develop Islamic financial products. The development of equity and other asset-based markets in particular would be in line with this. The events of 11 September impact primarily the general insurance industry, as terrorism-related cover is no longer available in the market. This, if unaddressed, will put pressure on the financial viability of projects, financing costs of companies, and ultimately financiers. It will also risk the sustainability of public finances, as the

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Government will be exposed to large losses from public sector properties and companies that remain uninsured, including potential liabilities by Pakistan International Airlines. In addition, tighter control and scrutiny of international capital flows can be expected. 30. A more detailed analysis of the key sector issues and opportunities is in Appendix 1.

IV. THE PROPOSED PROGRAM 31. Following successful implementation of the CMDP, the Government sought ADB’s continued support for its financial markets development agenda. Support for financial (nonbank) markets also forms part of the ADB’s financial sector strategy for Pakistan and was included in the CSP for 2002.20 Program formulation was closely coordinated with various stakeholders, including the private sector and other developments partners. An overview of processing steps, approaches, and background studies undertaken is provided in Appendix 2. Summary information on external assistance to the sector is presented in Appendix 3. The program framework is in Appendix 4. The agreements on the FMG Program loan are reflected in the Government’s development policy letter and the attached policy matrix in Appendix 5. A. Objectives and Scope 32. The overall goal of the Program is to facilitate private sector-led productivity growth as well as social protection. It thus aims to contribute to poverty reduction indirectly. This is to be achieved by improving the framework for mobilization of long-term resources for saving and investment through market-based financial instruments and institutions. The Program also aims to increase resilience against financial sector crisis and mitigate its negative implications for the poor. 33. The purpose of the Program is to support the Government’s financial sector reform agenda, and development of capital markets and other nonbank financial services in particular. The immediate objectives of the Program are to (i) strengthen investor confidence through improved governance, transparency, and investor protection; (ii) increase the depth and diversity of financial intermediation through new capital market issues for saving and investment; (iii) improve the operational efficiency and risk management of intermediaries; and (iv) reduce financial sector vulnerabilities. 34. These objectives will be achieved through a mix of reforms on various levels, including policy, governance, institutions, and operations. From a market perspective, the Program will cover equity markets, debt and money markets, contractual savings, and other NBFIs and services, including insurance, leasing, and DFI reform. 35. The policy reform agenda, to be financed through a program loan, is supported by two TA loans: one for strengthening of pension, insurance, and savings systems; and one for strengthening regulation, enforcement, and governance of nonbank financial markets. The Program is complemented further through nonlending initiatives including ADB’s guarantee products to enhance integration of Pakistan’s financial markets with international capital flows; and to ensure continued access to cover for selected noncommercial risks that was withdrawn by the international insurance industry following the terrorist events in the US on 11 September 2001. 20 The Program was originally listed as Capital Markets Development Program II, but the title was subsequently

changed to better reflect the contents of the Program.

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B. Policy Framework and Actions 36. Much of the basic regulatory and technological infrastructure has been put in place for capital market development, and the key challenge now is to get investment going. This requires above all promoting new capital market issues and developing institutional investment, which is closely linked to improvements in corporate governance of both financial intermediaries and corporate issuers. Improvements in corporate governance, in turn, are often brought about by institutional investors. The approach suggested under the Program is to break this nexus through simultaneous reforms that introduce instruments with lower risk to provide a wider choice of liquid investment alternatives to investors, vigorously improve and enforce corporate governance and risk management standards to increase investor confidence, introduce measures that encourage private sector participation in institutional investment, and upgrade skills at various levels. In addition, complementary financial products and services will be promoted for broadening and sustaining the financial sector base. 37. The reform agenda is structured around five components: (i) improvement of the fiscal, interest rate and investment policy environment; (ii) increase in investor confidence through improvement of governance, transparency, and investor protection; (iii) increase in supply of financial instruments and improvements in market infrastructure; (iv) increase in demand for financial instruments through development of contractual savings and institutional investment; and (v) development of related financial services and institutions. 38. In line with ADB’s evaluation findings on policy reform design of past program loans and revised policies on program lending,21 conditions have been formulated with increased focus on outcomes to allow for greater flexibility in actions to achieve compliance. Details on specific actions under the Program are in the policy matrix in Appendix 5.

1. Improvement of Fiscal, Interest Rate, and Investment Policy Environment 39. Reforms under this component will improve the fiscal policy environment to promote and encourage long-term saving and investment in financial markets, as well as further reform the NSS. Specific actions will rationalize tax treatment for financial instruments and investors, and provide selective incentives to stimulate long-term savings and nonspeculative equity investment. Distortions in foreign exchange transfer for reinsurance and of investment criteria for securities to qualify as statutory liquidity requirements are also being removed. In addition, a more systematic mechanism for linking interest rates for the NSS to market-based benchmarks is being introduced. NSS reforms are in particular required to further adjust the yield for short-term holding periods to comparable market rates for retail securities. For the medium term, consideration will be given to further lowering stamp duties and converting the NSS gradually from an unfunded into a funded scheme with investments in government securities and rated corporate debt, and to promote long-term capital formation through selected fiscal incentives. Policy measures under component 1 of the Program are summarized in Table 1.

Table 1: Policy measures to improve fiscal, interest rate, and investment policy environment

1st Tranche Release Action 2nd Tranche Release Action

(1) Rationalize tax treatment for financial instruments and investors.

(1) Further rationalization of tax treatment for financial instruments.

21 ADB. 1999. Review of ADB’s Program Lending Policies. Manila.

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(2) Adjust fiscal measures to promote long-term capital formation

(2) Further adjustment of fiscal measures to promote long-term capital formation.

(3) Adjust NSS rates to a more market-based benchmark mechanism.

(3) Improve the administrative efficiency of NSS.

(4) Rationalize investment eligibility criteria for securities.

(5) Remove distortions in foreign exchange transfer for reinsurance.

2 Increase in Investor Confidence through Improvement in Governance,

Transparency, and Investor Protection 40. Reforms to improve investor confidence seek to raise governance standards, and to improve transparency in information disclosure and enforcement for investor protection. Those reforms will be spearheaded by SECP. Important measures that have already been taken over the past year include the streamlining and clarification of responsibilities for policy formulation and regulation within the government as well as further improvements in the mandate and governance structure of SECP for broad-based regulation of financial markets and services. This should allow SECP to develop into a full-fledged financial services regulator following best practices recently applied elsewhere and taking account of the increasing integration of financial markets and products. A corporate governance code based on wider stakeholder consultation has been introduced and will be vigorously enforced, to cover the corporate sector, financial intermediaries, and related professions. The Companies Ordinance is being updated to provide legal cover for some of the provisions. In addition, laws and regulations for enhanced transparency in financial transactions and corporate affairs will be introduced, including legislation to combat money laundering and regulate corporate insolvencies. Brokers will be required to strictly separate proprietary trading from investor accounts. Standards for information providers and accounting and auditing firms as well as information disclosure will be improved. The stock exchanges will improve their governance structure and risk management systems, and the board of KSE has already been reorganized to allow enhanced representation by nonmember directors. A national exchange for financial instruments is envisaged with a corporate structure, possibly through integration of the existing exchanges or otherwise. Policy measures under component 2 of the Program are summarized in Table 2.

Table 2: Policy measures to increase investor confidence through improvement in governance, transparency, and investor protection


(6) Clarify and strengthen coordination for financial sector policy formulation and regulation.

(4) Improve the legal framework for transparency in financial transactions and corporate affairs.

(7) Enhance mandate and governance structures of SECP.

(5) Enhance SECP capacity for market surveillance, and for regulation and supervision of NBFIs.

(8) Improve corporate governance standards. (6) Enforce the corporate governance code. (9) Improve information disclosure standards and transparency in market transactions.

(7) Improve the quality of information disclosure.

(10) Improve governance of stock exchanges and other capital market intermediaries.

(8) Further reform the structure of stock exchanges.

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(11) Strengthen prudential and risk management standards for nonblank financial intermediaries.

(9) Further improve efficiency in trading and operational risk management practices.

(12) Improve dispute resolution mechanism between brokers and investors.

(10) Develop professional standards, qualifications, and continued education.

3. Increase in Supply of Financial Instruments and Improvements in Market

Infrastructure 41. This component seeks to facilitate new capital market issues and introduce new financial instruments. Reforms will be initiated primarily by SECP together with the stock exchanges, and supported by SBP as far as government bonds and money markets are concerned. A second board and/or new over-the-counter (i.e., quote-driven) market for equities is being created to facilitate equity issues by new or smaller companies with good growth potential. To increase the supply of equities, the government will make use of the stock market to implement its privatization program, in particular for blue chip companies. The use of electronic trading will be facilitated through adequate technology platforms. New risk management instruments are being introduced to facilitate forward cover and hedging. Equity futures have already been introduced, and concept papers for the development of interest rate swaps and new money market instruments are being initiated. Regulations and procedures will be developed to facilitate issuance and trading of commercial paper by rated companies and corporate bodies. Clearing and settlement systems will be upgraded further in particular to facilitate further secondary trading in debt instruments, and a system of market making for corporate debt will be introduced. Policy measures under component 3 of the Program are summarized in Table 3.

Table 3: Policy measures to increase supply of financial instruments and improve market infrastructure


(13) Introduce new markets for smaller and less frequently traded companies.

(11) Improve the supply of equity issues through privatization.

(14) Introduce financial hedging instruments and markets.

(12) Improve secondary debt market activity.

(15) Initiate development of a money market for commercial paper.

(13) Further develop money markets.

(16) Promote the bond market (PIBs and TFCs).

4. Increase in Demand for Financial Instruments through Development of

Contractual Savings and Institutional Investment 42. Improvements in the policy, governance, and supply side (under components 1–3) will provide the basic foundation for further growth of institutional investment. To build on this, institutional changes including increased private sector participation will be introduced in the largest government-owned institutional investors to ensure better alignment between the interests of management and investors and savers. This will include measures to improve asset management and better outreach and provision of services, in particular for pensions and life insurance. A regulatory framework will be introduced to improve minimum standards for pension funds. Mutual funds for the money and debt markets will be encouraged to tap into retail investment. At the same time, institutional investors that raise funds from the general public will be subjected to stricter governance standards and information disclosure. Professional

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standards will be introduced for fund managers and investment analysts. As the build-up of domestic institutional investment will require some time, foreign portfolio investment will be actively encouraged and may be supported through guarantee arrangements to address country risk issues. Foreign portfolio inflow through proper institutional channels will also transfer expertise into the domestic market. Policy measures under component 4 of the Program are summarized in Table 4.

Table 4: Policy measures to increase demand for financial instruments through development of contractual savings and institutional investment


(17) Upgrade regulation for mutual funds. (18) Clarify and streamline regulatory responsibilities for pensions.

(14) Promote private pensions.

(19) Liberalize investment restrictions for institutional investors.

(15) Improve the operational efficiency of large government-controlled institutional investors (SLIC, EOBI).

5. Development of Related Financial Services and Institutions

43. Improvements in the regulatory framework will raise the standards of financial soundness for NBFIs, and encourage consolidation of the highly fragmented sector. Improvements in the regulatory framework will also further encourage the development of mortgage-backed markets for housing finance and asset securitization, in particular by the leasing industry. Recently, the Government has allowed tax deductibility of mergers and carry forward of losses for merged entities to encourage merger and restructuring of financial institutions. The Government has also reduced the number of government-owned DFIs through liquidation or merger. The restructuring of the Industrial Development Bank of Pakistan (IDBP) is currently at an advanced stage. The Program will support the cost of restructuring IDBP for sale to the private sector or for liquidation in case no buyer can be found. Reforms have also been initiated in the insurance sector, including improved governance of state-owned insurance companies, reduction of the monopoly of state-owned companies, for public sector properties and activities, greater private sector participation for reinsurance, and improved retention capacity for selected noncommercial risks that are no longer covered by the market. Policy measures under component 5 of the Program are summarized in Table 5.

Table 5: Policy measures to develop related financial services and institutions


(20) Promote corporate and financial sector restructuring and consolidation.

(16) Strengthen the regulatory framework and supervision for NBFIs.

(21) Reduce government dominance and consolidate DFIs through sale or mergers

(17) Sell IDBP to the private sector or liquidate it if no buyer can be found.

(22) Improve governance of government-controlled insurance companies.

(18) Reduce public sector involvement in commercial insurance operations.

(23) Open the general insurance market (for public sector property and activities).

(24) Enhance risk retention capacity for noncommercial risks and strengthen reinsurance.

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C. Important Features 44. An important and innovative feature of the Program is that it builds on ADB’s unique capacity among multilateral financing institutions to combine public and private sector instruments and integrate nonlending assistance to leverage the policy reform agenda. In particular, the Program seeks to leverage private sector investment directly into the development process and establish a genuine public-private partnership, in addition to the traditional public sector lending, which seeks to finance the cost of adjustment. Through the innovative application of its PRG instrument, ADB will augment and sustain private sector resource flows into the economy. Two PRG Facilities (see paras. 63-68) will support risk mitigation to enhance Pakistan’s access to international capital flows and integration with international financial markets, and to ensure access to comprehensive insurance for soundness of investment and financial markets. Within this context, the Program will also respond to the Government’s initiatives in dealing with the consequences on the insurance industry of the terrorist attacks in the US on 11 September 2001, after which cover for selected violence-related risk was withdrawn. 45. The implementation of those nonlending components requires special arrangements with the private sector that are separate from the arrangements for implementation of the Program and TA loans. D. Financing Plan 46. The Government has requested a loan of $260 million from ADB’s ordinary capital resources to help finance the Program. The loan will be provided to support the FMG Program, as described in the development policy letter and the attached policy matrix (Appendix 5). The loan amount was determined on the basis of the cost and strength of the structural reforms as well as the strategic significance of the sector. The costs of structural adjustment are estimated to be about $939 million equivalent, consisting of the following main components:

(i) revenue shortfall due to harmonization of tax structure, selected tax incentives, and adjustment in interest rate structures ($592 million);

(ii) restructuring and development of government-owned institutions, including IDBP, SLIC, NIC, EOBI, and Central Directorate of National Savings ($316 million);

(iii) support to a guarantee mechanism to cover terrorism-related risks ($18 million); and

(iv) development and operation of regulatory and enforcement infrastructure ($13 million).

Costing details and underlying assumptions are in Appendix 6. 47. The loan will have a 15-year term including a grace period of 3 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.75% per annum, a front-end fee of 1.0% (the fee will be capitalized in the loan), and such other terms and conditions as set forth in the draft Loan Agreement. The Government has provided ADB with (i) the reasons for its decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice from ADB.

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48. Interest rate and currency conversion options may be exercised in accordance with the terms and conditions set forth in the draft Loan Agreement, the Loan Regulations, and ADB’s Conversion Guidelines. 49. The loan proceeds will be available for withdrawal in tranches upon satisfactory compliance with an agreed upon number of eligible conditions from the date of loan effectiveness up to the loan closing date, which is 31 December 2005 (paras. 55-56). E. Implementation Arrangements

1. Program Management 50. The Ministry of Finance (MOF) will be the Executing Agency for the FMG Program, and SECP will be the implementing agency. Both MOF and SECP have considerable experience with the implementation of comprehensive adjustment programs and have a number of competent staff, many of whom where recruited from the private sector or international financial institutions at market-based salaries. SECP has also been the beneficiary of earlier institutional strengthening TA by ADB and has demonstrated strong performance in implementation. 51. MOF will facilitate overall implementation of the FMG Program, administer the utilization of loan proceeds, and ensure compliance with all policy-related conditions. SECP will have full responsibility for implementation of all conditions and program components within its regulatory and development mandate. MOF and SECP will ensure effective coordination through existing mechanisms with other concerned agencies, including the Ministry of Commerce, Ministry of Labor, Privatization Commission, SBP, and the private sector as appropriate. SECP will facilitate wide stakeholder consultation and update the public on implementation progress through an electronic homepage for the Program within SECP’s website.22

2. Procurement and Disbursement 52. The proceeds of the loan will be utilized to finance the full foreign exchange costs, excluding local duties and taxes, of eligible imports.23 A list of ineligible items is in Appendix 7. All procurement under the program loan will be undertaken through normal commercial practices for the private sector or the Government’s prescribed procurement procedures acceptable to ADB, with due consideration to economy and efficiency. 53. Disbursements under the program loan will be made in line with ADB‘s simplified disbursement procedures and audit requirements.24 To withdraw the proceeds of the loan, the Borrower will certify that the value of eligible imports exceeds the amount of ADB’s projected disbursements under the program loan in a given period. ADB will have the right to audit the use of loan proceeds and to verify the accuracy of the Borrower’s certification.

3. Counterpart Funds

54. The counterpart funds to be generated out of the loan proceeds will be used to finance the cost of structural adjustment, including the establishment of funds and facilities under the 22 http://www.secp.gov.pk 23 Eligible imports refer to total imports minus imports from nonmember countries, noneligible imports specified in the

list of ineligible items, and imports already financed by ADB or other international and bilateral development agencies.

24 ADB. 1998. Simplification of Disbursement Procedures and Related Requirements of Program Loans. Manila.

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FMG Program, and high priority social and human development programs, including social protection for the poor.

4. Monitoring and Tranching 55. The loan will be disbursed in three installments based on performance in meeting specified tranche release conditions. The first tranche, equivalent to $100 million, will become available after loan effectiveness following compliance with the conditions specified in the policy matrix (Appendix 5). The second tranche will be released upon satisfactory compliance with 18 specified conditions, as well as continued compliance with all previous tranche conditions. The conditions focus on outcomes rather than inputs, in line with the finding of the policy review for program lending.25 Specific actions to measure and assess compliance with the conditions will be detailed in the Program Administration Memorandum. Continued dialogue between ADB staff and the Government throughout program implementation will be required to achieve the outcomes. To provide an incentive for early compliance, an incentive release under the second tranche amounting to $80 million can be made as soon as any 9 of the release conditions have been met, expected in November 2003. The final release of the second tranche of $80 million will take place upon satisfactory compliance with the remaining conditions, expected in November 2004. 56. Eligible second tranche release conditions are given in the tables 1-5 between paras. 39 and 44.

57. To monitor implementation of the FMG Program, the Government will prepare for submission to ADB quarterly progress reports as well as an annual report on program implementation. SECP will also regularly update the FMG Program website for transparency in implementation and information of the public. ADB will send regular review missions and conduct, jointly with the Government, at least semiannual reviews to evaluate compliance with the conditions and advise the Government on actions required to keep program implementation on course.

V. TECHNICAL ASSISTANCE LOANS 58. To augment impact, capacity for implementation and sustainability of the reform agenda, two TAs are proposed for (i) strengthening pension, insurance, and savings systems (TA1); and (ii) strengthening regulation, enforcement, and governance of nonbank financial markets (TA2). 59. TA1 seeks to strengthen policy frameworks for pensions as well as the institutional capacity of key government institutions involved in the management of pensions, insurance, and savings. It will comprise five components: (i) establishment of an overall framework for pension provision, (ii) financial assessment of civil and military pension schemes, (iii) institutional reform and strengthening of EOBI, (iv) capacity building for investment management in SLIC, and (v) institutional reform and strengthening of the Central Directorate of National Savings. The TA will be executed by MOF, and implemented in coordination with other ministries and agencies including the Ministry of Commerce and Ministry of Labor. The cost of TA1 is estimated to be $4.5 million equivalent, comprising foreign exchange of about $2.4 million and local currency costs of about $2.1 million equivalent.

25 ADB. 1999. Review of ADB’s Program Lending Policies. Manila.

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60. TA2 aims at strengthening standards and enforcement capacity for corporate governance, transparency in information disclosure, and sustainable risk management to improve protection of investors and policyholders. It will also seek to enhance the skills of various market participants to deal with a more sophisticated financial system, and will raise ethical standards in the market. The TA will comprise four components: (i) further improvement of legal and regulatory frameworks; (ii) capacity building of SECP with particular attention to its enlarged mandate for regulation and supervision of NBFIs, insurance, and pensions; (iii) support for restructuring of stock exchanges; and (iv) establishment of sustainable mechanisms for skills development and training. It will be implemented by SECP. The cost of TA2 is estimated to be $4.4 million equivalent, comprising foreign exchange costs of about $2.4 million and local currency costs of about $2.0 million equivalent. 61. The Government has requested two loans of $3 million equivalent each from ADB’s Special Funds resources to help finance TA1 and TA2. Each loan will have a term of 32 years, including a grace period of 8 years; an interest rate of 1% per annum during the grace period and 1.5% per annum thereafter; and such other terms and conditions as set forth in the Loan Agreements. 62. Details of the objectives, scope, costs, and financing as well as implementation arrangements are provided in Appendix 8 for TA1, and Appendix 9 for TA2.

VI. NONLENDING ASSISTANCE A. Political Risk Guarantee Facility for Enhancing Pakistan’s Integration with

International Capital Markets 63. To promote institutional investment in Pakistan’s capital market and integration with international financial markets, ADB will provide a facility that will issue PRGs to international investors. The PRG will guarantee payment of proceeds from eligible debt instruments if that payment is not made as a result of a guaranteed risk, including primarily restriction on foreign exchange convertibility and transferability blockage relating to repatriation of foreign exchange or related risks. The PRG facility will, however, not cover any risks that affect the market value of the investment itself. The PRGs issued under the facility will be counterguaranteed and indemnified by the Islamic Republic of Pakistan. The maximum aggregate liability under the PRG facility covered by ADB at any time will not exceed $25 million equivalent, but the PRG facility may be enhanced through coguarantee arrangements with the private sector. It is envisaged to leverage the ADB investment through comfort offered under ADB’s coguarantee program by $125 million, or a factor of up to 5 times, for a total volume of about $150 million. The counterguarantee would cover only a partial amount of this, but in any case will cover the aggregate ADB liability. 64. The PRG may be administered on behalf of ADB through a facility agent selected from the private sector according to normal commercial procedures. For each PRG issued, ADB will charge the beneficiary a one-time front-end fee of up to 1%, in line with the provisions in ADB’s policy on guarantee operations,26 payable on the nominal amount of the guarantee limit. ADB will also charge a PRG fee of 0.40% per annum on the aggregate value of all liabilities outstanding under the PRG, calculated on a daily basis. Each beneficiary of a guarantee will pay a fee as a percent per annum of the guaranteed amount for each investment guaranteed, which will be determined through discussion with the potential facility agents prior to the PRG becoming available. The fee may be changed from time to time in light of market conditions. 26 ADB. 2000. Review of the Partial Risk Guarantee of the ADB. Manila.

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Any establishment cost, including agreed upon legal and out-of-pocket expenses for external parties, may be financed through deduction from the FMG Program loan amount and be recovered from the fee income generated by the PRG over time. Any surplus generated by the PRG, after deduction of all expenses for establishment and operation, will be capitalized to build up a claims reserve or otherwise utilized as agreed upon between ADB and the Government. 65. Details on objectives, terms, conditions, and the proposed implementation mechanism for the PRG are presented in Appendix 10. B. Political Risk Guarantee Facility for Enhancing Access to Cover for Selected

Violence-Related Risks 66. To ensure the availability of insurance cover for violence-related risks, including terrorism cover, which is no longer readily available in the commercial market following the terrorist attacks in the US on 11 September 2001 – and thus to protect economic and financial sector soundness 2001 – ADB will provide a facility that will issue PRGs to investors with operations in Pakistan or their lenders. Under the PRG facility, ADB will guarantee payment of a certain amount to a guaranteed party in case terrorism or other political violence risk as specified under the PRG policy occurs. The PRG facility will be counterguaranteed and indemnified by the Islamic Republic of Pakistan. The maximum aggregate liability under the PRG covered by ADB at any time will not exceed $175 million equivalent, but the PRG facility may be enhanced through coguarantee and commercial reinsurance arrangements. 67. The facility will be administered on behalf of ADB through an agent with sound understanding of the international insurance market, selected from the private sector according normal commercial procedures. ADB will charge the beneficiary for each PRG issued a one-time front-end fee of up to 1%, in line with the provisions in ADB’s policy on guarantee operations, payable on the nominal amount of the guarantee limit. ADB will also charge a PRG fee of 0.40% per annum on the aggregate value of all liabilities outstanding under the PRG, calculated on a daily basis. Each beneficiary of a guarantee will pay a fee as a percent per annum of the guaranteed amount for each policy guaranteed, which will be determined through discussion with the facility agent and beneficiaries prior to the PRG becoming available. The fee may be changed from time to time in light of market conditions and risk assessment. Any establishment cost, including agreed upon legal and out-of-pocket expenses for external parties, may be financed through deduction from the FMG Program loan amount and be recovered from the fee income generated by the PRG over time. Any surplus generated by the PRG, after deduction of all expenses for establishment and operation, will be capitalized to build up a claims reserve or otherwise utilized as agreed upon between ADB and the Government. 68. Details on objectives, terms, conditions and the proposed implementation mechanism for the PRG are presented in Appendix 11.

VII. PROGRAM BENEFITS, IMPACTS, AND RISKS A. Benefits and Impacts 1. Program Benefits 69. The overall outcome of the Program will be a vibrant, diversified, efficient, and sustainable financial market offering a wide range of nonbank products and instruments for saving and investment in a well-regulated sector environment. This will contribute to productivity growth, employment generation, and strengthening of social safety nets, as well as fiscal and financial sector stability.

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70. Specifically, the following benefits will accrue: (i) improved resource mobilization and access to financing of economic expansion from domestic and foreign sources; (ii) wider choice of funding and saving instruments accessible to the corporate sector and general public, at more competitive pricing that does not penalize for inefficiencies in the banking sector; (iii) greater flexibility and improved risk management for institutional investors; (iv) increased investment skills and better advisory services to benefit the general public; (v) increased transparency, information disclosure, and investor protection; (vi) diversification and deepening of the financial sector, with less reliance on the banking sector, reducing vulnerability to financial sector crisis, which often has its most severe impact on the poor; (vii) enhanced social protection through wider range of insurance and old-age protection products, with greater client orientation and outreach including to the poor on a sustainable basis; and (viii) improved public finances through increased tax revenue in the medium to long term as a result of increased saving and investment, as well as a defined mechanism to deal with selected violence-related risks that can no longer be covered commercially. 2. Social and Environmental Impact 71. The impact of the FMG Program will be pro-poor in supporting the three components of ADB’s poverty reduction strategy: pro-poor sustainable economic growth, good governance, and social development. Pro-poor sustainable economic growth will be supported through productivity improvements as a result of the Program’s focus on more efficient resource allocation to finance employment-generating activities. Good governance will be supported through measures to improve transparency and accountability of corporate issuers, financial intermediaries, information providers, and regulators. The introduction of a corporate governance code and legislative amendments will provide better protection to minority shareholders and investors, and will ensure that economic decisions will be taken in the interest of a larger group of stakeholders rather than a select few insiders. The Program will also support the poverty reduction strategy’s third pillar of social development by improving access and sustainability of social insurance, including pensions and life insurance. In addition, increased financial intermediation activity will result in higher tax revenues in the medium-to-long term, which can support social sector and development spending. Well-developed capital markets also provide an avenue for mobilization of domestic resources for infrastructure financing, including for basic infrastructure required by the poor such as water supply, energy, or transport. In addition, the diversification of funding sources and diminished reliance on the banking sector will reduce vulnerability to financial sector crisis, which typically carries a high fiscal cost with negative implications for the poor. The support for the establishment of an explicit reinsurance mechanism for selected violence-related risks, which is no longer available commercially, will also reduce the Government’s fiscal exposure to unforeseen events that could cause fiscal disruption. The restructuring of state-owned institutions under the Program may result in reduction of employment by less than 1,000. This will be achieved largely through natural attrition, or by voluntary retirement schemes that provide adequate compensation well in excess of the minimum legal requirements. A summary poverty reduction and social strategy and poverty impact assessment of the Program is in Appendix 12. 72. The Program will have no direct environmental impact, and thus no mitigating measures will be required. In the long term, the benefits may be positive, as an increase in economic standards is generally accompanied by improvements in environmental standards. In the medium term, increased economic activity may result in increased environmental pressures, which will need to be addressed through general safeguards beyond the FMG Program.

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B. Risks 73. The success and impact of the program will depend on a number of key assumptions. The assumptions are subject to variable degrees of risk, for which mitigating measures have been put in place as appropriate. 74. Macroeconomic Stability and Investor Perceptions. The Government has managed to stabilize the economy, and the outlook is positive. The agreements with IMF and successful rescheduling of official debt have provided a good development framework. However, the economy remains vulnerable to external risks such as regional conflict or civil unrest, and to the perception of international investors concerning such. The measures under the Program are directed to improve investor confidence through improved governance standards. To lower the risk perceptions of international investors, ADB will also provide guarantees that will support increased cross-border transfer of funds for investment. A worsening global outlook will, as elsewhere, affect the performance of Pakistan's financial markets, but reform measures under the FMG Program are expected to lessen the impact of external shocks and strengthen resilience of the domestic system. 75. Policy Consistency and Reform Commitment. The elections in October 2002 have given a popular mandate for continuation of the reform process. In addition, implementation of the reform agenda will to a large extent rely on the private sector, which strongly supports and has been involved in formulation of the Program. Wide stakeholder consultation during processing sought to ensure awareness and broad-based ownership for the reforms. This makes the program less vulnerable to changes in government and policies. Furthermore, in September 2002 SBP was made a constitutional body with independence for monetary policies and shielded from government interference. 76. Short-Term Adjustment Costs. These may cause fiscal disruption. The adjustment costs under the program have been reflected in the budget and revenue targets agreed upon with IMF under the PRGF. Conservative collection targets for tax revenues from financial instruments have been applied, and incentives for tax benefits have been capped. 77. Political Interference into Regulatory Matters. The regulator has been given a solid governance framework with strong legal protection from direct government interference. 78. Capacity and Integrity of the Regulator. TA support will be provided under the Program to further upgrade skills; financial autonomy allows the regulator to attract and retain competent staff. 79. Inadequate Implementation of Governance and Risk Management and Standards due to Vested Interest. The regulator has in the past shown a very strong track record in taking tough decisions against vested interests and in favor of minority investors, and is equipped with strong regulatory powers to allow it to take appropriate action. The private sector and a wide range of stakeholders will be involved in program implementation and monitoring to lessen dependence on a single lobbying group. The establishment of a private sector-driven corporate governance center will raise governance standards and awareness. 80. Slow Progress in Reforming Key Institutions, including EOBI and SLIC. The Government has installed professional management in key institutions. Further measures to improve governance and reduce direct government interference are being promoted under the Program. Support to proreform forces and ongoing policy dialogue will also be provided under the proposed TA.

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VIII. ASSURANCES A. Specific Assurances 81. The Government and SBP have given the following assurances, in addition to the standard assurances, required for successful implementation of the Project, which have been incorporated in the FMG loan documents:

(i) The Government will maintain a conducive macroeconomic environment for financial market development.

(ii) The Government will maintain its commitment to the principles of good governance of the financial sector and not impose any laws, rules, regulations, or administrative measures that undermine the autonomy and effectiveness of the regulator and its capacity to attract, retain, and develop qualified staff.

(iii) The Government will ensure continuation of the policy measures taken in coordination with ADB and IMF beyond the Program period.

B. Conditions for Loan Effectiveness 82. The following conditions for loan effectiveness have been incorporated into the loan agreements:

(i) For each one of the three loans under the Program (the FMG program loan, the TA loan for Strengthening of Regulation, Enforcement and Governance of Financial Markets, and the TA loan for Strengthening of Pension, Insurance and Savings Systems): that each of the two other loan agreements under the Program will have been duly executed and delivered on behalf of the Borrower, and all conditions precedent to the effectiveness of each such agreement will have been fulfilled.

(ii) For each one of the TA loan for Strengthening of Pension, Insurance and Savings Systems and the TA loan for Regulation, Enforcement and Governance of Financial Markets: that each implementing agency will have appointed a project director satisfactory to ADB; and the project will have been duly approved by the appropriate authorities of the Borrower.

C. Conditions for PRG Effectiveness 83. The following will be conditions for effectiveness of the PRG facilities:

(i) The Government will have duly executed and delivered a counterguarantee and indemnity agreement in a form satisfactory to ADB.

(ii) The Government, ADB, and the facility agent, if applicable, will have signed an

agency agreement in a form satisfactory to ADB whereby the parties agree that the facility agent will act as the agent of ADB and the Government in administering the PRG.

(iii) The terms of an initial guarantee to be issued under the PRG facility will have

been negotiated to the satisfaction of ADB.

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IX. RECOMMENDATION 84. I am satisfied that the proposed program loan, technical assistance loans, and political risk guarantees would comply with the Articles of Agreement of ADB and recommend that the Board approve:

(i) the loan of $260,000,000 to the Islamic Republic of Pakistan for the Financial (Nonbank) Markets and Governance Program from ADB’s ordinary capital resources with interest to be determined in accordance with ADB’s LIBOR-based lending facility; a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board;

(ii) the loan in various currencies equivalent to Special Drawing Rights 2,268,000 to

the Islamic Republic of Pakistan for Technical Assistance for Strengthening Pension, Insurance, and Savings Systems from ADB’s Special Funds resources with an interest charge at the rate of 1% per annum during the grace period and 1.5% per annum thereafter; a term of 32 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board;

(iii) the loan in various currencies equivalent to Special Drawing Rights 2,268,000 to

the Islamic Republic of Pakistan for Technical Assistance for Strengthening Regulation, Enforcement, and Governance of Financial Nonbank Markets from ADB’s Special Funds resources with an interest charge at the rate of 1% per annum during the grace period and 1.5% per annum thereafter; a term of 32 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Project Agreements presented to the Board;

(iv) the political risk guarantee facility for Enhancing Pakistan's Integration with

International Capital Markets covering a principal amount of up to $25,000,000 equivalent in favor of international portfolio investors (subject to a counterguarantee by the Islamic Republic of Pakistan), and a coguarantee program for an amount of up to $125,000,000 million equivalent, in each case on such terms and conditions as are substantially in accordance with those set forth in this Report, and as may be reported to the Board; and

(v) the political risk guarantee facility for Enhancing Access to Cover for Selected

Violence-Related Risks covering a principal amount of up to $175,000,000 equivalent in favor of companies with direct investment in Pakistan or their lenders (subject to a counterguarantee by the Islamic Republic of Pakistan) and such terms and conditions as are substantially in accordance with those set forth in this Report, and as may be reported to the Board.

TADAO CHINO President 11 November 2002

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SECTOR ANALYSIS A. Fiscal, Interest Rate and Investment Policy Environment 1. A major obstacle to the development of stable financial markets, and a key factor in market segmentation, has been the differential tax treatment accorded to different financial institutions and instruments. This has created tax arbitrage and a negative impact upon the competitiveness of instruments and institutions. A market niche has been created for some institutions – investment banks (which operate like commercial banks), leasing companies and modarabas1 – by taxing them at a much lower rate than commercial banks. These factors have not only resulted in the proliferation of financial institutions but also distorted the link between financial operations and institutions. Another obstacle has been the frequently changing tax structure, which created a great degree of uncertainty in the market. 2. The income taxx structure that favored some instruments over others and some categories of investors over others is being reformed to remove these distortions. In line with agreements with the International Monetary Fund, a new income tax ordinance became effective 1 July 2002. As policy objective it seeks that all income be taxed on the same basis, and tax incentives be considered in only a few cases for developmental or other purposes. Different post-tax returns for instruments with same risk (but different investors or through different channels) should be avoided. It requires, among others, a simpler tax structure for individuals, less emphasis on withholding and presumptive taxes, fewer exemptions, and extension of income tax to all new issuance of National Savings Scheme (NSS) instruments. The measure may need some time to be phased in to avoid fiscal disruption, giving the excessive reliance on taxes from the financial sector in the current revenue scenario. 3. Another key policy impediment has been the arbitrary interference of the Government in the interest rate-setting mechanism through the NSS. NSS instruments are hugely popular with the general public, as they offer higher returns with lower risk than most other investment alternatives. Economic reasoning clearly calls for much lower rates for the NSS, but this is likely to be unpopular with the general public. With inflation under control, risk-free real interest for the NSS may well be among the highest in the world. Retail investment in capital market instruments is crowded out to a considerable extent by this. While NSS was originally designed as a long-term savings vehicle, it is competing also with medium- and short-term saving instruments due to the possibility of early redemption without much penalty. Recent moves have reduced the rates for the NSS, but such moves have been administered in an ad-hoc manner without adequate link to a suitable benchmark that adequately reflects market structures. As NSS instruments are risk-free retail securities, their returns should normally be lower than the level applicable to wholesale government securities, and considerably below private sector instruments. Likewise, there is little reasoning for the Government to borrow at higher cost from the retail level than it can do wholesale through bond issues. B. Transparency and Corporate Governance 4. Investors in Pakistan are keenly aware of the wide information asymmetry in the capital market. There is little confidence in the accuracy of information, integrity of transactions, or internal control mechanisms of the various participants. 5. Corporate governance – which defines and structures the interacting relationships of a company’s management, its board, its shareholders, and other stakeholders – has been

1 Modarabas are finance companies that operate according to Islamic principles of finance, not involving interest.

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recognized as a key element for improving economic efficiencies. The development of the capital market as a significant financial intermediary for the economy will depend highly on the framework of corporate governance adopted and the degree of adherence to the framework in practice. As the market develops, it in turn will play an integral role in promoting principles of good governance by enforcing transparency and financial discipline on companies. 6. Improving corporate governance standard for capital market development requires measures aimed at the various participants involved, including (i) the issuers, or those companies that tap the capital market for financial resources; (ii) the intermediaries and related service providers, which include the stock exchanges; the broker community; and depository, clearing, and settlement companies; (iii) the institutional investors; (iv) the information providers and advisors, including accounting and auditing firms, law firms, as well as rating agencies providing services needed to bring issuers to the market place; and (v) the regulator. 7. A draft code of corporate governance was issued in March 2002 by the Securities and Exchange Commission of Pakistan (SECP) after intense stakeholder consultation. It is a first phase and is aimed at listed companies. Its key elements include separation of the board of directors from management of the company, with clear distinction in their responsibilities; legal representation and protection of minority shareholders through inclusion of at least one independent director on the board of the company; strengthening of internal control mechanisms including an audit committee; and improved information disclosure requirements and compliance standards. If properly implemented, this is expected to have positive results on enhancing the transparency and accountability of the corporate sector and the rights of minority investors. 8. Some measures have also been taken to enhance governance standards of capital market intermediaries and increase market transparency, including inclusion of nonmember directors on the boards of the stock exchanges and appointment of independent managing directors, computerization of transactions, and the establishment of a central depository system. However, some serious issues remain to be resolved. For example, the listing criteria require further updating, and the delisting process is cumbersome and time consuming. There is also increasing recognition globally that stock exchanges perform a competitive business function, and that self-regulatory concepts promoted widely in the past have to be approached carefully and need strong regulatory backing. To provide efficient services to investors, many stock exchanges worldwide have demutualized and adopted corporate structures that separate ownership of the exchange from trading rights. This process may well be beneficial for Pakistan, too. Some key issues, including valuation of membership rights in the current setup, will need to be resolved to carry this process forward and may require further analysis. 9. Most critical is the widely held perception that a few well-connected insiders control market activities. Improper broker activities, including front running2 and nonseparation of proprietary and client trading as well as insider trading are believed to be widespread. As a result, trading is largely opportunistic and short term, and there is little genuine investor interest. The market is heavily discounted, and companies with solid fundamentals and high dividend yields, often as high as 20%, and low price earnings ratios, often as low as 3 or 4, are left without buyers. To address this situation, transparency in trading of shares must be increased, and the members of the stock exchange must be required to meet a strict set of professional standards; those that do not adhere to them should be properly penalized.

2 Front running is the practice by brokers of placing orders to buy or sell shares on the knowledge of a client’s order,

and thus raising or depressing the stock price.

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10. Both the quality and quantity of financial information made available to the public are insufficient. Listed companies are required to have their accounts audited under the Companies Ordinance of 1984. Disclosure standards are further reinforced by the special regulatory orders issued by the SECP that prescribe mandatory application of International Accounting Standards (IAS) to listed companies and the subsidiaries. Nevertheless, financial information is often not reliable, and enforcement of standards remains a key issue. It is estimated that less than 30% of the listed companies are audited by firms with adequate resources to conduct audits in accordance with IAS. The Institute of Chartered Accountants, in its effort to improve compliance with IAS, has prepared auditing manuals and organized training workshops. It has also established an investigation committee to take actions for cases of gross noncompliance. However, the legal framework is still lacking for the investigation committee to be an effective monitoring unit. There is the need to review the disclosure standards required by law, the capacity of the auditors and their professional qualifications, their code of conduct, as well as enforcement capacities for strict adherence to IAS. C. Supply of Financial Instruments

1. Debt and Money Markets 11. The fixed income market in Pakistan can be divided into the government and the corporate debt markets. Both segments are still at an emerging stage. The wholesale government debt instruments currently comprise Treasury bills (T-bills) of 91, 182, and 364 days maturity in the short-term and Pakistan Investment Bonds (PIBs) with maturities of 3, 5, and 10 years in the long-term. These securities cannot be traded in the secondary market, but have early redemption facilities attached with penalties. There is no on-line system for trading, clearing, settlement, and registration for government securities. Transactions in T-bills and PIBs are settled through manual book-entry transfers submitted to the State Bank of Pakistan's (SBP) Public Debt Office. SBP is, however, in the process of computerizing the register of government securities; it also has plans to set up a Real Time Gross Settlement System within the next 2 years. 12. The corporate bond market in Pakistan was established in 1995, although corporate bonds, known as Term Finance Certificates (TFCs), were privately issued as early as 1985. TFCs have both a private and a public issue component, which are regulated by SECP. The TFC market has a maturity of up to 5 years as investors are reluctant to underwrite longer terms in the absence of adequate credit enhancement or other risk mitigation tools. As traditional credit lines through development finance institutions (DFIs) have dried up, many companies with medium- to long-term funding needs have turned to issuing of TFCs for their funding needs. TFCs have been particularly attractive for the leasing industry. In 2002, SBP has also allowed banks to issue TFCs for raising long-term funds. About 80-90% of the TFC issues are subscribed by the commercial banks and often held to maturity. Secondary market trades – which can be through the stock exchange or over-the-counter – are limited between the banks, and these are seldom reported. There is also a need to establish real-time market infrastructure and improve education services for debt market participants. 13. Money market instruments, with maturities of less than 1 year, are an important source of funding in many developed and developing economies.3 Despite the inefficiencies in Pakistan’s banking sector, this source is not developed for the corporate sector. Introduction of instruments such as commercial paper (CP) and certificates of deposit should be encouraged. CP is an

3 E.g., in the US, more than 1,700 companies issue short-term commercial paper. In India, outstanding commercial

paper issued by corporates amounts to about $1.5 billion.

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alternative to borrowings from banks or other financial institutions and is sold to investors who invest in short-term money market instruments. Companies can fund much of their short-term borrowing through commercial paper, as interest rates on CP are often lower than bank lending rates, which makes it an attractive alternative to bank credit. Pakistan’s corporate sector is keen to tap this source for funding its short-term requirements. This would, however, require reduction in issuing cost, including stamp duty, and clear guidelines on modalities. The issuance and trading of CP and certificates of deposit would add more depth to the term money market in Pakistan, which would provide important pricing signals for the construction of a yield curve. Money market mutual funds should be encouraged, as they can offer attractive alternatives to retail investors, in particular for short-term savings, and introduce competitive pressure on the banking sector. 2. Equity Markets 14. Despite changes in the regulatory system and governing structure of the stock exchanges, there has been no appreciable increase in the number of retail investors in the recent past. The stock exchanges in Pakistan also play a limited role in facilitating companies to raise resources from the public as reflected by the low figures of new issues in the recent past. (Only four new companies raised capital on the stock market in 1997, 1 in 1998, none in 1999, 3 in 2000, 2 in 2001, and 2 in 2002). While these low figures may partly reflect the macroeconomic situation in the country, confidence of investors and issuers in the market is a critical issue. There has been a lack of widespread equity investment from the general public including through long-term private sector institutional investors, and this has contributed to the largely speculative nature of Pakistan’s stock exchange. 15. In particular the prevalent badla system4 and its impact on the market has been the subject of much debate. The question often raised is whether such a system of financing for carry-over transactions is necessary for sustaining trade volumes and market liquidity, considering its impact on price distortions and volatility. Given the unregulated nature of badla, it poses a systemic risk of destabilizing the market, which deters long-term investors. Other countries in South Asia, in particular India, have faced several badla-induced crises, and the regulators had to temporarily suspend trading operations, which severely undermined market credibility. There is an urgent need to review and properly regulate the badla process and make it fully transparent by providing badla-related information on a timely basis. However, badla has generally been a very profitable activity for stockbrokers,5 and there has been strong broker lobby for its continuance with more controls. Consultation among SECP, the exchanges, and brokers should lead to the introduction of a more regulated margin lending facility as per international practices. A stock-lending instrument should be promoted, and the futures market should be more encouraged (which can be used for badla purposes). The existing provisions of

4 Badla is a colloquial term for short-term trade-related transactions, based on the sale and repurchase of

an asset that serves as collateral. It is a commonly used method of finance in Pakistan's stock market. Badla transactors are traders who have an existing stock of the commodity/free funds, for which another trader is unable to make payment/delivery in a transaction. The purchaser enters into an agreement wherein the badla transactor makes the payment/delivery on his/her behalf, and takes possession of the commodity/funds until the purchaser settles the transaction by repurchasing the commodity at a pre-agreed price (incorporating interest or mark-up) and date. The badla market operates on the basis of trust, since there is no accompanied legal documentation to evidence the transaction.

5 Badla financing yields an average spread of 7-8% over the 6-month T-bill rates. It is estimated that on average PRs3-4 billion is being invested in the KSE depending on the financing charge, market sentiments, and prevailing interest rates in the interbank market. The net income from this financing activity is treated as a capital gain for the badla financier.

Appendix 1

29

the Companies Ordinance of 1984 may need to be reviewed in the context of margin lending by SECP, and suitable amendments proposed. D. Contractual Savings and Institutional Investments 16. Institutional investors have an important role to play in both deepening the capital markets and monitoring the activities of the issuers as their shareholders. As a result, they can bring stability to the capital market and induce higher corporate governance standards to companies listed on the exchanges. To the individual investors, they bring alternative saving vehicles that would give them access to professional fund management and risk diversification. Such saving vehicles would give competition to bank deposits, thus serving to increase the efficiency of banking operations in the longer term. 17. The absence of a diversified and professional institutional investor base has been a major shortcoming in the capital markets of Pakistan. A vast potential pool of institutional investors comprising mutual funds, pension funds, and insurance companies remains untapped. 18. Measures are required both to improve the operations of existing institutions as well as to promote the development of new investors. Institutional investment in Pakistan, dominated by government-owned institutions, does not operate in the best interests of the unit or policyholders. They do not only lack proper disclosure standards and benchmarks for measuring investment performance, but have inadequate investment skills and incentive structures. Initial steps would call for changes in the governance structure of the largest investors, improving the legal framework for fiduciary duties; improvement in information disclosure and investment guidelines; adoption of a code of ethics and performance measurement standards; enhanced professional fund management skills; and a streamlined tax structure. Without professional skills for fund management, the sizable funds held by government-owned institutions will remain inactive in the capital market. 19. Pakistan’s mutual funds industry represents only approximately 2% of bank deposits, compared with India’s 12%. The industry has been tainted by the poor performance of the government-owned mutual funds with investment objectives not in line with their obligations to investors. In addition, the mutual fund industry has suffered from unfavorable tax treatment, and inherent distortions that gave preferential treatment to the government-controlled funds, e.g., for statutory liquidity requirements. 20. The pension sector in Pakistan is poorly regulated, fragmented, and inefficient. Civil service employees with 20 years of service and military personnel with 25 years of service are entitled to a tax-free defined-benefit pension, adjusted partly for inflation. This operates on an unfunded pay-as-you go basis, and may create a significant fiscal burden in the future if no measures to address it are initiated. The largest scheme for industrial workers is the Employees’ Old-Age Benefit Institution (EOBI), which is a defined-benefit scheme. The scheme is mandatory for selected sectors and covers approximately one million workers. Contributions are compulsory for employers only, but compliance is patchy and contributions are often regarded by employers as another form of tax. Increases in benefits are subject to government determination rather than being indexed. EOBI has accumulated about PRs45 billion in net assets to meet its pension obligations, but assets are expected to become rapidly depleted as the scheme approaches maturity, and it is not financially sustainable in the long term. The Government directs investment policy, and the scheme suffers from a high cost structure. Administrative costs are estimated to account for 16% of collected contributions. Management systems are poor, and records are acknowledged to be incomplete. The scheme has experienced recent adverse publicity relating to financial mismanagement and alleged fraud, and is currently, under a new

Appendix 1

30

chairman, attempting reforms to its operational practices. There is a need for further governance reform, including a clear delineation of the responsibility of the board of trustees to enable discharging its functions in line with its fiduciary duties. Given the limited in-house fund management capacity and potential to develop this effectively within the Government’s pay structure, EOBI may consider contracting out management of part or all of its portfolios to investment management companies. 21. Private sector companies run provident funds that pay lump sums on termination of employment; defined-benefit pension plans that typically have extremely long vesting periods; or, for those companies providing neither, the traditional gratuity scheme under which an employee receives a taxable payment based on years of service. The gratuity schemes are not usually separately funded. The lack of portability of the schemes is likely to have an inhibiting effect on labor mobility. Private pensions lack a comprehensive legal and regulatory framework, although initial steps for the formulation of a legal framework for private pension funds have been taken by SECP. 22. Savings mobilization through life insurance remains relatively undeveloped in Pakistan,6 and total life insurance premiums have declined in recent years, despite the rising population. The sector was nationalized in 1971 and reopened to the private sector in 1992 (a small amount of business is also written by the Government on a pay-as-you-go basis under the Postal Life scheme). There are now five licensed life insurers. While competition including foreign investment in the life insurance sector is permitted under the regulatory regime, the nature of the business is long-term and requires a long gestation period and commitment. State Life Insurance Corporation (SLIC) is also the country's largest institutional investor, with more than PRs70 billion. Thus, SLIC remains a virtual monopolist in the area of traditional life insurance with about 95% market share, thanks in large part to its long history as sole provider, the government guarantee applicable to its policies, and its countrywide distribution network. 23. The operations of SLIC have been subject to political direction, and during the 1990s practices were followed that caused high turnover but at the cost of low persistency and a very high cost structure. A new executive chairman, a qualified actuary, was appointed in 2000, and the company has since reported commercial improvements. It remains closely controlled by the Ministry of Commerce. Considerable barriers to entry and to innovation typically exist in any life insurance industry. A new life insurance provider expects to take several years to establish itself, and during its earlier years expects to experience "new business strain" on its capital resources and therefore to report a loss for accounting purposes.7 Under management, it has so far pursued a rather passive investment strategy and not contributed significantly to secondary market activity. 24. The depressed nature of the Pakistan economy for the majority of the history of the four private sector companies has not assisted either their development or that of the life insurance industry in general. A lack of sophistication among potential clients, and limited investment options because of the deficiencies of the capital markets, have not encouraged the development of investment-linked products. A number of foreign life insurers are known to have examined the possibility of establishing an operation in Pakistan, but only two of these have proceeded to set up subsidiaries and only achieved mixed results so far. The private sector insurers have not, in general, sought to compete directly with SLIC for individual life business but 6 Total life insurance premiums in 2000 were 0.27% of gross domestic product, which is negligible compared with

some other countries in the region (e.g., Malaysia, 2.1%; India, 1.8%; Sri Lanka, 0.53%; and Indonesia, 0.54%). 7 In this context, the application of the turnover tax to life insurance is a particular problem, since it effectively

constitutes a tax on premiums only to new life insurance companies; mature life companies escape this impost because of the smoothed release of profits over time.

Appendix 1

31

have tended to concentrate on innovative products to be sold to a niche rather than mass market. While this strategy may make sense for the new entrants themselves, it does not address the issue of SLIC’s domination of the traditional life insurance market. It is difficult to find a justification for government ownership of a life insurance near-monopoly, and innovative solutions will be needed to increase private sector participation in the life insurance market. E. Nonbank Financial Services and Institutions 1. Specialized and Development Financial Institutions 25. There are numerous development and other specialized financial institutions in Pakistan, including DFIs, leasing companies, modarabas, housing finance companies, and investment banks. Yet, this large number of institutions mobilize less than 5% of deposits. DFIs and housing finance, in particular, have been dominated by government ownership, and are characterized by operational inefficiencies as well as a particularly high bad loan portfolio. The proliferation of other financial institutions has above all been driven by regulatory and tax arbitrage. Effective 1 July 2002, regulation and supervision for all nonbanking finance companies was transferred to SECP. 26. In conjunction with the banking sector reforms, the Government has also pursued DFI reforms through restructuring, privatization, merger, and closure. One DFI, Banker’s Equity, has already been liquidated and another, Investment Corporation of Pakistan, is in the process of liquidation; two DFIs have been merged with other government-owned institutions. After evaluation of options, the Government has decided to restructure the Industrial Development Bank of Pakistan (IDBP) to prepare it for privatization. The main attraction for the private sector to purchase IDBP is the commercial banking license that IDBP holds, though its focus has always been on development financing. SBP has also provided IDBP with a fresh line of credit of PRs5 billion against government guarantee, and conversion of government loans of about PRs12 billion into equity is expected to improve IDBP's balance sheet, while bad assets will be transferred to the Corporate and Industrial Restructuring Corporation, a government-run asset management company, for auction. 27. Housing finance has served as an engine of economic growth in many countries but has failed to do so in Pakistan. Housing finance is closely linked with capital market development. Housing finance companies typically need long-term funds to fund their long-term housing assets, and housing finance receivables are normally well suited for asset securitization. For improving the housing stock in the country, the Government needs to institute the required regulatory framework for major financial institutions to enter the housing finance market in a significant way. Existing constraints in enforcing foreclosure laws should be addressed, a refinance window should be set up for refinancing of housing finance extended by housing finance companies, and ground rules for housing finance companies to raise funds need to be established, among others. 28. Other forms of specialized finance include leasing, modarabas, and investment banks. There is a need to further consolidate the sector in order to have fewer but stronger institutions. Prudential standards in particular need to be improved. 2. Insurance 29. Total net premiums in the nonlife insurance market represent about 0.37% of gross domestic product, a low figure compared with some other countries in the region (e.g., Malaysia, 1.6%; Thailand, 1.0%; Sri Lanka, 0.7%; Iran, 0.7%; Indonesia, 0.7%; India, 0.6%). Although

Appendix 1

32

there are more than 50 nonlife insurers, the market remains dominated by a small number of insurers, among which the National Insurance Company Limited retains its monopoly over the insurance of "public property" (a term that includes externally financed projects and Government-owned enterprises). In the private sector, five companies control the large majority of total premium income. Many of the small players were established as captive insurers and are financially weak. The sector is characterized by a high cost structure and a low claims ratio. 30. Earlier, the Controller of Insurance within the Ministry of Commerce regulated the insurance sector. However, to reduce fragmentation and consolidate the regulatory activities of the financial sector, the Government in 1999 assigned the task to SECP. A new Insurance Ordinance was promulgated in 2000 to replace the Insurance Act of 1938. The new law has been introduced to strengthen the regulatory system, improve the financial base of insurance companies by increasing minimum paid-up capital and solvency requirements, improve administration in the insurance sector, and protect policy holders. The minimum capital requirement has been raised from PRs40 million to PRs80 million for nonlife insurance, and from PRs100 million to PRs150 million for companies dealing in life insurance. The first increases in paid-up capital requirements come into effect on from 31 December 2002, and a number of nonlife insurers appear unlikely to meet the new requirements. These requirements have to be met by 31 December 2004. Additionally, the statutory deposit to be maintained with SBP has been raised to the higher of PRs10 million or 10% of the paid-in capital. Under the new legislation, audited accounts have to be submitted within 4 months of the end of the period to which they relate. Limits prescribed on commission and expenses of management have also been eliminated. Provisions in the new ordinance have been made for an insurance ombudsman and the constitution of an insurance tribunal. 31. The recent reforms initiated are starting to have an effect on the insurance industry, although many of its provisions are being phased in, and implementation of some existing requirements is as yet not as robust as it could be. SECP’s Insurance Division has been established with a commissioner at its head and has acquired a number of staff. It does, however, experience difficulties due to the lack of professional insurance experience available to it. Both the regulator and the companies are feeling their way in the new structure, and a corpus of guidance and interpretation needs to be established. The implementation process also remains incomplete, since rules have not yet been gazetted. Until this is in place the regulator has only limited information on which to base its analysis of a company’s position. 32. Under the new Insurance Ordinance, compulsory reinsurance cession to Pakistan Reinsurance Company Limited (PRCL) has been reduced to 15% and will be eliminated by 2004. Insurers are still required to give PRCL first refusal of a proportion of excess reinsurance cover. In addition, insurance companies are being expected to get themselves reinsured by "A" rated insurance companies. SECP is also reviewing a proposal for insurance companies to get their insurance claim paying ability rated by rating companies like PACRA. Several insurers among the group of small, low-capitalized companies have been placed on notice of regulatory action for failure to obtain adequate reinsurance arrangements. 33. As has been the case worldwide, Pakistan insurers have been faced with rising reinsurance costs. In the case of terrorism insurance, insurers have been unable to obtain reinsurance cover at all, and as a consequence have largely withdrawn terrorism cover from their own policies. While the immediate impact of this withdrawal of cover may be limited so far as concerns the majority of domestic insurance coverage, the impact is significant for major risks, where insurance coverage tends to be a condition of financing. The absence of coverage for terrorism risk may effectively prevent the raising of finance for future projects, and endanger the sustainability of existing investments.

Appendix 2

33

PROCESSING APPROACH, BACKGROUND STUDIES AND CHRONOLOGY 1. In supporting the Government to formulate the Financial (Nonbank) Markets and Governance Program, the Asian Development Bank (ADB) has followed a process-based approach with intense stakeholder consultation. There is considerable understanding within Pakistan of the issues impeding financial markets development, both in the public and private sector, and no shortage of proposals for solution. However, despite a common vision and desire of all stakeholders to see markets progress, views are diverging on how best to achieve progress. This is often influenced by conflicting short-term interests and different assessment of constraints and needs. Thus, ADB’s role in formulating the Program has not been a prescriptive one, but rather to foster an educated dialogue that has led to agreement on a structured reform agenda with broad-based support by all participants. The Program seeks commitment from and offers an opportunity to the various parties involved to make a contribution to the reform process within a comprehensive overall framework. 2. The program content is based on intensive consultation and insights gained by ADB through ongoing dialogue over the past few years with senior public and private sector stakeholders, as well as the analytical work carried out in conjunction with the implementation of the first Capital Market Development Program. Background studies were carried out under

(i) TA 2812: Interest Management of the National Savings Scheme (Final Report, 1999);

(ii) TA 2865: Restructuring of Public Sector Mutual Funds (Final Report, 1999);

(iii) TA 2866: Reform of the Insurance Industry (Final Report, 2000);

(iv) TA 2867: Reform of Pension and Provident Funds (Final Report, 2001);

(v) TA 3559: Enhancing Capacity Market Depth (including a survey on market impediments and a high level workshop with extensive private sector participation held in September 2001); and

(vi) TA loan 1577: Capacity Enhancement of the Securities Market, including reports for Corporate Development for the Securities and Exchange Commission of Pakistan, Building of a Self-Regulatory Structure for the Stock Exchanges, Development of the Mutual Funds Industry, and Development of a Secondary Debt Market.

3. The following key processing steps were involved in formulation of the program:

(i) Reconnaissance Mission: 26 February to 6 March 2002;

(ii) Fact Finding Mission: 6 to 24 May 2002;

(iii) 1st Management Review Meeting: 1 July 2002;

(iv) Appraisal Mission: 13 to 25 August 2002;

(v) Guarantee Committee Meeting: 12 September 2002;

(vi) 2nd Management Review Meeting: 20 September 2002; and

(vii) Loan Negotiations: 7-9 October 2002. 4. The core ADB team in charge of formulation the program and its associated assistance components comprised W. Liepach (Principal Financial/Capital Markets Specialist, Mission Leader), V.V. Subramanian (Financial Economist), M. Endelman (Cofinancing Specialist), and M. Good (Counsel). S. Hattori (Sr. Financial Economist), J. Smith (Insurance Consultant) and R. Zauner (Secondee) contributed to the Reconnaissance and Fact-Finding missions, respectively.

Appendix 3

34

EXTERNAL ASSISTANCE

A. Development Coordination Matrixa for the Financial Sector

Banking and Formal Credit (including SME and Trade

Finance)

Capital Markets, Corporate Governance, and Nonbank

Financial Institutions

Rural and Microfinance

Asian Development Bank

Improving financing mechanisms to extend availability of credit to SMEs and trade finance. • Financial Sector Intermediation

Loan ($150 million) • Small and Medium Enterprises

Trade Enhancement Facility (SMETEF)/Foreign Currency Export Finance Loan ($150 million)

• SMETEF/PRG for L/C Confirmation ($150 million)

• Equity investment in Pakistan Export Finance Guarantee Agency Ltd. ($2 million)

• Proposed SME Development Project

World Bank

Improving financial markets, legal framework, banking regulations, banking court system, and regulatory and market mechanisms. • Financial Sector Deepening and

Intermediation Project ($216 million)

• Banking Sector Technical Assistance ($26.5 million)

• Banking Sector Adjustment and Privatization Project ($250 million)

• Structural Adjustment Credit (including Banking Sector Reforms), Phases I & II ($350 million+$500 million)


Strengthening legal, regulatory and supervisory framework, governance, operations and infrastructure of capital markets, insurance sector, and contractual savings. Support through TA for policy advisory and capacity building of key sector institutions. • Capital Markets Development

Program ($255 million, including TA for related capacity building)

• Proposed: Financial (Nonbank) Markets and Governance Program ($266 million, including TA for related capacity building)

International Finance Corporation

Direct investments into nonbank financial intermediaries, including capital market institutions, leasing companies and investment banks. Others • United Nations Development

Programme (for Corporate Governance).


Microfinance policy, microfinance legislatiion, supervisory and regulatory arrangements, institutional strengthening, and onlending support. Support for community organization, skills development, and community infrastructure. • Microfinance Sector Development

Program ($150 million) • Proposed Rural Finance Sector

Development Program World Bank

Wholesale funds to nongovernment organizations for microcredit community organization, capacity building, and rural infrastructure. • Pakistan Poverty Alleviation

Project ($90 million)

Others • Canadian International

Development Agency; Department for International Development (United Kingdom); Swiss Agency for Development Cooperation; and United Nations Development Programme.

International Monetary Fund

Poverty Reduction and Growth Facility (SDR1.03 billion: Higher allocations for poverty alleviation, revenue enhancements, financial sector reform, restructuring and privatization of public enterprises, and governance and transparency. SME = small and medium enterprise, TA = technical assistance, PRG = political risk guarantee, L/C = letter of credit. a Only major recent or ongoing interventions.

Appendix 3

35

B. External Assistance for Financial Sector Development (since 1995)

Institution/Project Type Year

Approved Commitment

Amount ($ ‘000)

Asian Development Bank Financial Sector Intermediation Loan 1995 100,000Capital Market Development TA 1995 865Capital Market Development Program Loan 1997 250,000Capacity Enhancement for the Securities Market TA Loan 1997 5,000Capital Market and Insurance Law Reform TA 1997 100Reform of the Insurance Industry TA 1997 700Restructuring of Public Sector Mutual Funds TA 1997 800Reform of Pension and Provident Funds TA 1997 600Rural Microfinance TA 1997 600Microfinance Sector Development Program Loan 2000 150,000SME Trade Finance Enhancement (SMETEF) Foreign Currency Export Financing Loan 2000 150,000SMETEF Letter of Credit Confirmation Facility PRG 2000 150,000Pakistan Export Finance Guarantee Agency Ltd. Equity 2000 2,000Enhancing Capital Market Depth TA 2000 150Institutional Strengthening of the State Bank of Pakistan TA 2001 450Capacity Building for Capital Market Development and Corporate Governance TA 2001 600SME Sector Development Program TA 2002 800

World Bank / International Development Agency Financial Sector Deepening and Intermediation Loan 1995 216,000Banking Sector Adjustment Loan Loan 1997 250,000Structural Adjustment Credit (including Banking Sector Reforms) Loan 1999 350,000Structural Adjustment Credit II (including Banking Sector Reforms) Loan 2002 500,000

SME = small and medium enterprise, PRG = political risk guarantee, TA = technical assistance.

Appendix 4

36

PROGRAM FRAMEWORK

Design Summary Performance Indicators and Targets

Monitoring Mechanisms

Assumptions and Risks

Goal � Contribute to poverty reduction and facilitate private sector-led economic growth through productivity improvement and more efficient financial intermediation as well as enhanced social protection.

� Increase monetary assets to gross domestic product (GDP) ratio.

� Increase investment and saving rates.

� Increase corporate securities issues.

� Increase market capitalization and trading volume.

� Increase insurance and pension funds assets/GDP ratio.

� Increase international portfolio investment.

� Economic and financial sector statistics. � Annual Reports of SBP and SECP

� Political and macro-economic stability.

� Sustained strong commitment of the Government to financial sector reforms

� Credible implementation of reforms under the FMGP increases investor confidence.

� Acceptance of new financial instruments by the market

� Sufficient skills developed to market and manage new instruments

Purpose/Objectives 1. Strengthen investor confidence through improved governance, transparency, and investor protection. 2. Increase depth and diversity of financial intermediation through new capital market issues for savings and investments. 3. Increase operational efficiencies and risk management of intermediaries. 4. Reduce financial sector vulnerabilities. 5. Strengthen fiscal position and sustainability.

� Number and quality of new standards issued, and amendments to rules and regulations � Number of enforcement actions by SECP � Compliance of intermediaries with solvency margins and capital requirements � Number of new securities issues � Number and turnover of actively traded stocks and TFCs � Transaction costs in capital markets � Spreads for bid/offer quotes � Foreign portfolio investment � Ease of access to nonbank saving products � Consolidation of DFIs through closure or mergers � Establishment of specialist reinsurance company

� SECP/SBP statistics and reporting by stock exchanges � Circulars/directives issued by SECP/SBP � Annual report by SECP/SBP � Periodic progress reports by MOF � ADB review missions and feedback from market participants

� Strong leadership, independence and capacity of SECP; SECP able to recruit and retain competent staff � Government support for legislative reforms and increased private sector participation, including privatization of state-owned institutions � Stock exchanges committed to reform and demutualization � Overseas investors willing to invest in Pakistan's capital markets � Stability of the Pakistan rupee � No foreign exchange restrictions for foreign investors on convertibility and transfer

ADB = Asian Development Bank, FMGP = Financial (Nonbank) Markets and Governance Program, SBP = State Bank of Pakistan, SECP = Securities and Exchange Commission of Pakistan, MOF = Ministry of Finance, DFI = development finance institution, TFC = term finance certificate.

Appendix 4

37

Outputs 1. Conducive fiscal and policy framework 2. Effective regulatory and governance framework with enforcement mechanisms 3. Transparent and competitive financial markets 4. Improved access and variety of saving and investment instruments 5. Efficient and effective institutional investors 6. Enhanced and more sustainable social protection nets 7. Reduced government involvement in financial operations of NBFIs, including insurance and pensions 8. Fewer but financially sound NBFIs

� Tax rates for financial instruments and investors streamlined � Reduction in NSS interest rates relative to other (riskier) instruments � Legislative and regulatory framework updated � Information and price disclosure to public � Reduction in issuance and transaction costs � Public availability of real-time pricing information at affordable cost (e.g., through Internet) � Liquidity and volume of secondary market trading � Number of retail outlets and Internet-based providers offering investment products � Availability an use of hedging instruments (futures, swaps, and options) � Use of money market instruments � Growth in life insurance and pension funds � Number of unit and policy holders � Ownership and nomination of outside directors by Government in SLIC, NIC, EOBI and other NBFIs � Mergers and closures of NBFIs

� Annual government budget announcement and notification of tax-related SROs � FMG Program website (maintained by SECP) � SECP/SBP statistics � SECP/SBP annual report � Progress reports by MOF � Report by facility agents on PRG utilization � ADB review missions

� SECP has adequate capacity for regulation and enforcement. � Willingness by issuers and investors to develop new products and markets � SBP to disclose price information on secondary market trading in government instruments and promote development of money and bonds markets � Willingness of international investors to accept ADB guarantees � Documentary ease of use for the PRG facilities

NBFI = nonbank financial institutions, NIC = National Insurance Company, NSS = National Savings Scheme, PRG= political risk guarantee, SLIC = State Life Insurance Corporation, EOBI = Employee's Old-Age Benefits Institution, SRO = Statutory Rules and Orders.

Appendix 4

38

9. Improved skills base of market participants 10. Increased international interest and investment in Pakistan's capital markets 11. Access to reinsurance for noncommercial risks

� Professional standards established and continued education programs in place; number of participants and graduates � Foreign portfolio investments and underwriting of new issues � Policies written, premium level and income from terrorism-related insurance

Inputs and Activities 1. $260 million funding by ADB to finance adjustment cost 2. $3 million TA loan for strengthening regulation, enforcement, and governance of financial markets 3. $3 million TA loan for strengthening pension, insurance, and saving systems

� Compliance with policy matrix � Advice to SECP to review, draft, and administer policies, rules, regulations, and procedures for introduction/utilization of new instruments, investors, and markets � Advice to government-owned savings institutions and pension schemes to improve policies and operations � Training of key staff � Organization of stakeholder workshops

� Regular progress reports, statistics, and review missions

� Adequate and timely provision of skilled staff and facilities � Project ownership by SECP, SBP, government ministries, and private sector � Active dialogue with private sector

4. Provision of up to $25 million PRG facility by ADB and $125 million coguarantees to cover transfer and convertibility risk of international investors 5. Provision of $175 million PRG facility to ensure access to selected violence-related insurance that is not commercially available 6. Continued dialogue with stakeholders to effectively promote new financial instruments and markets

� Appointment of facility agent and conclusion of legal documentation as well as pricing structure � Number and amount of PRGs issued for investment cover � Number of workshops and seminars conducted and attendance; number of comments via Internet on SECP website

� Follow up and facilitation by ADB staff and private sector parties

� Continued and consistent government and private sector support.

.J

~

SHAUKAT AZIZMinister for Finance& Economic Affairs

Mr. Tadao ChinoPresidentAsian Development BankManila, Philippines

-- DEVELOPMENT POLICY LETTER

Dear Mr. President,

Let me thank you for the continuing support of the Asian Development Bank and your

own keen interest in promoting economic growth of Pakistan. Given the critical role of the

financial sector in the growth process, the Government of Pakistan, as a part of its reform agenda

during the last three years, has been consistently improving the governance among the banking

and non-banking institutions.

Resultantly, direct government involvement in the operation of financial markets has

been substantially reduced and a sustainable regulatory and institutional framework has been

established. In this regard ADB Capital Markets Development Programme (CMDP) was of great

assistance. The establishment and operationalization of Securities and Exchange Commission of

Pakistan (SECP) as an effective regulator has been a singular achievement of this programme.

Besides the up gradation of market infrastructure and automation of trading, clearance and

settlement systems and establishment of a central depository system, a great progress has been

made in reforming the National Savings Scheme (NSS), privatization of government-owned

Appendix 5 39t'.(.\ , -r.1'~\

\'I. \I!'.\~.::J" ~J' .sW~

ISLAMABAD

November 11th 2002

40

~-:-cmutual funds, strengthening of the capital base of leasing and insurance companies, anddevelopment of a corporate bond /TFC market. '

Over the past years, financial markets have integrated globally and become increasingly

complex. The new challenges and opportunities require us to respond in a dynamic and flexible

way. The Government has thus developed a set of measures under the Financial (Nonbank)

Markets and Governance Programme (FMGP) which will help Pakistan to take advantage of

these developments in the global market. This programme ~ill be implemented with the

assistance of ADB over the next three years.

The FMGP is a comprehensive set of measures comprising policy reform, capacity

building and selected incentives to increase international private sector participation with a view

to support sustainable development of Pakistan's nonbank fmancial markets.

The Programme aims at achieving three key objectives. First, it seeks to position, .'

Pakistan as a credible financial market for investors by improving investor confidence through

better governance, transparency and risk management. Second, it seeks to both broaden and

increase the depth of the market in Pakistan, by strengthening secondary market activity,

channelizing funds safely and efficiently into investments particularly from the pension funds

and insurance industry. Third, the Programme seeks to diversify intermediation from the bankipg

sector, and reduce financial sector and fiscal vulnerabilities.

To implement the reform Programme, the FMGP has been structured around the

follOVfing components:

(i) Measures to improve the fiscal, interest rate and investment policy

environment. The"se measures seek to provide a level playing field among various

market participants. Important measures have already been announced in the Budgets for

FY 2002 and FY 2003, and include rationalization of tax treatment for financial

instruments and investors; adjustment of NSS rates and removal of distortions of foreign

exchange transfer for reinsurance. Measures to be taken i~ 2003 and 2004 will further

rationalize the tax treatment.

(ii) Measures to improve governance, transparency and professional standards.

These measures seek to strengthen investor confidence and credibility of the financial

markets. Important measures that have already been taken over the past year include the"

streamlining of responsibilities for policy formulation and regulation within the

""':'::'~":_' ,JContinuation Sheet

:)

::. I

government as well as further improvements in the mandated governance structure of

SECP itself and the corporate sector. A Code of ,corporate Governance has been adopted

by the stock exchanges and is being applied to all listed companies. The boards of the

stock exchanges have been reorganized to allow greater representation to non-member

directors. Risk management practices and prudential standards for nonbank

inteffi1ediaries have been raised and dispute resolution mechanism between brokers and, "

investors improved. Measures to be implemented over ,the next two years will further

improve the lega~ framework for financial transactions and corporate affairs and enhance

SECP's capacity for Tegulation and market surveillance.

(iii) Measures to improve the supply for financial instruments and improve the

market structure. These measures aim,at promoting new equity and debt issues as well

as new instruments, to develop yield curve and facilitate risk management.

(iv) Measures to develop contractual savings and institutional investment to

increase demand for fi~ancial instruments. These measures aim at increasing resource

mobilization from retail, investors. To ,this ,end, the Government is upgrading the

regulation of mutual funds; providing equal tax treatment and transferring management

of some of the government-controlled mutual funds to private sector.

(v) Measures to strengthen financial services and institutions. These meas~es,

seek further consolidation of the nonbank financial institutions including leasing,

development finance institutions, and the insurance sector. Recently, the government has

allowed tax deductibility..of mergers and carrying forward of losses for merged entities to

encourage mergers. The Government has also reduced the number of government-owned

development finance institutions through liquidation (BEL and FBC) or merger

(RDFC/SBFC/ NDFC). NIT is in the process of being privatized while ICP is being

wound up. Over the next two years, the regulatory framework and supervision ofNBFls

and the insurance sector will be further strengthened. IDBP will be privatized or

liquidated. Public sector involvement in commercial insurance operations will be

reduced.

The carrying cost of refoffi1s already initiated and planned for the next two to three years

under the FMGP will be considerable both in teffi1s of foregone tax revenues and direct

expenses. At the same time, technical assistance will be required for capacity building. To

finance these activities, the Government of the Islamic Republic of Pakistari request a Financial

Appe~dix 5

ContInuation Sheet

41

Appendix 542

(Nonbank) Markets and Governance Programme Lo~ of $260 million, as ~ell as ~o technical

assistance loans of $3 million each for strengthening regulation and governance of nonblank

financial markets; and improving the pension, insurance and savings systems.

Additionally the Goveffilnent requests the ADB for two political risk guarantee facilities

(i) to en11ance international capital flows into Pakistan's financial market through institutional

channels, for up to $25 million; and (ii) to enhance cover for selected violence-related risks to

sustain investment and fmancial sector stability fQr up to $175 million. The latter will assist

companies operating in Pakistan to cope with the reinsurance requiryments, following terrorist. .

attacks in tile United Sates on 11 September 2001.. After mutual discussion the Government may. .

also consider counterguara 'eeing the political risk guarantees issued by ADB under these two

facilities.

Let me Mr. President thank you once mo.re for your support and hope that the Financial

Sector Governance Programme Loan will be considered favourably by ADB Board at an early

date.

With best regards

., ! '4.,;

on SheetContinuati

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C'o.

~

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" ;. Shaukat !2..ziz .

Minister for Finance and Economic Affairs

,,'

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Appendix 5

43

Policy Matrix

1st Tranche Condition 2nd Tranche Condition I. Improve fiscal, interest rate and investment policy environment

(1) Rationalize tax treatment for financial instruments and investors: � Apply uniform income tax and move towards uniform withholding tax treatment on interest income from all saving and debt instruments. � Eliminate tax on bonus shares from listed companies. � Exempt options or right to acquire shares under Employee Shares Scheme from income tax, unless exercised or transferred. � Eliminate tax discrimination among institutional investors and multiple taxation for investment through collective investment schemes, including mutual funds. Undertake to rationalize tax treatment to allow mutual funds to retain (rather than distribute) capital gains, for consolidation of their financial position and growth of net asset value (NAV). � Eliminate tax discrimination of insurance companies: provide for equal tax treatment of dividend income; and CBR, SECP and insurance industry to initiate study to appropriately capture income of insurance companies under the various Heads of Income in the Income Tax Ordinance, including tax treatment of savings component in life insurance policies.

(1) Further rationalization of tax treatment for financial instruments: � Rationalize stamp duties. Federal and provincial governments to clarify stamp duty on convertible bonds and securitized debt to avoid double levying; lower stamp duties for corporate paper to internationally competitive rates. Investment banks not to be taxed on profits distributed on portfolio management. By issuing notifications with revised rates or taking other relevant action acceptable to ADB. (June 2003) � Equal withholding tax treatment on interest income from all saving and debt instruments by including appropriate measures in the Finance Act 2003 or other legislation. � Implement recommendations of study on income tax treatment for insurance companies. (June 2003)

(2) Adjust fiscal measures to promote long-term capital formation: � Allow income tax deduction for contributions to SECP-approved annuity schemes of life-insurance companies of up to PRs100,000 per annum (or 5% of income) to promote old-age protection and life insurance. � Allow income tax deduction up to PRs100,000 per annum for mark-up (interest) payments on housing loans to promote housing finance and mortgage markets.

(2) Further adjustment of fiscal measures to promote long-term capital formation: � Extend capital gains tax exemption beyond FY2004 only for investments held more than 6 months through the Finance Act 2004 or other appropriate legislation. � To promote capital formation through pensions/contractual savings, exempt from income tax new voluntary contributions by individuals to approved private provident fund and pensions schemes, up to PRs100,000 and provide that annuities from these investments be made taxable as income, through the Finance Act 2003 or other appropriate legislation. � To strengthen capital base of the insurance industry, allow tax deductability for transfer of profit to special reserves (up to a prescribed maximum level), with taxation to be levied upon utilization of reserves, through the Finance Act 2003 or other appropriate legislation. � To develop venture capital (VC), review and rationalize incentive structures for sustainable operations of VC Companies. (June 2004)

(3) Adjust NSS rates to more market-based benchmark mechanism: Further refine adjustment mechanism for NSS rates (for new investments) to better align this to an accepted benchmark (such as the yield curve). Reduce yield for early redemption through higher encashment premiums.

(3) Improve administrative efficiency of NSS: improve governance structure and administration of NSS/CDNS. Based on the recommendations of the TA loan for Pensions, Insurance and Savings (TA1), move NSS towards a funded system invested in government securities (for new investments); and computerize collections following a timeframe developed under TA1. (October 2004)

(4) Rationalize investment eligibility criteria for securities. Redefine statutory liquidity requirement (SLR) eligibility of various instruments for financial institutions to ensure level playing field. Undertake to remove special privileges for NIT/ICP on privatization. Allow approved mutual funds and investment schemes to qualify for investments by charitable, trust, welfare or provident fund institutions.

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1st Tranche Condition 2nd Tranche Condition (5) Remove distortions in foreign exchange transfer for reinsurance. Remove bar on remission abroad of life insurance premiums for accidental death risk.

II. Improve governance, transparency, and investor protection

(6) Clarify responsibilities and strengthen coordination for financial sector policy formulation and regulation: � Review and streamline policy and regulatory responsibilities and improve coordination of government ministries and regulator for financial sector (including NBFIs, insurance, and pensions). Further reduce direct government involvement in regulatory and operational matters, including delegation of regulatory powers for insurance to SECP. � Appoint a full-time government actuary (at market salary) to provide advice to the Government on actuarial matters, which may include public pensions, insurance, and risk management.

(4) Improve legal framework for financial transactions and corporate affairs: Based on the recommendation of the TA loan for Regulation, Enforcement and Governance of Financial Markets (TA2), (i) develop, enact and bring into force laws and regulations for enhanced transparency in financial transactions and corporate affairs, which may include new legislation for anti-money laundering and corporate insolvency; (ii) amend the Companies Ordinance, 1984 to further improve corporate governance standards, the Trust Act, 1888, for modern investment needs, the SECP Act 1997, the Securities and Exchange Ordinance 1969, the Central Depository Act 1997, and other laws as identified under TA2; and (iii) transfer selected powers of High Courts in relation to implementation of Companies Ordinance as appropriate. (June 2004)

(7) Enhance mandate and governance structure of SECP for broad-based regulation of financial markets and services: � Review existing structure and composition of Commission and Policy Board. � Assign regulatory powers for private pensions to SECP. � Review selected powers of High Courts in relation to implementation of Companies Ordinance for possible transfer to SECP.

(5) Enhance SECP capacity for market surveillance, and regulation and supervision of NBFIs: SECP to (i) recruit further market professionals with industry knowledge; and (ii) upgrade surveillance systems and procedures for on- and off-site inspection. (June 2003)

(8) Improve corporate governance standards. � SECP to develop (through stakeholder participation) and introduce corporate governance code to be applicable to the corporate sector, financial intermediaries and related professions. � Stock exchanges to update listing regulations to apply corporate governance code for listed companies; and start enforcement through delisting of noncompliant companies. � Update corporate governance provisions in Companies Ordinance, 1984.

(6) Enforce corporate governance code: SECP to devise effective enforcement mechanism, including adequate enforcement powers and sanctions, and monitor adherence to corporate governance code based on TA2 or other TA provided to SECP. SECP to ensure that stock exchanges delist non-compliant companies from the main board. Government to further amend legislation as required to extend application of relevant provisions of corporate governance code to companies beyond listed companies. (June 2003)

(9) Improve information disclosure standards and transparency in market transactions: Require quarterly reporting by listed companies of accounts and encourage financial projections in offer documents/ prospectus; make price relevant information available simultaneously and timely to all interested parties, including general public.

(7) Improve quality in information disclosure: SECP in coordination with ICAP and other relevant professional groups, to (i) strengthen professional standards for accounting and auditing firms providing services to listed corporations; (ii) develop statutory code of conduct for accounting and auditing firms providing services to listed firms; and (iii) enhance clarity and transparency in corporate financial information. (June 2003)

(10) Improve governance of stock exchanges and other capital market intermediaries: � Revise stock exchange board constituents and nomination/ selection procedures. � Initiate structural reforms for stock exchanges, including dialogue with SECP on different models for demutualization/ integration of stock exchanges. � SECP to request stock exchanges to regulate proprietary trading of brokers and separate investor accounts from broker accounts. Encourage opening of investors account with depository (i.e., CDC, or other identified depository participants as licensed by SECP).

(8) Further reform structure of stock exchanges: � SECP and stock exchanges to develop a comprehensive plan to encourage stock exchange demutualization and integration, to facilitate establishment of electronic communication networks (ECNs) and alternate trading systems (ATSs) for establishment of a national market. SECP to issue guidelines and regulations for operation of demutualized and new markets. � SECP to work with exchanges for OTC market to (i) introduce unified trading system as well as electronic system for second tier board; (ii) prescribe minimum capital size, minimum issue/offer size, disclosure norms, and compliance

i t (iii) i di ti ith t k h ( ) t

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1st Tranche Condition 2nd Tranche Condition requirements; (iii) in coordination with stock exchange(s) set up

a screening mechanism for screening companies prior to all IPOs; (iv) make market making mandatory for new issues at the OTC market up to a certain period; (v) adopt code of ethics for the companies, auditors and brokers; (vi) promote trading of debt securities on the OTC market. (November 2003)

(11) Strengthen prudential and risk management standards for nonbank financial intermediaries: � For capital market intermediaries: Introduce capital adequacy and issue guidelines for broker licensing; increase minimum capital requirements for brokers and fixed exposure limits; review margin requirements for the futures and cash market operations, with segregation of trading and clearing house members; review minimum capital requirements for clearing house members. � For the insurance industry: introduce mandatory rating for insurance companies of claims payment capacity; limit exposure (gradually) for illiquid assets relative to total assets in insurance to 25% for non-life and 10% for life insurance companies; enforce capital and solvency requirements in particular for nonlife business, to support industry consolidation and strengthening; phase out the quota-share compulsory cession to PRCL (to remove unnecessary cession below existing retention capacity).

(9) Further improve efficiency in trading and operational risk management practices: � SECP and stock exchanges to (i) thoroughly review the existing system of badla trading and its impact on market distortions and volatility; (ii) develop a time-bound plan to gradually phase out current badla system through introduction of established systems for margin trading; and (iii) promote establishment of institutions for stock lending and provide regulations. � Stock exchanges to regulate proprietary trading of brokers and separate investor accounts from broker accounts. � SECP to coordinate development of the derivatives market, and issue guidelines for web-based trading in capital market instruments, considering recommendations of TA2 or other TA. � SECP to (i) coordinate improvements in clearing and settlement infrastructure, including work with National Clearing Company (NCC) to upgrade clearing house information and provide real time information on client exposure with different brokers; (ii) issue rules for NCC; and (iii) encourage dematerialization of securities (to increase efficiency in clearing and settlement, and reduce incidence of fake securities). (November 2003)

(12) Improve dispute resolution mechanism between brokers and investors: Stock exchanges to issue regulations.

(10) Develop professional standards, qualifications and continued education: SECP and private sector to establish an institute for corporate governance (or similar) and/or develop continued education programs with established institutions (based on recommendation of TA2 and/or other TA provided). SECP and professional bodies to (i) enhance their public education programs; and (ii) encourage professional qualification for stock brokers, investment analysts, fund managers, insurance agents, and other relevant professionals. (June 2004)

III. Increase supply of financial instruments and improve market infrastructure

(13) Introduce new market for smaller and less frequently traded companies: SECP/Exchanges set up a second tier board/over-the-counter (quote-driven) market to attract smaller companies and new IPOs. Announce listing requirements.

(11) Improve supply of equity issues through privatization: GOP to float/offload shares of at least 5 state-owned enterprises (SOEs) on a stock exchange from any 3 sectors (which may include banking, insurance, transport and communications, oil and gas, power), to significantly increase market capitalization. (November 2004)

(14) Introduce financial hedging instruments and markets: � SECP/exchanges to introduce appropriate instruments for hedging. Review and update regulations to facilitate trading in futures. Deepen futures market by adding further scrips. � SBP to initiate concept paper for development of interest rate swaps.

(12) Improve secondary debt market activity: SECP and SBP to (i) facilitate and promote active market making in corporate debt securities, PIBs, and CPs; (ii) improve clearing and settlement, and information disclosure on market activity including pricing; and (iii) introduce designated market maker system. Government to adhere to T-Bill targets and borrowing plan. (November 2003)

(15) Develop money markets: SBP/SECP to initiate introduction and development of commercial paper (CP) market, including identification of key issues.

(13) Further develop money markets: SBP/SECP to issue guidelines for CP. Guidelines to permit investments by banks and pension/ provident funds in CP. Based on recommendations of TA2, take appropriate steps for promoting discount houses. (June 2003)

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1st Tranche Condition 2nd Tranche Condition (16) Promote bond market (PIBs and TFCs): � Review operations of existing primary dealers (PDs) for improving secondary market operations in PIBs, including minimum turnover commitment and two-way quotes and allowing independent securities firms as PDs for PIBs. � SBP to introduce PIB "Jumbo issues" to reduce fragmentation of issues and improve liquidity. � SBP/SECP/Exchanges to improve dissemination of information on secondary market trading on fixed income securities. SBP to publish information on secondary market trading in government securities.

IV. Increase demand for financial instruments by developing contractual savings and institutional investment

(17) Upgrade regulation for mutual funds: Amend Investment Advisor Rules (IAR) to allow closed end mutual funds to be established under the Trust Act. Integrate IAR and Asset Management Rules (AMR) within the framework of the proposed new NBFC rules.

(14) Promote private pensions: Taking into account recommendations of TA1 and TA2, Government in coordination with relevant stakeholders to (i) develop and introduce legal, regulatory and tax framework for private pension plans; and (ii) standardize relevant accounting and information disclosure standards. (November 2003)

(18) Clarify and streamline regulatory responsibilities for pensions: Assign explicit regulatory responsibility for private pensions to SECP.

(15) Improve operational efficiency of large government controlled institutional investors (EOBI, SLIC): Taking into account recommendations of TA1, Government to (i) review and amend EOBI Act; (ii) outsource investment management to private sector with well defined guidelines and controls, and improved administrative processes; (iii) review and align performance structures that allow to recruit and retain professionals with relevant expertise; and (iv) for SLIC, strengthen investment management, internal administrative processes and field office operations. (June 2004)

(19) Liberalize investment restrictions for institutional investors: lower the mandatory requirements for insurance companies and pension and provident funds to invest in government securities, and allow investments in listed securities, rated corporate debt and mutual funds up to 60% of investible funds.

V. Develop related financial services and institutions

(20) Promote corporate and financial restructuring and consolidation: Encourage mergers and restructuring of financial institutions by allowing tax deduction of merger cost and carry forward for losses of merged entities. In case of merger of financial institutions that carry on different businesses, the business losses of the merged entity as well as the cost of the merger will be allowed as deductible expense to the surviving entity to encourage consolidation in particular in the financial sector.

(16) Strengthen regulatory framework and supervision for NBFIs, including housing finance and development of mortgage markets, investment banking, leasing, asset securitization and insurance. SECP to further improve rules and regulations for NBFIs and the insurance industry as appropriate, based on experience in implementation and considering recommendations of TA2. (November 2003)

(21) Reduce government dominance and dispose of DFIs through sale or merger: Restructure IDBP, including (i) finalization of draft legal documents for conversion into public limited company under Companies Ordinance; (ii) initiate transfer of nonperforming loans to CIRC; (iii) substantive progress in audit for FY2002; and (iv) reduction of staff strength through VRS.

(17) Sell IDBP to private sector: Government to either (i) sell IDBP to private sector purchaser(s); or (ii) if no buyer can be found, Government to liquidate IDBP. (October 2003)

(22) Improve governance of government-controlled insurance companies: Boards of SLIC, PRCL, and NICL to adopt corporate governance code.

(18) Reduce public sector involvement in commercial insurance operations: Government to (i) reduce monopolies accorded to NICL, and eliminate compulsory cession and initiate gradual elimination in a phased manner of ‘first refusal’ cession entitlement for PRCL; (ii) convert SLIC to public limited

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1st Tranche Condition 2nd Tranche Condition cession entitlement for PRCL; (ii) convert SLIC to public limited company under Companies Ordinance and remove Government guarantee for contractual entitlements from new business by SLIC (through rescission of Life Insurance Nationalization Order, 1972); (iii) implement options for return of commercial insurance operations (including SLIC, NICL and Alpha Insurance) to the private sector for improved consumer choice and operational efficiency; and (iv) consider and initiate implementation of feasible options for regularising the position of Postal Life as a life insurance company under the Insurance Ordinance. (November 2004)

(23) Open general insurance market (for public sector property and activities): Initiate removal of NICL’s monopoly on public property business by gradually allowing private sector participation in underwriting of commercial public sector business.

(24) Enhance risk retention capacity for noncommercial risks and strengthen reinsurance: Develop and agree on concept for sustainable reinsurance arrangements for cover of terrorism-related and other noncommercial risks.

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ESTIMATE OF PROGRAM ADJUSTMENT COST (in PRs Million)

Item FY 02 FY 03 FY 04 FY 05 Total

A. Loss in Revenue

1. Capital Gains Tax Exemptiona 8,400 6,300 5,600 2,000 22,300 2. Carry forward and tax deduction of losses in case of mergerb

0 1,800 2,800 4,000 8,600

3. Other tax adjustment/exemptionc 0 200 500 500 1,500 4. Tax deduction for contribution for old-age savings (life insurance, pensions, housing)d

0 100 1,300 2,600 4,000

Subtotal A 8,400 8,400 10,200 9,100 36,100

B. Other/direct expenses

5. Interest payment due to adjustment in NSS ratese 0 -180 -180 -180 -540 6. Restructuring of IDBPf 5,000 12,000 0 0 17,000 7. Restructuring of other state-owned nonbank financial institutions, including EOBI, SLIC, CDNSg

0 0 500 1,500 2,000

8. Operation of regulatory infrastructureh 150 180 220 250 800 9. Support of guarantee mechanism to cover terrorism-related risksi

0 1,000 0 0 1,000

Subtotal B 5,150 13,000 540 1,570 20,260

Total Cost (in PRs million) 13,550 21,400 10,740 10,670 56,360

Total Cost (in $ million, @ PRs60/$) 226 357 179 178 939 NSS = National Savings Scheme, IDBP = Industrial Development Bank of Pakistan, EOBI = Employee's Old-Age Benefits Institution, SLIC = State Life Insurance Corporation, CDNS = Central Directorate of National Savings.

Note: Estimates are based on discussion for revenue projections by the Central Board of Revenue (CBR), past collections, and agreements and targets with the International Monetary Fund. Loss in revenue, in particular capital gains tax exemption, is sensitive to market movements and may be higher or lower depending on actual outcome. Revenue loss is estimated on assumptions as outlined below. Assumptions: a Assumes market capitalization at 30 June 2002 at PRs400 billion, vs. PRs296 billion on 30 June 2001. Less

allowance for new listed capital, bonus, and rights issues (totaling about PRs8 billion in FY 2002). Thus, unrealized capital gain is about PRs96 billion. Less 30% allowance for below taxable limit, net capital gain is PRs67.2 billion. Assuming 12.5% average income tax rate, tax foregone in FY02 would amount to PRs8.4 billion. For FY03 and FY04, lesser increase in market capitalization than in FY02 is expected (i.e., increase of 20% in FY03 and 15% in FY04 and FY05). In FY05, exemptions will only be granted to long-term investors with holdings longer than 6 months, estimated at 30% of total holdings.

b Total unrealized losses for nonbank financial institutions are estimated at PRs43 billion. CBR has assumed for budgetary purposes that PRs1.8 billion will be absorbed in FY02 through merger in the sector and subsequently be eligible for income tax deduction. Further increase due to increased merger activity is expected in FY04 and FY05.

c Includes turnover on savings components of life insurance policies by insurance companies without profit, and tax on securities listing and transactions.

d Assumes a nominal amount during the first year of introducing such schemes, and that benefits are being availed of in FY2004 by 0.25% of the population (25% of taxpayers) on average, taking up 30% of their benefit entitlement and average income tax rate of 12.5%. (This would mobilize about PRs10.5 billion in such schemes in 2004, compared with inflows of PRs40 billion in NSS by individuals in FY2002). Increase in FY2005 to 0.5% of population, and to 1% of population beyond this.

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e Assumes reduction in interest burden by 2% for 30% of new investments in NSS, estimated at PRs30 billion

annually. f Assumes conversion of PRs5 billion credit line by State Bank of Pakistan into equity in FY02 and injection of

additional PRs12 billion in FY2003. Includes voluntary retirement scheme (VRS) based on current practices for the financial sector.

g Assumes VRS in EOBI, CDNS, and SLIC (for total of less than 1,000 staff), improvements in pay structure, and computerization.

h Includes operation of SECP and staff development in key agencies. i Government contribution for establishment of terrorism reinsurance buffer fund.

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INELIGIBLE ITEMS 1. The proceeds of the loan will be utilized to finance the foreign exchange expenditures for the reasonable cost of imported goods (excluding any duties or taxes) required during the execution of the Financial (Nnonbank) Markets and Governance Program. All imported goods financed from the proposed loan must be produced in, and procured from, the Asian Development Bank member countries. 2. Notwithstanding the provisions of para. 1, no withdrawals will be made from the loan account in respect of the following: (i) expenditures for goods included in the following groups or subgroups of the United

Nations Standard International Trade Classification, Revision 3:

Group Subgroup Description of Items

112 ____ Alcoholic beverages; 121 ____ Tobacco, unmanufactured; tobacco refuse; 122 ____ Tobacco, manufactured (whether or not containing tobacco

substitutes); 525 ____ Radioactive and associated materials; 667 ____ Pearls; precious and semiprecious stones, unworked or

worked; 718 718.7 Nuclear reactors and parts thereof, fuel elements

(cartridges), nonirradiated for nuclear reactors; 897 897.3 Jewelry of gold, silver, or platinum group metals (except

watches and watch cases), goldsmiths’ wares or goldsmiths’ wares (including set gems); or

971 ____ Gold, nonmonetary (excluding gold ores and concentrates; (ii) expenditures for goods intended for a military or paramilitary purpose or for luxury

consumption; (iii) expenditures for pesticides categorized as extremely hazardous or highly hazardous in

Class 1a and 1b of the World Health Organization’s Classification of Pesticide by Hazard and Guidelines to Classification 4; or

(iv) expenditure for goods supplied under a contract that any national or international

financing institution or agency will have financed or agreed to finance including any contract under any loans from ADB.

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TECHNICAL ASSISTANCE FOR STRENGTHENING PENSION, INSURANCE, AND SAVINGS SYSTEMS

A. Background and Rationale 1. Pakistan’s pension system at present is fragmented, without a central framework for regulation or supervision, to encourage retirement savings and protection for beneficiaries. Although Pakistan does not at this time face the same urgent demographic pressures as some countries, the lack of a clear policy inhibits long-term labor and social security planning. Pension savings typically serve as a vehicle for financial intermediation and are of significant importance for capital market development. It is therefore appropriate to support the development of a policy that will encourage retirement savings through regulations and appropriate incentives. 2. Like many countries, Pakistan operates an unfunded pension scheme for its civil service and military personnel. This scheme is noncontributory, and benefits are linked to final salary. The scheme therefore has an unfounded liability representing the projected entitlements of existing pensioners until death and the accrued entitlements of those who are currently in work but who will become entitled to benefits on retirement. The amount of the unfounded liability is a hidden component of government debt. To assist in the management of this liability, an initial assessment is required of the projected cash flows under the system, following which an appropriate strategy may be desired. 3. The largest pension vehicle for workers is the Employee's Old-Age Benefits Institution (EOBI). It currently covers approximately one million workers in selected industry sectors and manages funds in excess of about PRs45 billion. Contribution compliance is patchy, management systems are very poor, and records are acknowledged to be incomplete. The scheme is run on a pay-as-you-go basis and is not financially sustainable over the long run in its present form. It has suffered from financial mismanagement and a high administrative cost structure. EOBI is currently under a new chairman, and has initiated reforms to improve its operational practices. An in-depth assessment of EOBI and its strategic options by external experts will support this process. Assistance would also be required for implementation of recommendations. 4. The potential for old-age savings through life insurance in Pakistan is poorly developed. The sector is dominated by the government-controlled State Life Insurance Corporation (SLIC). Overall reforms related to sector policies and governance of SLIC will be promoted under the Financial (Nonbank) Markets and Governance Program. On the institutional level, SLIC has under its new chairman started internal reforms to improve operational effectiveness and administrative efficiency. To further support these efforts, external assistance is required, particularly in the areas of investment management, field office operations, and computerization. 5. The Central Directorate of National Savings (CDNS) is the key agency for the administration of the National Savings Scheme (NSS). The scheme is currently on an unfunded basis. Records are kept primarily on a manual basis, which makes data consolidation and analysis administratively cumbersome and time consuming. Given the economic significance of the NSS – the total liability volume is about PRs700 billion – there is a need to improve debt management and administrative efficiency. In particular, the long-term implications of operating the NSS as an unfunded system within a market environment need to be assessed further, and options, e.g., for conversion into a funded scheme (with investments primarily in government securities) may be evaluated.

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B. Objectives and Scope 6. The objective of the technical assistance (TA) are to (i) assess key issues Pakistan is facing in managing pension and saving liabilities; (ii) recommend solutions to improve sustainability; and (iii) strengthen key public sector institutions involved in pensions, insurance, and savings mobilization. 7. The TA will comprise five components:

1. Establishment of an Overall Framework for Pension Provision 8. The TA will provide an in-depth analysis of the current framework (building on previous work already been done by the Securities and Exchange Commission of Pakistan, Ministry of Labor, and Asian Development Bank), which will serve as the basis for discussion among key stakeholders on the overall framework, with recommendations being formulated to identify long-term requirements for an adequate national pension and provident fund system in Pakistan and a strategy for achieving this during the next 10 years. The strategy recommended by the TA coordination committee should be formally adopted by the Government, together with an action plan for implementation to be developed under the TA.

2. Financial Assessment of Civil and Military Pension Schemes 9. During its first phase, the TA will assess the financial status and the sustainability of the civil service and military scheme and its overall fiscal impact on the government budget. As needed, the TA will outline options for redesign and will explore the financial feasibility of transition from a government pillar (pillar 1) pension scheme, to a multipillar pension scheme. It will assess the administrative, financial, and fiscal costs and benefits as well as risks and options for phasing in a second pillar;, and develop options for partial or full migration to such schemes by the government employees. It will also calculate the public sector transition costs to such schemes and estimate the long-term fiscal benefit.

3. Institutional Reform and Strengthening of EOBI 10. Based on an updated in-depth assessment on the operations and financial positions of EOBI (building on earlier work undertaken by ADB and the Ministry of Labor/EOBI), the TA will design a framework and present practical options with clear cost implications for modernizing EOBI into a more efficient, transparent, and sustainable private sector pension and provident fund system. The modernization plan will include timing and costing and be consistent with the broad context of strategic framework on pensions adopted by the Government. Subsequent to the formulation of the plan and approval by the relevant authorities, the modernization plan will be pilot tested at the headquarters and several selected branch offices.

4. Capacity Building for Investment Management of SLIC 11. The consultants will assist SLIC with the implementation of measures to improve its investment management, including development of investment strategies, performance parameters, internal controls, field office operations, and streamlining and computerization of operations. In particular, the investment management experts will assess investment policy, systems and procedures for funds management and develop and implement approaches that optimize returns with risks. The consultants will develop adequate benchmarks for performance measurement, and an effective control mechanism to ensure accountability and transparency in

Appendix 8

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operations. The consultants will also provide hands-on assistance to SLIC's top management in streamlining field operations in line with best international practices.

5. Institutional Reform and Strengthening of CDNS 12. The TA will assess institutional constraints of the NSS and recommend measures to improve transparency in financial management. It will assess the merits and feasibility of moving towards a funded scheme managed with a well-conceived investment policy in government securities. It will also assist in establishing basic parameters for such a move, and determine how the different schemes could be rationalized and the rates on small saving schemes made market oriented. The TA will also support streamlining, modernization and computerization of operations already initiated by CDNS. C. Cost and Financing 13. The total cost of the TA is estimated to be $4,500,000 equivalent, comprising $2,390,000 in foreign exchange costs and $2,110,000 equivalent in local currency costs. ADB will finance $3,000,000 equivalent, comprising the entire foreign exchange cost and $610,000 equivalent in local currency (Table A8).

Table A8: Cost Estimates and Financing Plan ($’000)

Item Foreign Exchange

Local Currency

Total Cost

A. ADB Financing 1. Consultants a. Remuneration and Per Diem i. International Consultants ii. Domestic Consultants b. Travel i. International ii. Local c. Communication and Reports 2. Equipment And IT Services 3. Local Transportation 4. Training Programs 5. Interest Charges 6. Contingency Subtotal (A) B. Government/Beneficiary Financing 1. Local Counterpart Staff 2. Counterpart Facilities: Office Space, Communications, Secretarial, and Related Services 3. Equipment 4. Local Transportation 5. Duties and Taxes 6. Contingency Subtotal (B) Total

1,380 0

105 0 5 300 0

200 100

300 2390

0 0

0 0

0 0 0

2,390

0 290

0

25 20 0 25

100 0

150 610

260 130

600 35

275 200

1,500 2,110

1,380 290

105

25 25

300 25

300 100 450

3,000

260 130

600 35

275 200

1,500 4,500

Source: ADB estimates.

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54

14. ADB will provide a loan in various currencies equivalent to SDR2,268,000 ($3 million equivalent) from its Special Funds resources with an amortization term of 32 years, including a grace period of 8 years, and with an interest rate of 1.0% per annum during the grace period and 1.5% per annum thereafter, and such other terms and conditions as are substantially in accordance with those set forth in the TA Loan Agreement. 15. ADB will finance 66.7% of the total cost of the TA, including international and domestic consultant services, a part of the cost of computer hardware and systems development, training programs and activities, as well as interest charges during implementation. The Government will finance 33.3% of the total cost, mainly for the counterpart budget of the executing and implementing agencies, including counterpart staff and facilities for the consulting team, taxes and duties on equipment, and taxes on consultants, as well as part of the computer equipment. D. Implementation Arrangements 1. The Executing Agency 16. The Executing Agency for the TA will be the Ministry of Finance. The TA will be implemented with support by other line ministries as appropriate, including the Ministry of Labor for pensions and the Ministry of Commerce, which will be implementing agencies (IAs) for components 3 and 4, respectively. The IAs for the various components will provide the necessary office space, counterpart staff, local transportation, and other services to the consultants. 17. MOF will establish and maintain separate accounts for the TA in accordance with accounting procedures acceptable to ADB. This will be audited annually by independent auditors in accordance with auditing standards acceptable to ADB. Certified copies of the audited accounts and financial statements and the report of the auditors will be submitted to ADB in English within 6 months after the end of each fiscal year. 2. Schedule, Reports, and Reviews 18. The TA is planned to commence as soon as practicable following the effective date of the TA loan, to be completed over a period of 18 month after inception and before December 2004. 19. Each component of the TA will be implemented in three phases. During the inception phase, the lead consultants of the various components will revalidate the policy objectives and assess priorities, key issues, and capacity-building needs on the governance, regulatory, and operational level. At the end of this phase, resource inputs may be adjusted as appropriate within the overall budgetary framework and TA scope, to better align the terms of reference, activities, and time-bound outputs with client expectations and needs. This will also include the refinement of performance parameters for the consultants. During the design phase, the consultants will formulate and detail the capacity-building and operational development plans. During the implementation phase, the consultant will implement and document required regulations, procedures, and systems, as well as arrange for training and skill development activities as appropriate. 20. The team of consultants will prepare an inception report on the respective components within 4 weeks of the commencement of their services, which will fine-tune and detail the work program and establish time-bound outputs. In addition to any full report required at the end of each individual component, the consultants and the IAs will submit quarterly progress reports.

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The final report, including complete documentation of all outputs, will be submitted within 3 months of the end of the assignment, after the comments of ADB and the Government have been incorporated. 21. In addition to regular and ongoing interaction among the IAs, ADB, and the consultants, a comprehensive midterm review will be undertaken jointly by ADB, the IAs, MOF and the consultants about 9 months after project inception to review all aspects of implementation. 3. Procurement 22. The computer hardware and software will be procured in accordance with the ADB’s Guidelines for Procurement. Each supply contract for equipment or materials estimated to cost the equivalent of more than $500,000 will be awarded on the basis of international competitive bidding. Each supply contract for equipment or materials estimated to cost the equivalent of $500,000 or less (other than minor items) will be awarded on the basis of international shopping. 4. Consulting Services 23. The TA will require about 103 person-months of consulting services, including 60 person-months of international and 43 person-months of domestic consulting services. Separate subcontracting of services of individual consultants or firms may be required for computerization under components 4 and 5 of the TA. The consultant team will include skills and expertise in (i) team leadership and change management; (ii) legal and regulatory frameworks for pension, insurance, and contractual savings systems; (iii) operation of funded and pay-as-you-go pensions systems; (iv) life insurance operations; (v) portfolio and investment risk management; (vi) accounting and auditing; (vii) actuarial science; (viii) information technology; and (ix) training and skills development. The team of consultants will be selected from reputable firms with proven track record in pension reform, insurance, and contractual savings and capacity building, and will be engaged in accordance with ADB’s Guidelines on the Use of Consultants under the quality-based selection method1 and other arrangements satisfactory to ADB on the engagement of domestic consultants. Separate subcontracting of services for individual consultants or firms, in addition to the main contract, may be required for specialist tasks. 24. Throughout TA implementation, the consultants will work closely with the counterpart staff from the IAs, maintaining active day-to-day communication. The international consultants will work closely with the domestic experts, who will advise on Pakistan’s legal and regulatory system and operational practices. Extensive field presence by the international consultants is expected. Pakistan nationals with relevant expertise and international experience are eligible for international consultant positions.

1 The quality-based selection method will be applied in light of the TA's nonstandardized nature and

emphasis on qualitative inputs.

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TECHNICAL ASSISTANCE FOR STRENGTHENING REGULATION, ENFORCEMENT, AND GOVERNANCE OF NONBANK

FINANCIAL MARKETS A. Background and Rationale 1. Regulation and governance of Pakistan's capital market and the corporate sector gained some credibility with the commencement of the Securities and Exchange Commission of Pakistan's (SECP) operations at the beginning of 1999. SECP’s role was further enhanced in 1999 when it was assigned regulatory responsibility for the insurance industry, and in 2002 when it was assigned regulatory responsibility for private pensions and other nonbank financial institutions (NBFIs), including leasing, housing, and investment banks. SECP has thus assumed a significant role. It is still a fairly new institution, and many of the functions it is performing were not done previously, or are done in a manner that requires a fundamental change. Given the critical importance of SECP for capital and nonbank financial markets, it is important that is has adequate capacity – skills, systems, and procedures – to effectively discharge its functions. 2. Previous technical assistance (TA)1 to SECP helped put in place the basic strategic, management, and administrative foundations for SECP. It also helped to raise prudential standards of key market participants and develop a national clearing and settlement system. Further than this, SECP has initiated on its own a number of measures to improve and restructure Pakistan’s securities markets, including structural reform of the stock exchanges and improvements in risk management. To ensure accountability and transparency in the corporate sector, SECP has formulated a code of corporate governance in coordination with the Institute of Chartered Accountants in Pakistan (ICAP). Further challenges arise with its newly enhanced mandate in insurance, pensions, and NBFI regulation and supervision. Beyond its regulatory and supervisory functions for investor and policyholder protection, SECP fulfills a development mandate. This also includes support for the development of professional standards and knowledge dissemination. 3. Despite these positive developments, the regulatory framework and institutional structure require flexibility to adapt to rapidly changing circumstances and emerging challenges. Given the fast changing nature and increasing complexity of modern financial markets, there is a need to further support the industry regulator and market participants to upgrade their skill base. B. Objectives and Scope 4. The TA will build on previous assistance already provided to SECP to support the sound and sustainable development of nonbank financial markets, application of proper risk management practices, and protection of investors and policyholders. The TA will include the review and update of the legal and regulatory framework as required, and building capacity within SECP for effective regulation through hands-on advice and training for (i) on-site and off-site surveillance, including of NBFIs; (ii) supervision of reformed and new exchanges; (iii) regulation and supervision of the insurance and pension industry; and (iv) regulation and supervision of the derivatives market. In addition, the TA will provide assistance to SECP and the stock exchanges in developing and implementing a plan for demutualization of the exchanges, and support measures to upgrade the skills of market participants.

1 ADB. 1997. Technical Assistance Loan to Pakistan for Capacity Enhancement of the Securities Market implemented

from 1998 to 2002; and ADB. 2001. Technical Assistance to Pakistan for Capacity Building for Capital Market and Corporate Governance. Manila.

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5. The TA will comprise four components:

1. Upgrading of the Legal and Regulatory Framework 6. The TA will identify areas of overlap, inconsistencies, and gaps in existing regulations governing Pakistan’s nonbank financial markets, and recommend legal and regulatory changes for a comprehensive and consistent regulatory agenda. This will seek to further align market rules and regulations with international standards, formulate recommendations to extend elements of the corporate governance code beyond listed companies, assist in drafting and improving regulations for contractual savings including insurance and private pensions, and improve the quality of information disclosure. This component will also help to better define roles and responsibilities for rule making and enforcement between the industry regulator and various self-regulatory organizations, including the stock exchanges and professional associations. The consultants may in the process assist in drafting any amendments that the regulatory agenda may require, or any revision in the statutes to upgrade self-regulatory capacities.

2. Capacity Building of SECP (with particular attention to its enlarged mandate

for regulation and supervision of NBFIs, insurance, and pensions) 7. This component will strengthen the various functional wings and divisions of SECP. This will include a review of the operational processes of SECP, and updating in particular those for regulation and supervision of NBFIs, insurance, and pension systems. It will also strengthen enforcement including assistance in conducting on-site and off-site examinations. The TA will also undertake a thorough review of the existing badla system and an assessment of its impact on market distortions and volatility, with a view to phasing out the current system and replacement through a derivatives market; recommend regulations for stock lending and systems for margin trading; and update, as required, existing futures regulations including contract specifications. This component will also assist in the implementation of an options market, including drafting of regulations and updating SECP staff on in relevant risk management methods applicable to Pakistan for derivative instruments including margin concepts and supervisory capacity of SECP over the derivatives market. This will also include a review and upgrading of SECP’s management information system, as required, to enhance and strengthen the market information and surveillance operations of SECP.

3. Support for Restructuring of Stock Exchanges

8. Based on the experiences and methodology followed in developed markets, the TA will assist the stock exchanges and SECP in assessing different models of demutualization for the exchanges and their applicability to Pakistan. Through a consultative process with key stakeholders, the TA will develop a comprehensive strategy and detailed implementation plan. The consultants will assist the exchanges to value their businesses and carry out changes in their statutes and regulations that would be required. In this context the potential integration of the three markets to a national stock market, or development of a new national market, may be considered as well. Some of the key issues to be resolved under this component include (i) valuation and distribution of shares among members, and (ii) remuneration for the membership fee paid by existing members.

4. Establishment of Sustainable Mechanisms for Skills Development and

Training

9. The component will ascertain the types of professional expertise needed by the market, review existing programs and facilities for training market participants, and assess skills of SECP staff and market participants. The TA will also examine and establish standards for various

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professions such as portfolio managers or insurance brokers, in line with international practices and as appropriate for Pakistan. Based on the needs analysis, the consultant will design a comprehensive approach for training market participants, and work with industry associations (such as the Leasing Association of Pakistan) or special training institutes (such as the Insurance Institute of Pakistan) to develop professional curricula including, e.g., for brokers and fund managers, and measures for enhanced professional education. Web-based training modules may be developed for self-learning, to be posted on the SECP or other relevant website. The TA will explore the feasibility and assist in the establishment of a training institute for capital market development. This component will also promote twinning arrangements and secondment of SECP staff to other regulators, and further measures to upgrade skills of SECP staff. C. Cost and Financing 10. The total cost of the TA is estimated to be $4,400,000 equivalent, comprising $2,365,000 in foreign exchange cost and $2,035,000 equivalent in local currency costs. The Asian Development Bank (ADB) will finance $3,000,000 equivalent, comprising the entire foreign exchange cost and $635,000 equivalent in local currency (Table A9).

Table A9: Cost Estimates and Financing Plan ($’000)

Item Foreign Exchange

Local Currency

Total Cost

A. ADB Financing 1. Consultants a. Remuneration and Per Diem i. International Consultants ii. Domestic Consultants b. Travel i. International ii. Local c. Communication and Reports 2. Equipments and IT Services 3. Local Transportation 4. Training Programs 5. Interest Charges 6. Contingency Subtotal (A) B. Government/Beneficiary Financing 1. Local Counterpart Staff 2. Counterpart Facilities: Office Space, Communication, Secretarial, and Related Services 3. Equipment 4. Local Transportation 5. Duties and Taxes 6. Contingency Subtotal (B) Total

1,265 0

105 0 5 300 0

300 100 290

2,365

0 0

0 0

0 0 0

2,365

0 360

0

40 10 0 20

100 0

105 635

210 230

450 50

275 185

1,400 2,035

1,265 360

105

40 15

300 20

400 100 395

3,000

210 230

450 50

275 185

1,400 4,400

IT = information technology. Source: ADB estimates.

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11. ADB will provide a loan in various currencies equivalent to SDR2,268,000 ($3 million equivalent) from its Special Funds resources with an amortization term of 32 years, including a grace period of 8 years, and with an interest rate of 1.0% per annum during the grace period and 1.5% per annum thereafter, and such other terms and conditions as are substantially in accordance with those set forth in the TA Loan Agreement. 12. ADB will finance 68.2% of the total cost of the TA, including international and domestic consultant services, a part of the cost of computer hardware and systems development, training programs and activities, as well as interest charges during implementation. The Government and beneficiaries (stock exchanges) will finance 31.8% of the total cost, mainly for the counterpart budget of the executing and implementing agencies, including counterpart staff and facilities for the consulting team, taxes and duties on equipment, and taxes on consultants, as well as part of the computer equipment. D. Implementation Arrangements 1. The Executing Agency 13. The Executing Agency for the TA will be SECP. SECP will provide the necessary office space, counterpart staff, local transportation, and other services to the consultants. SECP will closely coordinate with other stakeholders involved in the implementation of the TA, including those from the private sector. 14. SECP will establish and maintain separate accounts for the TA in accordance with accounting procedures acceptable to ADB. The accounts of SECP and the TA will be audited annually by independent auditors in accordance with auditing standards acceptable to ADB. Certified copies of the audited accounts and financial statements and the report of the auditors will be submitted to ADB in English within 6 months after the end of each fiscal year. 2. Schedule, Reports, and Reviews 15. The TA is planned to commence as soon as practicable following the effective date of the TA loan, to be completed over a period of 18 month after inception and before December 2004. 16. The TA will be implemented in three phases. During the inception phase, the team leader and lead consultants of the various components will revalidate the policy objectives and assess priorities, key issues, and capacity-building needs on the governance, regulatory, and operational level. At the end of this phase, resource inputs may be adjusted as appropriate within the overall budgetary framework and TA scope, to better align the terms of reference, activities, and time-bound outputs with client expectations and needs. This will also include the refinement of performance parameters for the consultants. During the design phase, the consultants will formulate and detail the capacity-building and operational development plans. During the implementation phase, the consultants will implement and document required regulations, procedures, and systems, as well as arrange for training and skill development activities as appropriate. 17. The team of consultants will prepare an inception report on the respective components within 4 weeks of the commencement of their services. In addition to any full report required at the end of each individual component, the consultants and SECP will submit quarterly progress reports. The final report, including complete documentation of all outputs, will be submitted

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within 3 months of the end of the assignment, after the comments of ADB and the Government has been incorporated. 18. In addition to regular and ongoing interaction among SECP, ADB, and the consultants, a comprehensive midterm review will be undertaken jointly by ADB, SECP, and the consultants about 9 months after project inception to review all aspects of implementation. 3. Procurement 19. The computer hardware and software will be procured in accordance with ADB’s Guidelines for Procurement. Each supply contract for equipment or materials estimated to cost the equivalent of more than $500,000 will be awarded on the basis of international competitive bidding. Each supply contract for equipment or materials estimated to cost the equivalent of $500,000 or less (other than minor items) will be awarded on the basis of international shopping. 4. Consulting Services 20. The TA will require about 109 person-months of consulting services, including 55 person-months of international and 54 person-months of domestic consulting services. The team of consultants will be selected from a reputable firm with a proven track record in financial markets development and capacity building, and will be engaged in accordance with ADB’s Guidelines on the Use of Consultants under the quality-based selection method2, or other arrangements satisfactory to ADB on the engagement of domestic consultants. Separate subcontracting of services for individual consultants or firms, in addition to the main contract, may be required for specialist tasks under components 3 and 4 of the TA. 21. The consultant team will include skills and expertise in (i) team leadership; (ii) legal frameworks and regulation of capital markets, insurance, pensions, and NBFIs; (iii) corporate governance; (iv) stock exchange models and operations; (v) nonbank financial market development; (vi) risk management, with particular expertise in derivative products; (vii) market monitoring, surveillance, and enforcement; (viii) information technology, in particular electronic trading, clearing, and settlement platforms; and (ix) training and skills development for financial markets. The consultants under the team must possess strong communication and teamwork skills, and the capacity to respond to client needs in a flexible, pragmatic, and professional manner. 22. Throughout TA implementation, the consultants will work closely with SECP staff, maintaining active day-to-day communication. The consultants will also be required to maintain an active dialogue with private sector parties (such as the stock exchanges, ICAP or other relevant parties) as required. The international consultants will also work closely and in a team with the domestic experts, who will advise on Pakistan’s legal and regulatory system and operational practices. Extensive field presence by the international consultants is envisaged. Pakistan nationals with relevant expertise and international experience are eligible for international consultant positions.

2 The quality-based selection method will be applied in light of the TA's nonstandardized nature and emphasis on

qualitative inputs.

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POLITICAL RISK GUARANTEE FACILITY FOR ENHANCING PAKISTAN’S INTEGRATION WITH INTERNATIONAL CAPITAL MARKETS A. Background and Rationale 1. Despite considerable improvement in market infrastructure for the past few years, Pakistan’s financial markets have remained depressed, and foreign portfolio investment has been negative (resulting in a further downward trend of the market). The reasons included weak macroeconomic fundamentals as well as poor governance and transparency in financial markets. In addition, international investors have shied away amid a generally high perception of country risk. As a result, even good companies with solid operations, sound management, and strong cash flows are very cheaply valued by international standards, with low price/earnings ratios and high dividend yields. In addition, there has been good progress in developing a corporate bond market, with more than $300 million equivalent of term finance certificates issued since 2001, as well as a fast-growing market for tradeable government debt offering attractive returns in real terms compared with other markets. With the recent stabilization of the macroeconomic situation and consistency in financial market and governance reforms pursued under the Financial (Nonbank) Markets and Governance (FMG) Program, Pakistan offers potentially attractive investment alternatives. 2. Pakistan has a relatively large population resident abroad, which constitutes a considerable investment pool that has so far not been tapped in a systematic and formal manner for investment in Pakistan. Further investigation – including a visit in early 2002 by a delegation of leading Pakistan capital market professionals to a number of international destinations with sizeable Pakistan overseas population – confirmed a very strong interest by overseas Pakistanis to invest in Pakistan’s financial markets, in particular in debt instruments, and identified formal market access and cross-border risk among the key concerns. 3. Mobilization of institutional investment is key for new initial public offerings, to develop secondary trading and increase the depth of securities markets. The policy initiatives under the FMG Program strongly aim at mobilizing domestic resources. Yet, this will develop only gradually over time, and there is both a need and considerable potential to accelerate the process by tapping into international portfolio investment.1 4. By providing suitable modalities that address key investor concerns, access to international capital flows and integration of Pakistan with international financial markets can be enhanced. In particular, this will allow a change in the investor profile in debt markets through professional fund managers who more actively try to optimize market opportunities, thereby enhancing liquidity, and an increase in fund management expertise in Pakistan. In conjunction with the reforms under the FMG Program, this can be achieved through a revolving political risk guarantee (PRG) facility, which will cover selected risks for investment that is carried out through formal channels. This will allow investors to concentrate on the economic and commercial aspects of the investment. B. Objectives, Scope, and Basic Principles 5. The objectives of the proposed PRG facility are to (i) strengthen confidence for overseas investors and support the country's integration into international capital markets through formal

1 It is generally considered desirable to have about 10-20% of international investment in a country's financial market.

In Pakistan, however, this share had dropped to only about 2% at the end of FY2002.

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channels; (ii) develop, diversify, and broaden professional institutional investment vehicles and thereby stimulate secondary market activity, particularly in the debt markets; and (iii) attract political risk insurance (PRI) providers from the private sector to reestablish cover for Pakistan, initially under the umbrella of the Asian Development Bank's (ADB) coguarantee program (CGP).2 6. PRGs issued under the facility will guarantee repatriation of proceeds from investments in debt instruments, including listed corporate bonds, corporate commercial paper, as well as government paper. It will create cross-border political risk-taking capacity, focusing on currency inconvertibility and transfer cover. 7. The PRG facility will have a revolving nature, allowing individual PRGs to be issued on a case-by-case basis in line with the facility agreements, and after due diligence by ADB on eligibility. The PRG facility will be uncommitted, giving ADB and the Government the right to cancel unutilized limits after consultation at any time with prior notice. 8. Pricing of each PRG will be market based to appeal only to investors who would otherwise be unlikely to invest in Pakistan. Thus, the PRG will not give rise to "adverse selection" (i.e., a situation where investors routinely request this). 9. To comfort investors that they will be able to safely remit the proceeds from the sale of their securities, PRGs issued under the facility must be of unquestioned quality, cost effective, and provided in line with best international practice. Initial exposure will be counterguaranteed by the Government. 10. The PRG facility will be designed to leverage ADB’s exposure by attracting private sector PRI providers through the comfort being offered under ADB’s CGP. ADB will also seek parallel guarantee arrangements with official guarantee agencies, such as the Overseas Private Investment Corporation or Multilateral Investment Guarantee Agency, under the proposed implementation structure. Over time, it is expected that private PRI providers will progressively take over the bulk of the liability under the facility as they become more comfortable with Pakistan cross-border political risk associated with portfolio investment. This will give ADB and the Government an exit strategy and make sure that investors do not become dependent on ADB and the Government for cover offered by the facility. 11. The PRG facility will take advantage of previous experience gained by ADB in implementation of similar vehicles. To the extent possible, the PRG facility will be structured in a similar manner as the PRG facility for Letter of Credit Confirmations under the Small and Medium Enterprise Trade Enhancement Finance Project, which was made effective in September 2001. C. Major Terms, Conditions, and Arrangements of the Proposed PRG Facility Facility: A revolving PRG facility with government counterguarantee covering primarily

currency inconvertibility and transfer blockage, and other cross-border political risks (as defined in the PRG documentation in line with ADB’s guarantee policy). Under the facility, ADB will issue PRGs, from time to time and on a case-by-

2 As a multilateral development finance institution ADB is in a strong position to leverage private sector risk cover.

Under the PRG CGP, ADB will however not be liable for any amount owed by the PRI provider to the investors as a result of a claim. Detailed information about the PRG CGP can be found in para. 62.3 of www.adb.org/Documents/Policies/PRG/prg405.asp.

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case basis after due diligence, to selected institutional investors for identifiable debt investments in Pakistan’s financial markets.

Guaranteed Investments and Investors:

The facility will guarantee repatriation of proceeds from eligible debt investments in Pakistan. To discourage speculative capital flows, funds must remain invested in Pakistan for at least 6 months.

Eligible investments include tradable debt instruments issued by the corporate sector or the Government, as well as loans to financial intermediaries for the purpose of nonbank financial market development, made through guaranteed investors.

Guaranteed investors, or participating financial intermediaries (PFIs), may include formal institutional investment vehicles such as mutual and pension funds or other corporate entities, with adequate professional investment management expertise.

Guaranteed Risks:

Loss as a result of

• foreign exchange inconvertibility or transferability blockage; or

• other related and clearly definable politically motivated event directly affecting the orderly sale, payment of interest, or repayment of the underlying investment (as agreed upon with the Government in the PRG documentation in line with market needs).

In any event, ADB will not guarantee, indemnify, or cover loss as a result of breach of contract or any commercial or other market-related risk.

Guarantor: ADB will be the sole Guarantor, backed by its ordinary capital resources up to an aggregate liability under the facility of $25 million equivalent (the ADB limit).

For any amount in excess of the ADB limit, ADB will be acting as guarantor-of-record, under the PRG CGP, for one or more private sector PRI providers that wish to participate in the facility.

Counter-guarantor:

The Government of Pakistan will provide a counterguarantee and indemnity to ADB in an amount of not less than the ADB limit (the counterguarantee limit) so that ADB’s exposure will always be counterguaranteed.

Amounts in excess of the counterguarantee limit will be without Government counterguarantee, but will benefit from ADB’s CGP up to the total facility limit.

Facility Limit: The initial facility limit will not exceed the ADB limit of $25 million equivalent.

ADB will seek to attract other PRI providers to expand the facility limit, and the total facility limit can be increased gradually for an additional amount of up to $125 million under ADB’s PRG CGP. This could bring the total facility limit up to $150 million.

The facility limit is based on estimated demand and market potential. Due to the revolving nature of the facility, actual utilization of limits is expected to fluctuate over time in line with changing perception of country risk and corresponding change in risk premiums.

Maximum Limit of Liability per PRG Issued:

The maximum liability under any PRG swill be the lesser of

• 90% of the net sale proceeds of the guaranteed investment, or

• the agreed cover amount;

plus 90% of accrued interest or other income.

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The agreed cover amount is the purchase price of the investment on the day the investment is made. PFIs will have the option to periodically increase or decrease the agreed cover amount to reflect the prevailing market price of the investment or investments covered.

Claims Management:

Claims made by the beneficiary under a PRG will be paid by ADB when a guaranteed risk has occurred after appropriate waiting periods and evaluation following sound market practice. The guarantee amount paid will be not more than the maximum limit of liability of the PRG. The beneficiary will surrender local currency proceeds as realized from the sale of the underlying debt investment to ADB or its nominee.

PRG Pricing: A market-based guarantee fee (premium) payable by the PFI will be charged periodically in advance as a percentage per annum on the agreed cover amount. The premium will reflect the Pakistan country risk premium for the selected risks as well as ADB fees and administrative charges needed to cover the cost of establishment and operation of the PRG, and may be adjusted from time to time.

Indicative market soundings by ADB with potential investors suggest that the premium could be around 0.5-1.2% per annum. This is indicative only and will need to be adjusted in the light of market sentiments during implementation.

Premiums collected will be deposited into an escrow account, which will be used first to reimburse ADB for its guarantee fees and for agreed upon management and administrative expenses, including external parties, then the Government for any agreed upon out-of-pocket expenses, and the balance will be retained to build a claims reserve over time.

ADB Fees and Administration Charges:

For each PRG issued under the facility, ADB will charge at the time of issuance and prior to effectiveness of the PRG a front end fee of up to 1% in line with the provisions in ADB’s policies on guarantee operations.

For outstanding PRGs up to the ADB limit that are counterguaranteed, ADB will charge an ADB guarantee fee at the rate of 0.40% per annum on the covered amounts, calculated on a daily basis and payable periodically in arrears.

Expenses incurred by external parties related to the establishment of the facility and its administration, including legal fees and out-of-pocket expenses, will be paid out of the premium income generated by the facility during utilization. Up-front fees may be financed out of disbursement proceeds from the FMGP loan as agreed upon with the Government, and be recovered through premium income as it arises.

For guarantees in excess of the ADB limit, the private sector PRI providers under the CGP will determine and charge premium consistent with market practice. In line with the ADB PRG Review Paper, ADB will charge an arrangement and administrative fee for making the CGP available.

A fee may also be paid to any facility agent appointed for establishing and managing day-to-day operations of the facility.

Implementation Structure and Legal Documentation:

ADB may appoint a facility or management agent to administer the facility or individual PRGs on behalf of ADB in accordance with sound commercial and international best practices for governance, management, and underwriting as set forth under a guarantee management agreement. The agent may enter on behalf of ADB (or other PRI providers under the CGP) into a master risk participation agreement (MRPA) with each PFI.

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The agent may (i) arrange and manage the MRPAs; (ii) receive all notifications issued by PFIs; (iii) collect all premiums from the PFIs and operate the PRG account; (iv) receive any demand made by the PFIs under an MRPA, which will be immediately sent to ADB and the Government; (v) provide quarterly statements showing ADB’s and the Government’s liabilities under each MRPA and the total facility; and (vi) do other things required to administer and promote the PRG facility.

The agent will be an experienced and trustworthy financial institution or private sector PRI provider, and will be selected by ADB in a transparent manner following normal commercial practice. The agent will ideally be domiciled in an international financial center having close proximity to investors interested in Pakistan.

ADB will also enter into a counterguarantee agreement with the Government.

Schedule and Availability Period:

The facility will become effective after finalization of legal agreements and identification of an initial PRG transaction, expected within 6 months after ADB Board approval.

The facility will be available for a period of 4 years from the effective date of the facility. During the availability period, a PFI may increase cover amounts subject to overall availability, and new PRGs may be issued.

Individual PRGs issued under the facility may have a maximum term of 10 years.

Cancellation: ADB may, after consultation with the Government, and prior notice to PFIs, cancel any uncommitted portion of the facility if it is determined that it is no longer required.

A PFI may reduce the cover amount or cancel a PRG at any time after a PRG is issued, with prior notice given to ADB.

Market Collaboration and Exit Strategy:

During the term of the facility, ADB and the agent will actively seek to encourage both public and private sector PRI providers to participate in the facility, especially as demand grows.

The agent, on behalf of and if requested by ADB, may also arrange parallel counterguarantees from private sector PRI providers for individual PRGs, issued under the facility, to further leverage or improve the risk profile of the facility.

Over time it is envisioned that the share of private PRI providers extending cover under the facility will increase, and the share covered under the ADB limit with government counterguarantee will correspondingly decline.

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POLITICAL RISK GUARANTEE FACILITY FOR ENHANCING ACCESS TO COVER FOR SELECTED VIOLENCE-RELATED RISKS

A. Background and Rationale 1. The terrorist attacks in the United States (US) on 11 September 2001 have accelerated the hardening of insurance and reinsurance markets worldwide and caused a major reduction in, and in some cases complete disappearance of, international insurance and reinsurance capacity for property, casualty, and other forms of insurance in developing countries. For what little capacity that is left, much higher rates and very restricted terms are demanded. The difficulty is exacerbated by the low capitalization of insurers in many of these countries, which magnifies their dependence on international reinsurance markets. Without reinsurance cover, primary insurance companies are unable to offer comprehensive insurance for risks in developing countries, or can do so only very sparingly. This shortage has been aggravated further, as cover for terrorism and related risks, which was in the past routinely included in general insurance policies, is now explicitly excluded. 2. In particular, airlines and project sponsors for large investments are now finding it difficult to obtain or renew insurance cover for a variety of risks. Cover for terrorism and sabotage risks is among the hardest to get. In Pakistan the exposed investments include the national airline and a number of vital existing infrastructure projects, including projects supported by multilateral and bilateral institutions. In addition, affordable investment capital from both domestic and foreign sources for new high-profile strategic projects and the privatization of certain Government-owned enterprises in Pakistan may be in jeopardy unless primary insurers (backed by their reinsurers) are willing and capable of offering comprehensive and reasonably priced insurance – inclusive of terrorism and sabotage cover. The lack of adequate and comprehensive insurance cover, including political violence and terrorism risk, also undermines financial sector soundness, as many assets that are pledged as collateral against syndicated loans or bond issues are no longer fully insured. 3. Some commercial insurance companies have responded to the changed industry scenario and are now offering stand-alone terrorism insurance products. However, underwriting capacity in this regard is very limited, policies are restrictive, and they are limited to a select few policyholders and generally beyond reach for emerging markets. Governments in many European countries and the US have thus taken various initiatives to help the insurance market overcome this situation, which is generally perceived as a temporary market failure until more private capacity has been established.1 In this context, government generally serves two functions, to overcome capacity shortage and to act as insurer of last resort. 4. The Government of Pakistan has requested the Asian Development Bank (ADB) to assist it in addressing key industry concerns and ensuring continued access by Pakistan companies to comprehensive insurance and reinsurance. This assistance can be achieved through the innovative application of ADB’s political risk guarantee (PRG) instrument in the form of a revolving PRG facility.2 Specifically, ADB would issue individual PRGs under the facility that 1 A report issued in March 2002 by Swiss Re, a leading re-insurance company, estimates that it could take 3 to 5

years for the private insurance industry to develop means to cover terrorism. 2 The 2000 PRG Review Paper establishes the policy framework for political risk guarantees, which conditionally

guarantee a variety of political risks including acts of “political violence”. Because conditional guarantees contain characteristics similar to insurance, and because ADB’s conditional guarantee may be used to co-guarantee cover provided by commercial PRI providers, insurance and guarantee terms and concepts may be used interchangeably.

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guarantee payment of a certain amount to a guaranteed party, normally a company, in case terrorism or other political violence risk as specified under the PRG policy occurs. This payment will permit the guaranteed party to maintain its operations and thus continue servicing its financial obligations to its lenders in the case of an existing enterprise, or support the guaranteed party to attract debt financing in case of a new enterprise.3 ADB will be counterindemnified by the Government. Thus ADB will facilitate the provision of risk retention capacity that is ultimately made available by the Government, or commercial reinsurers, and credit enhance the collateral pledged by enterprises to its lenders. B. Objective, Scope, and Basic Principles 5. The principal objective of the proposed PRG facility is to establish a mechanism that assists in protecting Pakistan’s economy and financial system from the negative economic fall-out associated with noncommercial risks, in particular terrorism and other acts of political violence for which cover is no longer readily available after the events of 11 September 2001. This will enable vital investments and infrastructure projects in Pakistan to be insured comprehensively and help maintain their financial sustainability, thereby protecting the lenders to such projects. Subsidiary benefits may arise through enhancement of the retention capacity of the Pakistan insurance market, mobilization of additional international capacity, and arbitrage in reinsurance rates for the selected risks covered through the intermediary power of the proposed PRG facility. 6. The Government will ultimately and implicitly provide some underwriting capacity for the terrorism and other political violence risks covered under the PRG facility. ADB will guarantee that this capacity be made available in a claim event, thereby enhancing international acceptance of the Government’s initiative. In case of a claim, ADB may, at the request of the Government and at its sole discretion, opt to finance any payouts owed under the counterguarantee, thereby spreading the fiscal impact of a claim over a number of years. ADB will also seek to leverage the capacity provided, enhanced through the PRG, in the international reinsurance market to obtain additional cover at competitive rates. 7. PRGs under the facility will be issued on a case-by-case basis to support agreed upon investments and infrastructure projects that have been subject to due diligence. The PRG facility will be administered by a facility agent, which will be an experienced private sector PRI broker or provider, or other trustworthy financial institution. The PRG facility will build on the previous experience gained by ADB in implementation of similar vehicles including the PRG Facility for Letter of Credit Confirmations under the Small and Medium Enterprise Trade Enhancement Finance Project, which was made effective in September 2001. C. Major Terms, Conditions, and Arrangements of the Proposed PRG Facility Facility: A revolving PRG facility with counterguarantee from the Government of Pakistan

to cover political violence risk, including terrorism and sabotage, for which insurance in Pakistan is not readily available. Under the facility, ADB will issue individual PRGs from time to time and on a case-by-case basis after due diligence to

3 It should be noted that under its Charter and policies, ADB’s guarantee operations are intended to cover repayment

obligations to credit providers. The proposed PRG will credit enhance the collateral that is pledged against debt obligations. Therefore, the amount of individual PRGs issued under the proposed facility to cover specified violence events will be limited to the amount of outstanding debt of the enterprise covered, and the PRG may be assigned to specific lenders.

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• sponsors or owners of approved investments and projects, alongside other coguarantors or primary insurers; and/or

• guarantors or primary insurers of approved investments and projects, to counterguarantee their guarantee or insurance in favor of the investment and/or project.

Guaranteed Beneficiaries and Investments:

Ultimate beneficiaries of a PRG will be Pakistan or international enterprises, and their lenders.

The primary beneficiary may be a Pakistani or international enterprise, or when a PRG is issued to counterguarantee a guarantee or insurance contract issued by a guarantor or primary insurer, such guarantor or primary insurer may be the primary beneficiary.

Investments eligible for cover under a PRG include new and existing assets of vital economic importance located in Pakistan, as agreed upon between ADB and the Government from time to time.

Guaranteed Risks:

Loss as a result of a political violence event, including terrorism and sabotage, as agreed upon with the Government and defined in the PRG documentation.

In any event, ADB will not guarantee, indemnify, or cover loss as a result of any commercial or other market-related risk.

Guarantor: ADB will be the sole guarantor, backed by its ordinary capital resources, up to aggregate liabilities under the facility of $175 million.

Counter-guarantor:

The Government of Pakistan will provide a counterguarantee and indemnity to ADB for all amounts owed under the each PRG provided under the facility, so that ADB’s exposure will always be counterguaranteed.

After the occurrence of a guaranteed event, should the Government so request, ADB may at its sole discretion convert any outstanding counterguarantee obligation into a loan to Pakistan to finance the cost of the claim.

Facility Limit: The aggregate liability under all PRGs issued under the facility will not exceed $175 million equivalent.

The total facility limit can be increased through participation of coguarantors.

The facility limit is based on estimated initial demand. Due to the revolving nature of the facility, actual utilization of limits is expected to fluctuate over time in line with changing risk perceptions and development of private sector alternatives over time.

Maximum Limit of Liability per PRG Issued:

ADB and the Government, in consultation with the market, will agree to guidelines that will specify the deductible and limit of indemnity for each PRG, taking into consideration the risks covered and other factors. The facility and amounts under each PRG will be managed in line with prudent risk management guidelines to avoid unreasonable concentration of risk.

In any case, the maximum limit of liability under each PRG will not exceed the total amount of debt incurred by the guaranteed project or enterprise.

Claims Management:

When a guaranteed risk has occurred, claims made under a PRG will be paid by ADB to the primary beneficiary, or to one or more lenders if the PRG has been assigned, after appropriate waiting periods and evaluation following sound market practice. The amount paid will not be more than the maximum limit of

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liability under the PRG.

PRG Pricing: For each PRG issued under the facility, a market-based guarantee fee (premium) will be charged to the primary beneficiary, and be set in light of the following:

• the objective of the facility to offer fair and reasonable premiums, which do not disadvantage investment in Pakistan as compared with investment into other countries having the same probability of loss;

• the difficulty of measuring the probability of loss due to terrorism, sabotage, and other risks covered;

• the individual risk profile and deductibles retained; • the requirement to cover ADB fees and other administrative costs applicable

to the operation of the individual PRG issued under the facility; and • the need to build a claims reserve over time.

Pricing for each PRG may vary as a function of the characteristics and location of the guaranteed project or enterprise, but is indicatively expected to be between 0.6% and 2.5% per annum of the covered amount. This is indicative only and will need to be adjusted periodically in the light of market sentiments during implementation.

Premiums collected will be deposited into an escrow account, which will be used first to reimburse ADB for its guarantee fees and for agreed upon management and administrative expenses, including external parties, then the Government for any agreed upon out-of-pocket expenses, and the balance will be retained to build a claims reserve over time.

ADB Fees and Administration Charges:

For each PRG issued under the facility, ADB will charge at the time of issuance and prior to effectiveness of the PRG a front end fee of up to 1% in line with the provisions in ADB’s policies on guarantee operations.

For each PRG issued under the facility, ADB will charge an ADB guarantee fee at the rate of 0.40% per annum on the covered amounts, calculated on a daily basis and payable periodically in arrears.

Expenses incurred by external parties related to the establishment of the facility and its administration, including legal fees and out-of-pocket expenses, will be paid out the premium income generated by the facility during utilization. Up-front fees may be financed out of disbursement proceeds from the Financial (Nonbank) Markets and Governance Program loan as agreed upon with the Government and be recovered through premium income as it arises.

A fee may also be paid to any facility agent appointed for establishing and managing day-to-day operations of the facility.

Implementation Structure and Legal Agreements:

ADB will appoint as facility or management agent an experienced private sector political risk insurance (PRI) broker or provider or other trustworthy financial institution to operate the facility on behalf of ADB, in accordance with sound commercial and international best practices for underwriting management and governance, as set forth under a facility agent management agreement.

The agent will (i) issue individual PRGs within agreed upon limits on behalf of ADB after due diligence and concurrence by ADB; (ii) collect all premiums and operate the PRG account; (iii) receive all notifications and any demand made under a PRG, which will be immediately sent to ADB and the Government; (iv) provide periodic statements showing ADB’s and the Government’s liability under

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each PRG and the total facility; and (v) do other things required to administer and promote the PRG facility.

The agent will be selected by ADB in close collaboration with the Government and appropriate representatives of the insurance industry in Pakistan. Selection will be made in a transparent manner and follow normal commercial practice. The facility agent will ideally have (i) representation in an international insurance center; (ii) close working relationships with international reinsurers interested in emerging market political risk, including Pakistan; (iii) close working relations with insurance and reinsurance companies in Pakistan; and (iv) experience in setting up and managing captive insurance companies and or acting as an agent for an international financial institution.

ADB will also enter into a counterguarantee agreement with the Government.

Schedule and Availability Period:

The facility is expected to become effective after selection of the agent and finalization of legal agreements within 6 months following ADB Board approval.

The facility will be available for a period of 4 years from the effective date of the facility. During the availability period, new PRGs may be issued to replace those that are canceled or expire.

Individual PRGs issued under the facility may have a maximum term of 10 years.

Cancellation: ADB may, after consultation with the Government, and prior notice to the agent, cancel any uncommitted portion of the facility if it is determined that it is no longer required.

The beneficiary of a PRG may reduce the cover amount or cancel a PRG after issuance with prior notice to ADB.

Market Collaboration and Exit Strategy:

During the term of the Facility, ADB and the agent will actively seek to encourage both public and private sector PRI providers to participate in the facility, especially as demand grows.

If requested by a primary insurer, the agent may on a best endeavor basis assist the primary insurer to arrange reinsurance in excess of the PRG provided by ADB. The agent may charge a commission or fee for such assistance, provided the amount is consistent with market practice.

The agent, on behalf of and if requested by ADB, may also arrange parallel counterguarantees from private sector PRI providers for individual PRGs, issued under the facility to further leverage or improve the risk profile of the facility.

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SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY AND POVERTY IMPACT ASSESSMENT

A. Linkages to the Country Poverty Analysis Sector identified as a national Yes priority in country poverty analysis? Financial Sector

Sector identified as a national Yes priority in country poverty partnership agreement?

Contribution of the sector/subsector to reduce poverty in Pakistan:

An efficient financial sector is regarded as necessary (but not sufficient) for sustainable poverty reduction. It underpins private sector-led pro-poor economic growth and employment generation by providing better access for all to credit and savings products, improving allocation efficiency, and reducing the vulnerability of the economic system to external shocks that carry negative fiscal implications, in particular for the poor. Many of these functions cannot be fulfilled by Pakistan’s inefficient banking sector but require the development of other nonbank financial products and services, including long-term finance.

B. Poverty Analysis Proposed Classification: Growth

Analysis:

The Financial (Nonbank) Markets and Governance Program is indirectly pro-poor in supporting the three components of ADB’s poverty reduction strategy: pro-poor sustainable economic growth, good governance, and social development. Pro-poor sustainable economic growth is to be achieved through the program focus on measures to increase investor confidence and restore the flow of much-needed investment capital to Pakistan. This, in turn, will provide employment fpr Pakistan’s rapidly growing population and raise the real wages of the working poor. To support good governance, the Program will induce transparency and information disclosure to ensure more sustainable economic management and protection of minority interests. It will improve governance of the financial market and the corporate sector through more effective market regulation, restructuring of key participants including the stock exchanges, and improved transparency of the quality and quantity of reported and audited financial statements. In addition, the Program will support better fiscal management through rationalization of distortions related to taxation policy and reduction of reliance on inherently volatile revenue from financial markets. The Program will also support the poverty reduction strategy’s third pillar of social development. Providing basic infrastructure and services such as water or electricity requires investment with long-term payback horizons, which can be supported through capital markets, in particular if private sector involvement is sought. At the same time, the development of social protection programs such as pensions and other insurance schemes requires long-term investment opportunities, which are provided in particular by capital markets.

C. Participation Process Stakeholder analysis prepared No Intense stakeholder consultation has been pursued throughout program formulation, but did not require specific stakeholder analysis, as direct impacts on specific stakeholder groups are limited. Participation strategy : No

D. Social Issues Subject

Significant, Not Significant,

None

Strategy to Address Issues

Output Prepareda

Resettlement None - None Gender None - No Affordability None - No Labor Not Significant - No Indigenous People None - No Other Risks/Vulnerabilities None - No a A plan will be required if any of the potential issues are found to be significant.

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Poverty Impact of the Program Channel Indirect Macro Nonpoor Labor Increased access to

capital markets and allocation efficiency lead to productivity improvement and creation of employment opportunities for the skilled poor. Job creation revitalizes labor markets and can lead to increased real wages for the working poor.

Increased accountability and clarification of fiduciary responsibilities reduce the possibility for market manipulation, fraud, and abuse. The cost of financial crimes and misreporting has a direct impact on business confidence, future investment, and consequently on labor absorption.

More investment funds flow into sectors, industries, and countries with transparent and efficient markets. The potential impact on labor is directly correlated to activity in the economy; therefore, the greater the business confidence, the higher the potential for labor absorption.

Access to markets and services

Improved access to contractual savings products and more stable and predictable funding of saving schemes reduces vulnerability to poverty for the working poor.

Greater investor confidence leads to greater capital formation, increasing the pool of funds for short-term and longer term investment.

Stability of funding for insurance sector liabilities provides a sounder basis for greater returns in the insurance sector, including life insurance.

Sustained expansion of economic activity leads to an improved tax base from business and personal income, enabling increased provision of basic services for the poor.

Increased transparency and stability in financial markets increase the opportunities for local government, pension plans, and insurance schemes, matching the need for long-term investment and Long-term savings instruments.

Enhanced disclosure and more accurate financial reporting in the market, including collective investment schemes, will protect smaller investors.

In turn, this enables expansion of the provision of public services to the poor and improves the reliability of the social protection system.

Prices Capital market development leads to alternative sources and more competitive of finance for companies, leading to lower production costs and more competitive prices.

Increased prudential standards and greater efforts to increase compliance and enforcement with rules and regulations lead to a more robust system, thereby reducing its vulnerability to external shock and price swings.

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Net Impact The direct impact of the Program is poor-neutral. The indirect impact is pro-poor.

Narrative The actions taken under the Program will lead to an efficient capital market where investors are informed and protected. This will diversify the range of financial instruments available to the public and private sectors, reducing vulnerability to the banking sector and buffering against external shock. Increased access to financial markets by small and medium enterprises will create employment opportunities for skilled and unskilled labor and increase opportunities for small businesses. Increased transparency and stability in financial markets will increase the opportunities for local government, pension plans, and insurance schemes, matching the need for long-term investment and long-term savings instruments. This will enable expansion of the provision of public services to the poor and improve the reliability of the social protection system.

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