The years 2022 and 2023 marked a transformative period for Pakistan’s financial sector. Amid high policy rates and monetary tightening, banks and financial institutions experienced unprecedented growth and profitability. However, this economic climate also catalysed significant shifts in business strategies across the industry.
As previously reported by Profit, commercial banks have pivoted away from traditional lending practices. Instead, they’ve increasingly adopted investment firm-like approaches, favouring secure government securities over riskier private sector investments. Surprisingly, this trend has extended beyond commercial banks, permeating sectors traditionally focused on underserved markets—areas often overlooked by mainstream financial institutions.
Development Finance Institutions (DFIs) and Microfinance Banks, originally designed to bridge financial gaps, have found themselves swept up in this strategic shift. A prime example is Pak Kuwait Investment Company (PKIC), Pakistan’s largest DFI. After operating akin to a hedge fund for two years, PKIC is now in the midst of a strategic realignment. This change comes on the heels of challenging financial results, with the company reporting net interest income losses in both the first and second quarters of 2024.
To fully grasp the implications of these industry-wide changes and PKIC’s evolving strategy, let’s dive deeper on how the past 24 months have played out.
DFI landscape of Pakistan
In Pakistan’s financial landscape, DFIs are categorised into two distinct groups: broad objective and specific objective institutions. Broad objective DFIs, also known as joint venture financial institutions, are established through collaborative efforts with bilateral partners. These institutions are majority-owned by national governments and serve as key instruments in implementing foreign development policies. Typically, their shareholding structure consists of a 50-50 split between the Government of Pakistan (represented by either the Ministry of Finance or the State Bank of Pakistan) and the partner foreign government’s relevant institutions.
One of the significant advantages of these broad objective DFIs is their enhanced creditworthiness, often bolstered by government guarantees or access to international development funds. This privileged position enables them to raise substantial capital from international markets at highly competitive rates, further amplifying their impact on the country’s economic development.
In contrast, specific objective DFIs are created to address the development needs of particular sectors. A prime example is the Pakistan Microfinance Investment Company (PMIC), established as a key component of the National Financial Inclusion Strategy (NFIS). Founded through a collaboration between the Pakistan Poverty Alleviation Fund (PPAF), Karandaaz Pakistan, and the KfW Development Bank, PMIC embodies a partnership dedicated to empowering Pakistanis at the bottom of the economic pyramid by supporting microfinance institutions that serve underserved communities.
For the purposes of this story, our focus remains on the joint venture DFIs in Pakistan. The country boasts seven such institutions: Pak Kuwait Investment Company, Pak Oman Investment Company, Pak China Investment Company, Pak Brunei Investment Company, Pak Libya Investment Company, PAIR Investment Company, and Saudi Pak Industrial Agricultural Investment Company. These entities form the backbone of Pakistan’s development finance sector, each playing a unique role in driving economic growth and fostering international partnerships.
Amongst these DFIs, PKIC is the largest with an asset book of more than Rs 1 trillion. Pak Oman and Pak Libya follow with an asset book of around Rs 414 billion and Rs 511 billion respectively as of June 2024
“All DFIs are relatively small except for PKIC. PKIC’s advantage lies in its 30% stake in Meezan Bank, from which it receives dividends of around Rs 12-13 billion. Hence, PKIC’s profitability compared to other industry players will be significantly different due to these high dividends,” explained an industry source.
(Note: Pak China Investment Company’s annual reports are available for the year 2022 only. The asset book figure corresponds to total assets un the year 2022 which is the latest period for which financial reports are available)
Decades old presence
Established in March 1979, Pak Kuwait Investment Company (PKIC) is a joint venture between the governments of Pakistan and Kuwait. The institution is equally owned by Pakistan through the State Bank of Pakistan (SBP) and Kuwait via the Kuwait Investment Authority (KIA). Like other Development Finance Institutions (DFIs), PKIC was created to support economic growth and capital formation in Pakistan.
Over the years, PKIC has made several significant investments. The most notable venture has been its investment in Meezan Bank, Pakistan’s largest Islamic bank. PKIC holds approximately 30% of Meezan’s shareholding, which has proven to be a profitable stake for the DFI.
PKIC’s involvement in Islamic banking extends further. The company has received in-principle approval to establish Raqami Islamic Digital Bank Limited, in which it holds a 73% equity stake. This digital bank is expected to offer Sharia-compliant digital banking solutions, potentially influencing the country’s banking sector.
In addition to its banking investments, PKIC is expanding into private equity. In March 2022, it signed an MoU with R.J. Fleming and Company Limited to jointly establish a private equity fund. PKIC will provide seed capital, with additional funding to be sourced from both local and international investors through R.J. Fleming’s network. The fund aims to provide growth capital to Pakistani entrepreneurs and potentially facilitate international listings or sales.
The DFI also ventured into the tech sector by acquiring an equity stake in Planet N, a platform that invests in over 40 tech startups. This move adds a technology-focused component to PKIC’s investment portfolio.
Financial performance
Between 2018 and 2023, PKIC has demonstrated significant financial growth. The company’s total revenues have increased by approximately 51% over this five-year period. This growth is fairly evenly distributed between net interest income, which grew by 48%, and non-interest income, which increased by about 51%.
PKIC’s revenue structure is notably influenced by its investment in Meezan Bank. The revenue chart indicates that non-interest income, primarily consisting of income from shares in associates (mainly from the Meezan Bank investment), is a major driver of PKIC’s revenues.
While the share of net interest income in total revenues has remained relatively stable over the years, 2023 saw a remarkable increase in this category. Net interest income jumped by 140%, rising from Rs 2.5 billion to Rs 6 billion in a single year. But how did the DFI manage such exponential growth?
An abrupt shift in strategy
Over the past two years, Pak Kuwait Investment Company (PKIC) has implemented an aggressive growth strategy, which began to take shape in the latter half of 2022. This shift in strategy was largely influenced by changes in government borrowing dynamics and broader financial context.
Historically, when the government needed funds, it could either borrow from banks or directly from the State Bank of Pakistan (SBP). The SBP had the ability to create new money to purchase government bonds at low interest rates, particularly when banks were not offering favourable rates in bond auctions.
This landscape changed significantly with the implementation of an IMF pushed SBP autonomy act, the door for directly borrowing from the central bank was permanently closed. This decision was motivated by concerns over inflation, as direct borrowing from the central bank led to increases in the money supply.
Yet, the government figured out a work around in the shape of Open Market Operations (OMO). OMOs are a central bank tool used to regulate interbank market liquidity through the buying and selling of government securities.
These operations can be either mop-ups (reverse repos) or injections (repos). Post the autonomy act, the SBP, on the government’s behest, started injecting liquidity by lending money to commercial banks in exchange for government securities. The banks then used these repo borrowings to further invest in government securities.
This created a tripartite arrangement where the SBP lent to commercial banks to enhance their liquidity for purchasing government securities, effectively channelling the initial injection to the sovereign.
In June 2022, this benevolent scheme was extended to the DFIs as well by allowing them to participate in OMOs as primary dealers.
PKIC, seeing the opportunity, wasted no time and started borrowing heavily through OMOs to fund its government securities investment. As a result, both PKIC’s investment portfolio and its borrowings expanded sixfold.
In simpler terms, PKIC adopted a cyclical strategy: it used its funds to purchase floating-rate government securities, such as T-bills and PIBs. These securities were then used as collateral to borrow money through repos (OMOs) from the SBP. With the borrowed funds, PKIC bought more government securities and repeated this process.
Financial institutions like PKIC, in this whole arrangement, acted as intermediaries to facilitate the lending to the government by SBP and in return earned a meagre spread of around 0.5% to 1%. However, the DFI was particularly eager on capitalising on this opportunity as by the end of 2023, it held almost 21% of all outstanding OMOs by SBP.
But PKIC was not alone in this
PACRA’s recent report (June 2024) on DFIs highlights significant growth in the sector. The asset base of joint venture DFIs grew by approximately 79% in 2023, reaching Rs 2,231 billion. This growth was primarily driven by a 73% increase in investments, which constituted 87% of joint venture DFI’s asset base by the end of December 2023, up from 81.6% at the end of December 2022. Total assets grew by 63.3% year on year during 2023 and further by 38.8% year on year in the first quarter of 2024.
PKIC, however, was central to this growth, comprising 51.8% of total investments in the category at the end of 2023, with its investments rising to Rs 1,046 billion, a 44.0% increase from the previous year.
PKIC’s investments continued to grow in Q1 2024, reaching Rs 1,067 billion and forming 63.4% of the sector’s total investments. The sector’s overall investments grew by 1.4 times in Q1 2024 compared to the same quarter in the previous year, primarily on the back of higher investments in government securities.
This investment strategy, while profitable, comes with significant risks. The repo rate driving this strategy is directly tied to the SBP’s policy rate. While government treasuries are also heavily influenced by the policy rate, they are subject to market sentiment in the secondary market as well.
PKIC and other banks benefited from the yield differential between government securities and the borrowing rate. As a result, PKIC’s net markup income increased substantially, reaching Rs 6 billion in 2023 from Rs 2.5 billion in 2022. However, despite the rise in net interest income, margins remained slim due to the high borrowing rate nearly matching returns on government securities. This necessitated a volume-driven approach to boost profitability.
This strategy was not unique to PKIC. Other DFIs, such as Pak Libya Investment Company, also saw significant increases in their investment portfolios. Pak Libya’s investments grew from Rs 27 billion in 2021 to Rs 107 billion in 2022, and further quadrupled to Rs 419 billion by 2023. This trend reflects a broader shift among DFIs, all capitalising on the SBP’s liquidity injections and essentially operating like hedge funds by leveraging borrowed funds to increase exposure to government securities.
While this volume-driven strategy had resulted in healthy profitability and growth for DFIs, as increased transactions paid off, it came at the cost of DFIs straying from their core mission—serving as catalysts for development finance. Instead of channelling funds into long-term economic projects, DFIs have focused on lending to the government through securities.
Downside risks materialising
The rapid growth and profitability of financial institutions like PKIC proved to be short-lived. As the market began anticipating progressive rate cuts, yields in secondary markets, for government securities, started to decline. This yield compression put pressure on net interest margins, as borrowing costs remained tied to the SBP policy rate while returns on government securities dropped.
This scenario exposed a potential mismatch in PKIC’s asset-liability management. With investments predominantly in interest rate-sensitive assets and borrowings not adequately matched, the company faced challenges in managing interest rate risk.
The spread for PKIC and many other institutions eventually turned negative, with borrowing rates surpassing returns on government securities. Consequently, net interest margins fell into negative territory. By the first quarter of 2024, PKIC reported a net interest income loss of approximately Rs 4 billion, which doubled to Rs 8.4 billion by the end of the first half of 2024, marking a sharp reversal from previous gains.
An important aspect of this situation relates to bond valuation principles. Typically, declining yields lead to upward revaluation of these securities, which would be reflected in a company’s income. However, PKIC, like most financial institutions in Pakistan, categorised its investment in government securities as “Available for sale.” This accounting treatment requires that revaluation gains or losses are parked in Other Comprehensive Income (OCI) and only transferred to the profit and loss statement when the security is sold or paid off at maturity.
A closer examination of PKIC’s financials reveals a revaluation gain of Rs 3.8 billion on government securities in the second quarter of 2024. However, this gain couldn’t be transferred to the profit and loss statement due to limited opportunities to sell these securities in the secondary market in a rapidly declining interest rate environment.
In response to these challenges, PKIC implemented strategic changes in the second quarter of 2024. For the first time in six quarters, both its investments and borrowings declined. Borrowings reduced by 10%, while investments dropped by around 9%. This shift represented PKIC’s efforts to mitigate the risks of negative interest margins by scaling back its exposure to government securities and reducing reliance on borrowed funds.
What compelled PKIC?
According to an industry source, the involvement of DFIs in the purchase of government securities was crucial. Their participation prevented commercial banks from exploiting the situation and demanding excessively high rates. Without DFIs, aggressive bidding by banks could have potentially driven the policy rate to an alarming 25-27%, rendering government borrowing costs unsustainable.
It’s also worth noting that DFIs like PKIC operate under partial government ownership, which inherently limits their autonomy. Moreover, unlike their counterparts in other countries, Pakistani DFIs lack access to concessional lending schemes for development objectives. Instead, these favourable schemes are predominantly utilised by commercial banks, leaving DFIs without preferential treatment.
Looking ahead, the current interest rate of 17.5% remains prohibitively high for project financing, continuing to skew assets towards government securities. Market risk is expected to escalate further, as evidenced by the government’s recent rejection of all bids for floating-rate Pakistan Investment Bonds (PIBs). This move signals the government’s anticipation of declining interest rates and its strategy to secure lower borrowing costs in the future by avoiding long-term commitments at current rates.
However, this approach introduces new uncertainties for DFIs like PKIC. As yields on government securities potentially shrink, these institutions may face further margin compression and limited near-term profitability. In response to these challenging market dynamics, PKIC has begun adapting its strategy. It’s probable that other DFIs will follow suit, indicating a broader shift in the financial landscape as institutions navigate this complex economic environment.
