Progress Report on Tranche Release

Program Number: 41108 Loan Number: 2340 June 2011

Pakistan: Second Generation of Capital Market Reform Program (Second Tranche)

CURRENCY EQUIVALENTS (as of 15 June 2011) Currency Unit – rupee/s (PRe/PRs) PRe1.00 = $0.01166 $1.00 = PRs 85.76

ABBREVIATIONS ADB – Asian Development Bank AETP – Accelerating Economic Transformation Program FSCP – Financial Services Commission of Pakistan FY – fiscal year GDP – gross domestic product ICM – Institute of Capital Markets INPRS – International Network of Pension Regulators and Supervisors IOSCO – International Organization of Securities Commissions ISE – Stock Exchange KSE – LSE – Stock Exchange MOF – Ministry of Finance NBFC – nonbank finance company NBFI – nonbank financial institution NIT – National Investment Trust NSC – national savings center OPS – occupational pension scheme PC – Privatization Commission REIT – real estate investment trust SBP – SECP – Securities and Exchange Commission of Pakistan SOE – state-owned enterprise TA – technical assistance

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., FY2010 ends on 30 June 2010. (ii) In this report, “$” refers to US dollars.

Vice-President X. Zhao, Operations 1 Director General J. Miranda, Central and West Asia Department (CWRD) Director D. Kertzman, Financial Sector, Public Management and Trade Division, CWRD Team leader L. Schou-Zibell, Senior Economist, CWRD Team members A. Bhandara, Project Officer, Pakistan Resident Mission L. Nazarbekova, Senior Counsel, Office of the General Counsel L. Raquipiso, Senior Economics Officer, CWRD F. Teves, Assistant Project Analyst, CWRD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area. CONTENTS

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I. INTRODUCTION 1 II. MACROECONOMIC PERFORMANCE AND PROGRAM IMPLICATIONS 1 III. PROGRAM PERFORMANCE AND THE STATUS OF POLICY ACTIONS 4 A. Second-Tranche Policy Actions 4 B. Status of Second-Tranche Policy Actions 5 C. Summary of Progress 12 IV. CONCLUSION 13 V. THE PRESIDENT’S RECOMMENDATION 13

APPENDIXES 1. Key Financial Sector Indicators 14 2. Karachi Stock Exchange Trading 15

I. INTRODUCTION

1. The Asian Development Bank (ADB) approved the Second Generation of Capital Market Reform Program (the Program) for the Islamic Republic of Pakistan on 31 July 2007.1 The program builds on the ’s longstanding capital market reform agenda, which aims to develop a more balanced finance sector and improve financial intermediation. Policy outcomes promote (i) the development of institutional investors to facilitate long-term capital formation and increase demand for securities, (ii) improved efficiency in the securities market to increase the supply of corporate securities and optimize the allocation of financial resources to productive investments, and (iii) the strengthened governance of capital markets to improve market transparency and protect investors.

2. The Program comprises a $400 million program loan from ADB’s ordinary capital resources and a $1 million technical assistance (TA) grant to support implementation. The program loan has two tranches, each to be released after compliance with specified policy actions. The first tranche of $200 million was disbursed on 16 June 2008, 11 months after program approval. The delay was caused by changes to draft legislation prepared under the first tranche of the program that occurred after approval by ADB's Board of Directors. These changes appeared to reverse a key reform action.2 The government was able to address ADB’s concerns.3

3. To meet the second-tranche release requirements, nine second-tranche policy actions need to be complied with and sufficient progress needs to be achieved in the carrying out of the program, including compliance with 14 monitorable actions. This progress report outlines the second-tranche reforms implemented and achievements that demonstrate good compliance with tranche release policy actions and monitorable actions. While Program implementation was slower in 2009-2010 due to a range of factors, including rethinking of financial sector regulatory architecture in light of the global financial crisis, greater focus on tax and overall fiscal management reforms, the Government’s pre-occupation with the flood disaster, and a major Constitutional amendment which realigned powers between different levels of governments, there has been renewed focus on the Program in the last two quarters. Of the nine second- tranche policy actions, seven have been complied with and two partly complied with (while full compliance is being pursued by the Government). Of the 14 monitorable actions, eight have been complied with, three have been partly complied with, and three have not been complied with.

II. MACROECONOMIC PERFORMANCE AND PROGRAM IMPLICATIONS

4. Macroeconomic developments. Pakistan’s economy has struggled to regain stability since the global financial crisis in 2008. Unprecedented floods that affected the entire country in August 2010 further exacerbated the economy’s underlying fragility. Flood damage was

1 ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Technical Assistance Grant to the Islamic Republic of Pakistan for the Second Generation of Capital Market Reform Program. Manila (Loan 2340-PAK, for $400 million). 2 Subsequent legislative changes enabled senior government officials to participate on the policy board of the Securities and Exchange Commission of Pakistan (SECP), raising concerns regarding its independence. Changes also raised issues concerning the alignment of powers among financial sector regulators and the potential for regulatory overlap. 3 The government revised the draft amendments to remove senior government participants from the SECP policy board and to clarify that the SECP would regulate the securities and debt market and nonbank finance companies. However, issues concerning regulatory jurisdiction remain because of the blurring of product lines and financial consolidation.

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estimated at $10 billion, equal to 5.8% of the gross domestic product (GDP) of fiscal year 2010. Even before the floods, concerns were growing about the state of Pakistan’s economy. While Pakistan's external economic position improved significantly—the external current account deficit declined to 2% of GDP in 2010, State Bank of Pakistan (SBP) foreign exchange reserves rebounded to $13.1 billion by June 2010, and economic activity showed signs of acceleration, with real GDP growing by 4.1% in 2010—fiscal performance deteriorated. The 2010 fiscal deficit target, which was revised upward to 5.1% of GDP in March 2010, was missed by a wide margin of 1.2% of GDP.4 This was because of substantial overruns in electricity subsidies and other public spending and a shortfall in tax revenues. The paucity of structural reforms caused delays in mobilizing budget support from development partners, which caused the government to borrow from the central bank to finance its substantially higher fiscal deficit. Expansionary fiscal policy and the monetization of government debt added to inflationary pressures.

5. During 2010, headline inflation increased to 15.5% from 10.5% in 2009. In particular, the contribution of perishable food commodities to overall 2010 consumer price index inflation rose to 16.5%, the highest since 2004. This rise is attributed to shortages of perishable food commodities caused by floods and rains, the direct impact of rising international commodity prices, the indirect impact of increased fuel prices on transportation costs, upward adjustment in the electricity tariff, strong external demand for key food staples, and the monetization of the fiscal deficit. Although this may be a temporary acceleration in prices resulting from flood damage to crops, heavy government borrowing from the banking system to meet burgeoning government expenditures is likely to exacerbate the problem. To mitigate inflationary pressures, the SBP raised the policy interest rate by an average of 1% in 2010.

6. The balance of payments has thus far remained stable but is coming under pressure. After posting a 6-month surplus in the first half of 2011, Pakistan’s current account balance fell back into deficit because of rising imports and declining inflow of dollars. Foreign exchange reserves at the end of the third quarter of 2011 stood at $17.49 billion.

7. To help stabilize the economy after the global financial crisis but before the floods, the government requested ADB and other development partners to provide exceptional financial assistance. 5 In response, ADB processed subprogram 1 of the Accelerating Economic Transformation Program (AETP) cluster in September 2008.6 Subprogram 1 of the AETP helped the government mitigate the adverse short-term impact of spiraling food and fuel prices and address some of the more fundamental challenges constraining faster growth, including reforms to strengthen the financial sector. In June 2009, ADB processed subprogram 2 of the AETP to help the government complete short-term stabilization measures including (i) reducing distortions in the agriculture and energy sectors, (ii) improving the social safety net for the poor and vulnerable, and (iii) strengthening financial intermediation.7

8. The government’s tight demand-management policies, infrastructure deficits, and the economic and financial impact of the floods will continue to exert pressure on Pakistan’s

4 The 2011 fiscal deficit target is 4.0%; the government’s fiscal deficit as of May 2011 is 5.7%. Source: Pakistan Budget 2011–2012. 5 The government entered into a standby arrangement with the International Monetary Fund in November 2008. ADB has closely coordinated its exceptional financial support with the International Monetary Fund and the World Bank. 6 ADB. 2008. Report and Recommendations of the President to the Board of Directors: Proposed Program Cluster and Loans to the Islamic Republic of Pakistan for Subprogram 1 of the Accelerating Economic Transformation Program. Manila (Loans 2446/2447-PAK totaling $500 million). 7 ADB. 2009. Report and Recommendations of the President to the Board of Directors: Proposed Program Cluster and Loans to the Islamic Republic of Pakistan for Subprogram 2 of the Accelerating Economic Transformation Program. Manila (Loans 2524/2525-PAK totaling $500 million).

3 economy, which expects GDP growth of 2%–3% in 2011. The economy will continue to face pressure as well from the uncertain security environment, higher inflation, acute power shortages, and slowdown in the heavy manufacturing and services sectors.

9. Global financial crisis. The global financial crisis imposed liquidity constraints and increased prudential risks on Pakistan’s finance sector (Appendix 1). Gross nonperforming loans as a percentage of total loans in the banking sector increased from 9.1% in 2008 to 12.4% in 2010. The floods in 2010 contributed to a further increase in nonperforming loans to 14.7% in 2011. The risk increased of interconnected and direct lending and contagion among banking groups, many of which have nonbank finance company (NBFC) subsidiaries and affiliates. The institutional structure of financial regulation in Pakistan makes such risks difficult to supervise. A firm’s legal status (e.g., as a bank, broker dealer, or insurance company) determines which regulator oversees its safety and soundness and business conduct. Under this approach, the Securities and Exchange Commission of Pakistan (SECP) regulates NBFCs and the capital market and the SBP regulates banks.

10. Regulatory architecture. The reforms under the Second Generation of Capital Market Reform Program build on the institutional approach to regulation and strengthen the framework for SECP oversight of NBFCs. After the Program was approved, the SBP requested ADB to provide TA to help strengthen prudential regulation and the supervision of financial conglomerates in accordance with international best practice principles. 8 Under Basel Core Principle 24, the relevant regulator should have sufficient powers to address prudential risks arising from affiliates and subsidiaries. SBP reforms to strengthen prudential regulation were included in subprogram 1 of the AETP. The SBP prepared draft legislation, approved by the cabinet that designated the SBP as the lead regulator of financial conglomerates and transferred the regulation of deposit-taking NBFCs to the SBP.

11. During discussions on subprogram 2 of the AETP and in light of lessons from the global financial crisis, the government decided to revisit prudential regulation reform under subprogram 1 of the AETP. Instead of adopting the lead regulator concept, the government proposed moving to an integrated regulatory framework. ADB urged the government to review alternative approaches and related resource implications carefully before making such a drastic change. Subsequently, under subprogram 2 of the AETP, the government decided to take a three- pronged approach to strengthening prudential regulation, by which the government would (i) initially focus on better cooperation and information sharing between the SECP and the SBP, with joint oversight of financial conglomerates, and move toward harmonized prudential regulation to address regulatory arbitrage concerns; (ii) impose higher capital requirements on NBFCs that accept retail deposits; and (iii) examine options to improve the regulatory architecture over the longer term to address perceived regulatory gaps (footnote 7). ADB plans to continue to work with the government on this issue, with a focus on capacity building to ensure that key decision makers understand various regulatory options and their applicability to Pakistan.

12. Stock market performance. In 2008, deteriorating economic conditions induced an outflow of foreign investments and contributed to a significant decline in stock market activity (Appendix 2). After joining the list of best-performing stock markets in the world in 2007, the stock market became one of the worst performers in 2008, when Pakistani stocks lost 57% of

8 ADB. 2007. Technical Assistance to the Islamic Republic of Pakistan for Support to Governance Reforms in Pakistan. Manila (financial governance subproject under TA cluster 4922-PAK for $11.5 million).

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their value. The decline was exacerbated by the implementation by the Karachi Stock Exchange (KSE) of a floor on exchange traded prices in August 2008, which was lifted in December 2008.

13. To revive the market, the government-owned National Investment Trust (NIT), the country’s largest asset management company, invested PRs7 billion into the PRs20 billion State Enterprise Fund in January 2009, which invested in turn in the stock market. Current NIT investments in the fund stand at PRs11.8 billion. Other contributors to the fund included government institutions (the National Bank of Pakistan, State Life Insurance Company, and Employees Old Age Benefits Institution) and a consortium of commercial banks. The fund invested in eight eligible stocks trading in the market, seven of which are state-run companies and one of which is a private company: Pakistan Telecom. The government provided sovereign guarantees to the lenders to the fund and planned to repay the amount lent in 3 years at the annual Karachi interbank offered rate plus 1%. This interest is paid by NIT semiannually. Installments due in May 2011 are paid. As NIT is the only unit holder of the fund, all earnings after deducting applicable costs are kept by NIT. When the market stabilizes, NIT plans to sell units of the fund to nonresident Pakistanis. Currently, NIT is the only unit holder, and the fund is not offered to the public. After the stock market crash, the fund helped to improve trading liquidity by investing PRs200 million in the market daily but is now investing only as and when required. With support from the fund, the market bounced back to near pre-crisis levels (Appendix 2).

14. Lessons Identified. Several important lessons were learned implementing the Second Generation of Capital Market Reform Program. First, based on ongoing financial consolidation and the blurring of product lines, a sector-wide approach to finance sector development and regulation is needed. In an increasingly consolidated finance sector, a fragmented regulatory approach leaves gaps in consumer protection and additional systemic risks. Ongoing engagement with key stakeholders, including both financial sector regulators, is needed to develop consensus on, and strong ownership of, the way forward. During the processing of the program and the AETP, the lack of effective government coordination of finance sector regulatory issues placed ADB in a difficult position and caused conflicts in regulatory approaches and related turf battles.

15. Second, with regard to financial market oversight, the primary focus should be on regulatory objectives rather than on regulatory architecture, which is a political issue. Decisions are based on the role envisioned for the central bank, market size, development objectives, and regulatory culture and objectives.

16. Third, a number of program reforms required enacting legislation, which is outside the control of the executive branch. While the preparation of legislation reflects government commitment to reform, unless laws are enacted, these outputs may not bring tangible changes. A number of reforms were outside the scope and power of the SECP, the key implementing agency, and ineffective intergovernmental coordination and poor market conditions dampened momentum.

III. PROGRAM PERFORMANCE AND THE STATUS OF POLICY ACTIONS

A. Second-Tranche Policy Actions

17. The Second Generation of Capital Market Reform Program supported three interrelated outcomes to remove ongoing constraints on capital market development. These outcomes are reflected in the goals set forth in the government’s Medium-Term Development Framework

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2005–2010 9 and Strategic Directions to Achieve Vision 2030 10 and include (i) developing institutional investors to facilitate long-term capital formation, (ii) improving the efficiency of securities markets to optimize the allocation of financial resources, and (iii) strengthening the governance of capital markets to improve market transparency and protect investors. The five program outputs sought to (i) strengthen the enabling environment for private pension funds and other institutional investors; (ii) remove policy and regulatory constraints on the development of corporate bond markets; (iii) widen equity market breadth and reduce its volatility; (iv) strengthen the institutional framework for sector supervision by transforming the SECP into the Financial Services Commission of Pakistan; and (v) strengthen the governance of securities markets, market professionals, and public issuers.

B. Status of Second-Tranche Policy Actions

18. The government has made steady progress since July 2007 in implementing the second-tranche policy actions (Table 1). Of the nine second-tranche policy actions, seven have been complied with and two partly complied with, while full compliance is being pursued by the Government subject to adoption of legislation by the Parliament.

Table 1: Status of Compliance with Second-Tranche Policy Actions

Policy Action Status S.1. SECP to conduct a sample survey on employer-sponsored OPS in Pakistan and issue a Complied report for stakeholder comments on the enabling environment for such schemes. with S.8. The government to (i) issue tradable government bonds through NSCs and (ii) ensure a Complied lower rate of return for NSC instruments as compared with that of tradable government with bonds. S.9. PC to (i) obtain approval of the Cabinet Committee on Privatization for a policy of Complied supporting capital market development through the sequenced divestment of shares in state- with owned companies through stock exchanges in both domestic and international markets, taking into account stock market conditions and investor demand; and (ii) publicly disclose this policy. S.11. MOF to consider and submit to the cabinet, the draft FSCP law that strengthens overall Partly regulatory governance, after stakeholder consultation and clearance by the Ministry of Law. complied with S.13. SECP to provide a legal and regulatory framework on the reporting requirements of Complied holding companies, including (i) ownership structure and the relationship of companies within with the holding company group; (ii) disclosure of intercompany and related party transactions; and (iii) public disclosure of audited financial reports in accordance with international accounting standards. S.15. MOF to consider and submit to the Cabinet the Securities Law, as defined, after Complied stakeholder consultation and clearance by the Ministry of Law. with S.17. SECP to issue guidelines on obtaining information about unlisted publicly tradable Partly companies (with stock exchanges continuing to provide disclosed information on listed complied companies). with S.19. SECP to (i) develop a system of certification by examination for securities market Complied professionals, and (ii) require all securities brokers and mutual fund sales agents dealing with with public customers to be certified by a designated agency. S.22. SECP to direct all stock exchanges to prepare and submit to SECP a plan for Complied consideration and approval on self regulation, including (i) identification of functions to be with

9 Planning Commission of Pakistan, Government of Pakistan. 2005. Medium-Term Development Framework, 2005– 2010. Islamabad. 10 Planning Commission of Pakistan, Government of Pakistan. 2006. Approach Paper—Strategic Directions to Achieve Vision 2030. Islamabad.

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Policy Action Status performed and capacity needed to perform these functions; (ii) plans for each area (e.g., listed companies, market surveillance, and on- and off-site supervision of professional market participants) in accordance with sound business practices and applicable laws and regulations, including the financial responsibility for, and the quality of execution of, trades on behalf of customers; and (iii) budget estimates of the cost of regulatory compliance. FSCP = Financial Services Commission of Pakistan, MOF = Ministry of Finance, NSC = national savings center, OPS = occupational pension scheme, PC = Privatization Commission, SECP = Securities and Exchange Commission of Pakistan. Source: Asian Development Bank.

19. Of the 14 monitorable actions, progress has been made on actions being implemented by the SECP and the Ministry of Finance (MOF) (Table 2). Eight actions have been complied with, three have been partly complied with, and three have not been complied with. With regard to the three actions that have not been complied with, one requires improved market conditions and legislative changes11 and two require the resolution of regulatory architecture issues. A narrative summary of progress under each of the four components of the program is discussed below.

Table 2: Status of Second-Tranche Monitorable Actions

Monitorable Action Status S.2. SECP to develop guidelines for voluntary employer-sponsored OPS. Complied with S.3. Upon approval of the Cabinet Committee on Privatization on a case by case basis, the Partly PC to offer a specified portion of the SOE shares offered to the general public to private complied pension funds registered by the SECP. with S.4. SECP to draft and submit to MOF, and MOF to submit to Parliament for approval Not legislation governing NBFCs and collective investment schemes (mutual funds) that complied (i) establishes SECP as the regulator and supervisor; and (ii) includes independent with regulation-making authority (such as for issuing prudential regulation) and inspection, investigation, and enforcement powers. S.5. The PC with the support of a financial advisor and/or lead manager to consider various Not options for structuring the privatization of NIT and seek the approval of the Cabinet complied Committee on Privatization on the transaction structure. with S.6. MOF and SBP to maintain the benchmark yield curve and increase its liquidity over Complied time by increasing the amounts of individual issues. with S.7. SECP to publish guidelines for the creation of a limited secondary market among Partly “qualified institutional buyers” of corporate bonds issued through private placements. complied with S.10. Upon the approval of the Cabinet Committee on Privatization on a case to case basis, Not the PC to offer a specified portion of SOE shares through a book-building process in line complied with international best practices to domestic buyers with such shares being eligible for with secondary market trading among such buyers for a specified period of time, and SECP to allow the use of shelf registration procedures. S.12. The government to submit to Parliament for enactment the draft FSCP law as Partly approved by the Cabinet. complied with

11 In 2008, after the program was approved, the Supreme Court declared the privatization of Pakistan Steel Mills null and void based on procedural irregularities that produced an unfair reference price. Pakistan Steel Mills was privatized through an open auction in May 2006, when a controlling stake was sold to a consortium of companies that submitted a winning bid. In response to public outcry, the chief justice of Pakistan brought an action against the privatization, citing irregularities in the process. The voiding of this transaction has raised issues regarding the fairness and predictability of the privatization process and concerns about the government’s ability to implement its privatization agenda.

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Monitorable Action Status S.14. SECP to undertake a self-assessment to determine compliance with international best Complied practices in the regulation and supervision of securities markets and private pension funds. with S.16. The government to submit to Parliament for enactment the draft Securities Law as Complied approved by the cabinet. with S.18. The government to give SECP the power to approve or disapprove audit firms Complied authorized to audit financial institutions licensed or registered by SECP, listed companies, with publicly tradable companies, and financial holding companies that one or control over or more NBFIs. S.20. SECP to require all brokerage firms to designate a compliance officer certified by Complied examination by a designated agency. with S.21. The intermarket surveillance committee to meet and submit reports bimonthly or as Complied otherwise deemed appropriate by the SECP. with S.23. SECP to conduct public consultations on stock exchange rules and practices that Complied constrain the exchange of information between stock exchanges (which leads to price with distortion). FSCP = Financial Services Commission of Pakistan, MOF = Ministry of Finance, NBFC = nonbank finance company, NBFI = nonbank financial institution, NIT = National Investment Trust, OPS = occupational pension scheme, PC = Privatization Commission, SBP = State Bank of Pakistan, SECP = Securities and Exchange Commission of Pakistan, SOE = state-owned enterprise. Source: Asian Development Bank.

1. Supporting the Development of Institutional Investors to Facilitate Long- Term Capital Formation

20. One second-tranche policy action and four monitorable actions support the outcome to develop institutional investors and thereby facilitate long-term capital formation. While the policy action was fully complied with, progress has been slow in implementing monitorable actions relating to privatization or requiring the resolution of regulatory architecture issues.

21. The SECP is in compliance with policy action S.1. It conducted a survey on employer- sponsored occupational pension schemes (OPSs) that sought to obtain information about the coverage, investment, and benefits of OPSs and was posted on the SECP website for public comment. The SECP sent the survey to 575 listed companies. 322 out of 355 who responded offer OPSs and/or pension schemes to their employees. The survey found that OPSs are not regulated or supervised by any regulatory body in Pakistan, leaving gaps in plan-holder protection. For example, trustees’ responsibilities have not been prescribed nor have actuaries and auditors for such plans been provided with any guidelines on standards of practice or valuation.

22. The SECP is in compliance with monitorable action S.2, requiring the development of guidelines for OPSs. Based on survey findings, the SECP issued a report recommending a regulatory framework for OPSs. After the program was approved, the SECP Act, 1997 was amended to codify the SECP’s power to regulate OPSs. Thus, instead of preparing guidelines, which are not enforceable and more a short-term measure, the SECP prepared, with the assistance of an ADB expert under the associated TA,12 comprehensive and forward-looking legislation in this area that incorporates international best practices. The draft legislation includes provisions regulating OPSs that can be turned into enforceable implementing regulations as an interim measure. However, consequent to the recent 18th Amendment to Pakistan’s Constitution, which raises issues regarding the power of the federal government to

12 ADB. 2007. Technical Assistance to the Islamic Republic of Pakistan for Supporting Second Generation of Capital Market Reform Program. Manila, for $1 million.

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regulate pensions, issuance of such regulations has been deferred. The devolution of functions from the federal government to provincial governments should be completed by 30 June 2011.

23. Monitorable action S.3, requiring the Privatization Commission to allocate a certain percentage of state-owned enterprise (SOE) shares to registered private pension funds, was partly complied with. Shortly after the approval of the Second Generation of Capital Market Reform Program, the Privatization Commission conducted two privatizations in which private pension funds were eligible to participate. Because domestic pension funds are small, with only about PRs1 billion, a decision was taken to make a broad public offering—the October 2007 sale of 7.5% of Habib Bank shares through the local stock market—and an offering to all institutional investors: 3.26% of United Bank Limited through global depository receipts. Subsequently, no privatization transaction was undertaken because of the fragile economic and security situation.

24. Another monitorable action, S.4, required the SECP to prepare and submit to MOF draft legislation governing the regulation and supervision of NBFCs, and for MOF to submit this legislation to Parliament for approval. This was not complied with. While the SECP began preparing this draft, work was discontinued because of conflicting views on NBFC oversight within the government (para. 11). With support initially provided by ADB, the SECP continues to work closely with the SBP and MOF to develop an optimal framework for NBFC oversight. Once the government has developed a consensus on the way forward with regard to its regulatory architecture, legislation can be drafted. In addition, under the AETP, the government is moving to a risk-based approach to regulating NBFCs to address regulatory arbitrage concerns. Legislative reforms will need to reflect this approach.

25. Monitorable action S.5 requires the Privatization Commission, with the support of a financial advisor and/or lead manager, to consider various options for structuring the privatization of NIT and to seek the approval of the Cabinet Committee on Privatization on the transaction structure. This was not complied with, and NIT privatization has been delayed because of poor market conditions, so options have not yet been developed for structuring NIT privatization.

2. Improving the Efficiency of the Securities Market to Optimize the Allocation of Financial Resources

26. The program included two second-tranche policy actions and three monitorable actions to facilitate the development of the corporate bond market. Both policy actions have been complied with and so has been one of the monitorable actions. However, the monitorable action relating to privatization and one related to SECP oversight over NBFCs and collective investment schemes have not been complied with. For the SECP to oversee NBFCs and collective investment schemes, the government needs to decide on its financial regulatory architecture and adopt the legislation related to this oversight.

27. The government has complied with second-tranche condition S.8, which required introducing tradable retail bonds to be sold through national savings centers at a rate higher than the rate of return for other tradable government bonds. The government launched these bonds in January 2010. They are listed and traded on Pakistan’s stock exchanges and transferable through the central depository system. To promote the sale of these bonds, the government is paying a rate of return of 12.50%–12.60%, which is 0.35%– 0.60% higher than the rate of return on other non-tradable national savings scheme certificates and bonds.

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28. The government has complied with second-tranche condition S.9, to promote SOE privatization through stock exchanges. On 3 February 2011, the Cabinet Committee on Privatization approved a policy for supporting capital market development by the divestment of shares in several SOEs through international and domestic capital markets. The implementation of this policy has been delayed, as the global financial crisis caused a significant decline in share prices on local stock exchanges and created an environment in which pricing fairly or attract investors continues to be difficult (Appendix 2). The government is monitoring the market, and if it sees a positive response from investors, it plans to offer specified portions of SOE shares through open market bidding and the stock market.

29. The government has complied with monitorable action S.6, on improving the benchmark yield curve and increasing liquidity over time. MOF and the SBP have worked closely to ensure the regular issuance of government securities, consolidate issues, and lengthen duration to build the yield curve. Participation was good in the December 2010 Pakistan investment bond auction, with bonds auctioned for a value of PRs22.39 billion. In February 2011, a reopening of the Pakistan investment bond issuance (the 40th regular auction—4th reopening) was held, and bonds were auctioned for a value of PRs27.85 billion. MOF has been provided with full autonomy to decide the cutoff yield for government securities. The trading of government securities is increasing and stood at PRs390.03 billion as of February 2011, nearly double the PRs200.2 billion of October 2010. However, corporate bond issues remain limited and are open mainly to banks issuing term finance certificates to raise tier 2 capital. Major industrial corporations have stayed out of the market to keep their financial positions confidential.

30. The SECP has partly complied with monitorable action S.7 to enable the creation of a limited secondary market for corporate bonds issued through private placements for qualified institution buyers. The SECP and all three stock exchanges are working closely to develop the secondary market for privately placed corporate debt issues. SECP has approved amendments to regulations governing the over-the-counter (OTC) market of the three stock exchanges to provide a regulatory framework for the trading of such securities among qualified institution buyers. Thus instead of issuing guidelines to enable such market, SECP approved relevant amendments to stock exchange regulations. In addition, all three stock exchange are revamping their legal and operational framework for trading corporate bonds. In this regard, the SECP approved the Bonds Automated Trading System Regulations for all three exchanges. All three exchanges are implementing the online trading system for corporate debt. This system promotes transparent and efficient price discovery by providing for electronic order entry and screen-based trading with a matching facility, operating on a price–time priority and matching orders automatically. In addition, the system provides complete online market information through various inquiry facilities. The volume of trading through the system on 31 January 2011 was 121.35 million shares totaling PRs7.46 billion.

31. The government has not complied with implementing monitorable action S.10, related to the use of shelf registration for the sale of privatized SOE shares, because of legal ambiguities. While shelf-registration procedures for corporate debt are allowed under SECP procedures for term finance certificates, sections 57A and 62B of the Companies Law, 1984 do not recognize shelf registration for equity issuances. To address this legal ambiguity, the SECP has included the power to allow shelf registration for equity shares in the draft securities law. A comprehensive shelf-registration regime will be put in place after this draft is enacted. Regulations for the issue of shares through the book-building process have been notified as part of the Listing Regulations of the KSE in March 2008, in May 2008 and Islamabad Stock Exchange in July 2008. Pending clarification of the legal and regulatory

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framework for the shelf registration of SOE shares and improvement in market conditions, the Privatization Commission is willing to use such procedures for future SOE privatizations.

3. Strengthening the Governance of Capital Markets to Improve Market Transparency and Protect Investors

32. The program includes six second-tranche policy actions and seven monitorable actions to strengthen the institutional framework for capital market supervision and governance. The government complied with four second-tranche policy actions but needs a waiver of full compliance with two policy actions. The government has complied with four monitorable actions, partly complied with two, and needs to defer compliance of one monitorable action pending the resolution of financial regulatory issues.

33. The MOF has partly complied with policy action S.11. The draft Financial Services Commission of Pakistan act that was submitted to MOF as a condition for the release of the first tranche under the program was subsequently revised to address issues relating to the ongoing debate on regulatory architecture issues and to strengthen SECP independence, accountability and powers (see para. 2). The draft was renamed the SECP act, 2009 to dispel the impression that the SECP was becoming an integrated financial sector regulator. The SECP policy board approved this draft, which was then submitted to the Parliament in June 2011 after clearance from the cabinet and the Ministry of Law. However, policy action S.11 is considered partly complied based on a last minute inclusion in the Finance Bill 2011-2012 and the draft SECP act of a provision that is being imposed on a few revenue generating agencies including the SECP. These provisions require the SECP to remit any surplus revenue to the Federal Consolidated Fund. It was introduced in order to consolidate any non-tax receipts over and above expenditures of regulatory agencies, given the government’s focus on increasing its tax and non-tax revenues. However, in light of the role of the SECP Policy Board and its current composition, inclusion of such a clause may undermine the SECP’s independence—SECP Policy Board approves the SECP budget and comprises the Finance Secretary as its chair along with the SECP Chairman, three representatives from the Government, and 4 private sector representatives as its members. The four private sector representatives on the Policy Board are yet to be appointed. To address such concerns, the Government has provided ADB with a written assurance that it will: (i) seek to remove the revenue related amendments from the Finance Bill 2011-2012 and the draft SECP act that are under consideration by the Parliament, (ii) appoint, by September 2011, the four private sector representatives to the Policy Board, and (iii) adopt other measures to address any conflict of interest that may affect SECP’s autonomy in the meantime.

34. The submission of the SECP act to the Parliament, with the above referenced provision, ensured partial compliance with monitorable action S.12 which requires submission of the draft act to the Parliament as approved by the cabinet.

35. In compliance with policy action S.15 and monitorable action S.16, MOF also submitted the new draft securities law to the cabinet and then to the Parliament.

36. The SECP has complied with policy action S.13, which required the adoption of a legal and regulatory framework for the reporting requirements of holding companies. The SECP adopted the Group Companies Registration Regulations, 2008 in December 2008. In addition, in February 2009, it adopted and began implementing a new organizational strategy to improve employee efficiency, which was not a second-tranche action but built on first-tranche reforms to improve SECP capacity.

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37. The government has complied with monitorable action S.14. Good progress has been made in undertaking a self-assessment to determine compliance with International Organization of Securities Commissions (IOSCO) Principles and Objectives of Securities Regulation. The SECP established an interagency task force to undertake the self-assessment and has reviewed SECP compliance with core IOSCO principles. With the help of the United States Securities and Exchange Commission, the IOSCO assisted the SECP in assessing compliance with principles related to information sharing in connection with cross-border fraud. In April 2011, the IOSCO announced that the SECP had been invited to become a full signatory of the IOSCO Multilateral Memorandum of Understanding Concerning Consultation, Cooperation, and the Exchange of Information. The United States Securities and Exchange Commission helped the SECP prepare a draft IOSCO assessment identifying legal, regulatory, and supervisory gaps. Based on this assessment, ADB provided consultant support under the associated TA to help the SECP address related regulatory and supervisory gaps regarding stock exchange demutualization and term finance certificates. ADB also helped to strengthen the Institute of Capital Markets. With regard to private pensions, the SECP has undertaken a self-assessment of compliance with best practice principles prepared by the Organization for Economic Co- operation and Development and adopted by the International Network of Pension Regulators and Supervisors (INPRS).13 ADB provided support to the SECP for developing new legislation that incorporates these principles (paragraph 22).

38. The SECP has partly complied with second-tranche policy action S.17. It prepared draft regulations on obtaining information about unlisted publicly traded companies. Issuing these regulations requires enacting the new securities law that has been submitted to the Parliament. Under the law, companies that would like to have their shares publicly traded are required to be listed. Thus, the emergence of “unlisted” publicly traded companies requires legislative amendment. The draft securities act, 2010, which has been submitted to Parliament, provides the SECP with the power to regulate unlisted publicly traded companies and will enable the development of an unlisted secondary market for privately placed securities.

39. The SECP has complied with monitorable action S.18. In accordance with the action, the SECP was provided with the power to regulate firms that audit regulated institutions under section 4(j)(b) of the SECP Act through amendments to the Finance Bill, 2008. Under this section, the SECP can establish a panel of auditors, from which regulated companies may appoint auditors, and approve audit firms for regulated entities. While this power has been challenged in court, the SECP is confident that these amendments will be upheld. The case is pending.

40. The government has complied with second-tranche policy action S.19, requiring it to develop a certification system for securities intermediaries and impose related certification requirements. The Institute of Capital Markets (ICM) has been established for examinations and certification. In collaboration with the National Testing Service, it has developed systems to conduct examinations and finalized the curriculum, study guidelines, and recommended reading materials for certification programs for brokers and mutual fund agents. In October 2009, the SECP adopted a requirement for securities brokers and mutual fund agents dealing with the public to be certified, with effect from 30 June 2011. Intermediaries need to have either two individuals on their staff or 20% of their professional staff certified, whichever is higher. New

13 As part of an effort to codify best practice, in April 2001, the INPRS adopted a set of 15 principles of supervision for private OPSs designed to safeguard the interests of beneficiaries and ensure the efficient running of such plans. The INPRS is a group of 100 regulatory and supervisory institutions in more than 60 countries. The SECP became a member of the INPRS in June 2004. INPRS members include the Organisation for Economic Co-operation and Development, World Bank, and International Social Security Association.

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professional entrants into the market need to be certified within 1 year of employment. Existing professionals aged 35 and above with relevant capital market experience of at least 5 years have been grandfathered.

41. The SECP has complied with monitorable action S.20, which requires all brokerage firms to designate a compliance officer certified by examination by a designated agency. As of 2011, the ICM has conducted four sets of examinations for each of the programs, which saw 88 candidates receive mutual fund certification and 11 candidates receive broker certification. The examinations take place on the last Sunday of every quarter. The ICM has also developed detailed curriculum and study material for an upcoming certification program for research analysts working at equity brokerage houses and asset management companies. These have been approved by the ICM board of directors and are pending SECP approval.

42. The SECP has complied with second-tranche policy action S.22, requiring stock exchanges to develop plans for self-regulation. The KSE has submitted a plan that the SECP is reviewing. All three exchanges have requested the SECP to defer final submission to enable them to develop these plans as part of their demutualization, which will raise new regulatory issues. Under the TA, ADB provided the SECP with an expert to help develop new policies for self-regulation after demutualization to address conflicts of interest effectively. In addition, to enable demutualization, the cabinet approved the new Stock Exchanges (Corporatization, Demutualization, and Integration) Ordinance on 22 January 2008.

43. The SECP has complied with monitorable action S.21, on establishing the Inter Exchange Surveillance Committee—composed of staff of the KSE, Lahore Stock Exchange, Islamabad Stock Exchange, and SECP—as a forum to facilitate prompt, interactive, and effective decision making on surveillance issues and improve coordination among the stock exchanges. Nine Inter Exchange Surveillance Committee meetings have been held to date.

44. The SECP is in compliance with the objectives under monitorable action S.23, requiring the SECP to conduct public consultations on stock exchange rules and practices that constrain the flow of information between exchanges and cause price distortions. With the new trading system (para. 30), price quotations from the KSE are now available at the Islamabad and Lahore exchanges in real time, so there is no need for public consultations, as there are no longer impediments to price discovery.

C. Summary of Progress

45. Overall, there has been steady progress in implementing the Program, notwithstanding a range of macroeconomic challenges and natural disasters (para. 3). Notable second-tranche achievements include (i) submitting new securities legislation that incorporates international best practice principles to the Parliament, (ii) providing clear power to the SECP to regulate OPSs and develop an enabling regulatory framework for them, (iii) adopting and implementing a new framework for certifying securities market professionals to promote higher standards of conduct, (iv) developing the bond market by strengthening of the benchmark yield curve, and (v) increased market liquidity through the development of new tradable retail government bonds. In addition, the government is taking a longer-term and more holistic and integrated approach to finance sector regulation to address regulatory gaps and arbitrage and develop a more effective enabling environment. With ADB support, the SECP is closely coordinating with the SBP and MOF on the oversight of financial conglomerates and NBFCs. The SECP has also implemented a number of reform initiatives that complement the program. To increase the supply of tradable instruments, it developed a regulatory framework for real estate investment trusts (REITs). As of

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March 2010, this regulation had resulted in the formation of two REIT management companies, one of them licensed by the SECP to undertake REIT management services. The SECP is also developing an enabling framework for Islamic capital market products and implementing a new capacity development strategy to strengthen its ability to regulate and supervise the market effectively. Less success has been achieved in privatizing SOEs through the capital market to expand product offerings and attract investors.

IV. CONCLUSION

46. As reflected by compliance with second-tranche policy actions and sufficient progress on monitorable actions, the government has demonstrated its commitment to program reforms. ADB continues to engage actively in policy dialogue on finance sector reforms. Additional time is needed for the reforms to have their full impact.

V. THE PRESIDENT’S RECOMMENDATION

47. In view of the steady progress made in implementing the Second Generation of Capital Market Reform Program, as evidenced by compliance with seven second-tranche release conditions, partial compliance with two tranche release conditions, and sufficient progress in the carrying out of the Program, including compliance with monitorable actions, the President recommends that the Board approve, on a no-objection basis:

(i) the waiver of full compliance with two second-tranche policy actions (S11 and S17 in Table 1 above), which have been partly complied with for reasons outlined in paras. 33 and 37 above, and

(ii) the release of the second tranche, in the amount of $200,000,000, for the Second Generation of Capital Market Reform Program.

14 Appendix 1

KEY FINANCIAL SECTOR INDICATORS

Item 2004 2006 2007 2008 2009 2010 A. Sector Outcomes Increased financial intermediation - Broad money (M2) (% of GDP) 44.60 43.60 76.70 44.80 39.20 39.40 - Financial sector assets (% of GDP) 81.80 72.90 74.10 66.00 63.10 62.70 - Banking subsector assets (% of GDP) 55.00 52.60 53.90 48.10 46.50 48.60 - Nonbank subsector assets (% of GDP) … 0.92 0.69 0.51 0.51 0.89 Stock market capitalization (% of GDP) 30.60 35.90 46.20 36.05 16.20 18.40 Outstanding corporate bonds (% of GDP) 0.70 0.40 0.70 0.60 0.90 2.00 B. Sector Outputs 1. Improved financial sector soundness and stability - Total capital of banks (% of total assets) 10.50 9.24 10.52 10.01 10.50 9.90 - Nonperforming loans (% of gross loans) 11.60 6.90 7.60 10.50 11.50 14.70 - Foreign owned banking assets 20.40 5.20 3.30 4.20 3.80 3.30 (% of total) - Total number of commercial banksa 42.00 45.00 47.00 48.00 48.00 46.00 2. Improved financial sector efficiency - Private-owned banking assets 75.00 72.00 74.00 75.00 75.00 80.90 (% of total) - Interest rate spreads 3.50 5.50 7.50 7.80 8.20 7.60 (lending–deposit rate) - Money outside of banks (% of deposits) 37.00 27.80 26.10 26.50 28.90 … - Stock market turnover (% of GDP) 102.90 162.90 87.20 77.20 8.60 11.62 - Stock market turnover 412.90 446.00 187.70 228.90 50.95 63.21 (% of capitalization) - Longest availability of bond maturity (years) 8.00 7.00 8.00 10.00 10.00 10.00 3. Improved financial sector access - Credit to the private sector (% of GDP) 29.30 28.50 28.59 28.08 22.20 21.67 - Bank deposits (% of GDP) 43.30 38.90 41.72 37.09 33.78 29.72 - Number of companies listed at stock exchange 661.00 652.00 658.00 652.00 651.00 652.00 - Number of equity issues 12.00 9.00 11.00 9.00 3.00 8.00 - Number of corporate bond issues 4.00 6.00 7.00 10.00 1.00 15.00 GDP = gross domestic product. a Includes microfinance banks. Sources: Asian Development Bank, International Monetary Fund, Securities and Exchange Commission of Pakistan, State Bank of Pakistan, and Pakistan stock exchanges.

Appendix 2 15

KARACHI STOCK EXCHANGE TRADING

KSE Trading 16,000.00 14,000.00 12,000.00 10,000.00 Index 8,000.00 100 6,000.00 KSE 4,000.00 2,000.00 - Feb-08 Feb-09 Feb-10 Feb-11 Aug-07 Nov-07 Aug-08 Nov-08 Aug-09 Nov-09 Aug-10 Nov-10 May-08 May-09 May-10 May-11

KSE = Karachi Stock Exchange.

Table A1: Karachi Stock Exchange Karachi Stock Market Capitalization Market Capitalization Average Volume Datea Exchange 100 Index (PRs billion) ($ billion) (shares in million) Aug 2007 13,688.90 4,018.34 66.37 197.65 Oct 2007 13,737.47 4,211.53 69.23 341.27 Dec 2007 13,923.68 4,302.75 70.19 244.35 Feb 2008 13,974.41 4,287.83 68.30 264.25 Apr 2008 15,209.86 4,652.92 74.06 270.63 Jun 2008 12,281.20 3,791.25 57.10 140.19 Aug 2008 10,171.39 3,178.49 44.52 103.14 Oct 2008 9,178.97 2,846.28 36.49 0.74 Dec 2008 9,187.10 2,820.42 35.84 39.82 Feb 2009 5,333.95 1,689.60 21.39 160.91 Apr 2009 6,931.90 2,081.34 25.86 289.37 Jun 2009 7,210.34 2,137.13 26.48 110.77 Aug 2009 7,716.99 2,277.17 27.44 155.26 Oct 2009 9,301.18 2,702.82 32.56 214.91 Dec 2009 9,013.04 2,605.55 31.26 119.37 Feb 2010 9,591.51 2,760.43 32.47 164.06 Apr 2010 10,246.77 2,907.18 34.57 194.32 Jun 2010 9,294.18 2,626.16 30.79 99.45 Aug 2010 10,373.53 2,910.62 33.90 59.39 Oct 2010 10,042.44 2,779.23 32.69 106.96 Dec 2010 11,221.81 3,065.80 36.07 163.22 Jan 2011 12,022.46 3,268.95 38.45 186.95 Mar 2011 11,289.23 3,058.03 35.98 116.54 Jun 2011 12,264.06 3,217.53 37.39 93.96 a Index value as of the first day of each month.

Source: Securities and Exchange Commission of Pakistan.