Salman Ahmed Shaikh
Energy crisis in Pakistan has worsened in recent years leading to loss of output, increased incidence of manufacturing unemployment, cost push inflation, capital flight, low manufacturing capacity utilization and loss of export markets. The contributing factors to the crisis include inefficient energy mix, price distortions and low investments in alternate energy. The short term measure by the government to absorb loss from price distortions created by an inefficient energy mix has resulted in ballooning fiscal deficit.
One important piece of solution lies in increased availability of financing for energy infrastructure. Here, we analyze the role of Islamic banks in fulfilling this need. Islamic banking in Pakistan has exhibited exceptional success in terms of assets growth. Within 10 years, the niche market now comprises almost 12% of the overall banking sector in Pakistan.
However, questions are still raised about its differential economic merit and contribution to the economy. Energy financing presents a vital opportunity for Islamic banks to show their importance and contribution through financing energy infrastructure.
Islamic banks will benefit from increased financing to energy sector since it will help them i) narrow their banking spreads, ii) increase financing to deposit ratio and iii) reduce operational inefficiencies. Economy wide effects of resolution of energy crisis will help in increasing investment, productivity, fiscal space and export competitiveness. It will also help in reducing crowding out of private sector credit, capital flight and de-industrialization.
In recent months, the gap between deposits and advances has widened in Islamic banking. Islamic banking deposits have outgrown the advances. Islamic banks have surplus liquidity and if they can provide this in the form of energy financing, it will improve their profitability and efficiency ratios. It can also enable Islamic banks to cut down their spreads which are currently higher than conventional banks. This in turn will make them more competitive with other banks.
Furthermore, the contribution of energy financing in the total financing mix is extremely low. Hence, with stagnant industrial demand for credit, Islamic banks can increase their financing to the energy sector itself to solve the bottleneck and contribute in pulling the economy out of sluggishness.
How will Energy Financing Help Islamic Banks
Islamic banking spreads – the difference between average financing and deposit rates – have been constantly higher than the overall banking spreads in Pakistan. By utilizing the growing deposit base in long term energy financing, the Islamic banks will be able to improve profitability ratios and will not have to depress deposit rates which they were doing before as they did not make effective use of pool of assets available for financing.
Improve Financing to Deposit Ratio
Islamic banks in Pakistan have surplus liquidity. Energy financing will enable them to use their liquidity themselves and earn greater profits on new financing assets creation rather than placing the funds with conventional banks.
Less than 1% of Islamic financing assets are involved in micro financing. Financing costs are also high in Islamic banking as depicted by the high spreads ratio. Contribution to SME financing and rural presence is also low in Islamic banking as compared to conventional banking in Pakistan. This has raised the issue of form versus substance in Islamic banking. Energy financing is one specific avenue for Islamic banks to explore and through which they can meaningfully create a positive and visible contribution in the economy.
Deepening of Islamic Money Market
Through issuance of more Sukuk, the investment class assets universe will expand and it will enable the Islamic-conscious individual and institutional investors to effectively diversify their portfolios. Treasuries of Islamic banks will also have an expanded set of investment avenues. It will increase liquidity of these Sukuk and generate wider interest among all investors in the economy to consider investing in these investment vehicles.