Dubai January 30 2024: The Pakistani Islamic finance industry has been growing on the back of government initiatives to convert the financial sector into being sharia-compliant, along with notable demand from the Muslim-majority population, Fitch Ratings says.
The industry crossed USD53 billion as of end-2023. Fitch expects that, in the medium term, Islamic banking would reach 25% of industry assets, while sukuk would reach 20% of the debt capital market. However, this growth could be dampened by the challenging operating environment, product and distribution gaps, and cases of lower pricing competitiveness than conventional banks. It is also too early to assess if the government will achieve its sharia-conversion targets.
The State Bank of Pakistan’s (SBP) strategic plans for 2023–2028 include transforming existing conventional banks into Islamic banks. SBP had aimed for Islamic banks to have 30% of overall banking assets and deposits by 2025. In 2022, the Federal Shariat Court of Pakistan (FSC) directed the government to adopt sharia-compliant modes while borrowing from domestic or foreign sources, and set a five-year timeline to convert the economy into an “equitable, asset-based, risk sharing and interest-free economy” by end-2027.
Pakistan’s diverse Islamic finance ecosystem consists of Islamic banking assets (55%), followed by outstanding sukuk (37.6%), Islamic non-bank financial institution (NBFI) assets (7%), and takaful assets (0.4%). The financial sector in general is underdeveloped. Sharia-compliant assets made up 36.1% of NBFIs as of end-9M23.
The market share of Islamic banking system assets (end-September 2023: 19.6%; end-2019: 14.9%) and deposits (22.5%; 16.6%) have consistently risen over the past five years. A number of conventional banks are converting to Islamic banks due to growth potential, a government push, and more lax regulations. Faysal Bank Limited completed its conversion to an Islamic bank in 2023. Summit Bank secured approval from SBP to change its name to Bank Makramah, and is transitioning into an Islamic bank, and the Bank of Punjab announced its plans to convert into an Islamic bank in the near term.
Part of the drive to convert is due to regulations that require conventional banks to offer a minimum rate of return on saving deposits, which is 150 basis points less than the prevailing benchmark interest rate. However, Islamic banks are exempt from this. In practice, some Islamic banks offer depositors with minimum rate of return, while for others, the offered rates are lower. While the regulatory exemption may support Islamic banks’ profitability through lower cost of funding, their competitiveness could reduce if they offer lower deposit rates than conventional banks.
Sukuk is helping the government diversify its funding and meet fiscal gaps. Outstanding sukuk reached about 12.8% of the debt capital market at end-2023 (2022: 10%). The government has increased its recourse to domestic borrowing, given limited external financing options for the government. About 95% of outstanding sukuk are denominated in Pakistani rupees. However, the amount that can be raised through sukuk could also be constrained by the value of underlying assets. During the first half of the fiscal year ending 30 June 2023 (FY23), the government’s sukuk offerings were undersubscribed, with only 54% investor acceptance. The consolidated general government fiscal deficit was a wide 7.8% of GDP in 2023 (2024F: 6.8%).
The government’s 2024 funding target includes a USD1.5 billion issuance in Eurobonds/sukuk. This will likely prove challenging as Pakistan remains vulnerable to shifts in investor confidence and bilateral funding due to low reserve coverage and high gross financing needs. Fitch’s December affirmation of Pakistan’s ‘CCC’ rating reflected some near-term certainty over external liquidity and funding provided by Pakistan’s nine-month Stand-By Arrangement with the IMF.
