Why Has Pakistan's Private Sector Been Crowded Out?

The Export Collapse: From Regional Competitor to Laggard

In 1999, Pakistan exported goods and services worth approximately 16% of its GDP. This placed it roughly on par with regional peers. Textile exports dominated, but the economy was integrated into global trade.^[1]

By 2021, that share had fallen to just 9% of GDP.^[1] Meanwhile, Pakistan's competitors transformed their economies:

Vietnam's trajectory is particularly striking. The country leveraged foreign direct investment and trade agreements to become a manufacturing export hub. Bangladesh, starting from a lower base, has steadily expanded textile exports while beginning to diversify.

Pakistan moved in the opposite direction. Its share of global exports declined even as global trade expanded.

What Explains the Divergence?

Three structural factors explain Pakistan's export stagnation.

First, trade policy has been actively anti-export. High effective protection rates make selling domestically more profitable than competing internationally. Import tariffs and non-tariff barriers raise the cost of imported inputs, disadvantaging exporters who need competitive input prices.^[1]

Second, the export base remains undiversified. Textiles and garments still dominate, as they did decades ago. Pakistan has failed to move into higher-value manufacturing, electronics, or services exports that have driven growth elsewhere.^[1]

Third, foreign direct investment (FDI) has been minimal. The World Bank estimates Pakistan's FDI potential at $2.8 billion annually, but actual inflows have consistently fallen short.^[1] Without FDI, Pakistan lacks access to the technology, management practices, and global value chain connections that drove export growth in Vietnam and Bangladesh.

The $88 Billion Gap

Using gravity model analysis, which estimates expected trade based on economic size, distance, and other factors, the World Bank calculated Pakistan's export potential at $88 billion.^[1]

Current exports hover around $30 billion. The gap represents an enormous missed opportunity. Closing even half of this gap would transform Pakistan's external position, create millions of jobs, and generate fiscal space through higher growth.

But closing the gap requires addressing why private firms cannot compete. The answer lies in the financial system.

How Government Borrowing Crowds Out the Private Sector

For an economy to grow, businesses need access to credit. Banks collect deposits from savers and lend to firms that invest in new capacity, hire workers, and expand production. This is the basic function of financial intermediation.

In Pakistan, this system has broken down. Banks have largely stopped lending to the private sector. Instead, they lend to the government.

The Numbers Are Stark

In 2010, government borrowing absorbed 43% of total bank lending. By 2022, that share had risen to 73.4%.^[1] Government bonds offer high yields with zero credit risk and minimal capital requirements. For banks, lending to the government is simply more attractive than lending to businesses.

The consequence has been a collapse in private sector credit. Credit to the private sector fell from 29% of GDP in 2008 to just 13.8% by 2022.^[1] Financial sector depth, a key measure of development, has been cut in half in just fourteen years.

This is crowding out in its purest form. A fixed pool of savings exists. When government absorbs most of it, less remains for private investment. The mechanism is straightforward: high government bond yields pull funds away from private lending.

Private Investment Has Declined

With credit unavailable, private investment has fallen. Private investment averaged 13.7% of GDP through the 2000s but declined to approximately 10% by FY21.^[1]

Compare this to regional peers. India maintains private investment around 20-25% of GDP. Bangladesh has achieved similar levels. These countries benefit from deeper financial systems that channel savings to productive investment.^[1]

Pakistan's declining investment rate means fewer factories built, fewer machines purchased, and fewer jobs created. It explains why productivity growth has stagnated while peers surge ahead.

Financial Exclusion

The weak financial system also excludes most Pakistanis from basic banking services. Only 21% of Pakistani adults have a bank account, according to Global Findex data.^[6] This is among the lowest rates in the world.

Without bank accounts, households cannot save safely, access credit, or participate in the formal economy. Small businesses cannot receive payments, build credit histories, or finance growth. Financial exclusion perpetuates informality and limits economic opportunity.

The Sovereign-Bank Nexus: A Dangerous Interconnection

The problem extends beyond simple crowding out. An IMF analysis published in September 2024 identified a more dangerous dynamic: a "sovereign-bank nexus" that ties the fate of Pakistan's banking system to the government's fiscal position.^[2]

The term "sovereign-bank nexus" describes a situation where banks hold so much government debt that the creditworthiness of the government and the solvency of banks become inseparable. If the government faces stress, banks face stress. If banks face stress, the government loses its primary financing source.

The Scale of the Problem

Pakistani banks hold approximately 60% of their total assets in government securities. This is the highest ratio in the world.^[2]

To put this in context: the average emerging market economy sees banks holding roughly 20% of assets in government securities. Pakistan's ratio is three times the emerging market average.^[2]

The numbers can be expressed in multiple ways, each highlighting the same basic reality:

• Banks' claims on the public sector are three times their claims on the private sector.^[2]
• Credit to government reached 72% of total bank lending in FY23.^[2]
• The ratio of government securities to bank deposits approached 100% in FY23.^[2]

Pakistani banks are, in effect, government financing vehicles that also happen to accept deposits.

How the Nexus Evolved

The current situation emerged from efforts to improve monetary policy. Before 2019, the government routinely financed deficits through direct borrowing from the State Bank of Pakistan (SBP). This is called monetary financing or money printing. It is inflationary and considered poor practice by central banking standards.

Under IMF program conditionality, Pakistan agreed to end direct monetary financing. The 2022 amendments to the SBP Act legally prohibited the central bank from lending directly to the government.^[2] This was intended to strengthen monetary policy independence and reduce inflation.

The reform had an unintended consequence. With SBP lending prohibited, the government turned to commercial banks for financing. Banks were happy to oblige. Government bonds offered high yields, required no credit analysis, and carried zero risk weight for capital adequacy purposes.

But banks needed funds to purchase these bonds. They obtained liquidity from the SBP through Open Market Operations (OMOs), using the very government bonds they had purchased as collateral.^[2]

The Tripartite Connection

The result is a circular flow that connects sovereign, banks, and central bank:

Step 1: Government issues bonds. Fiscal deficits averaging over 7% of GDP since 2019 require continuous financing.^[2]

Step 2: Banks purchase bonds. With high yields and zero risk weight, government securities are the most attractive asset class available.

Step 3: Banks borrow from SBP. To fund bond purchases, banks use OMOs to obtain short-term liquidity from the central bank, pledging government bonds as collateral.

Step 4: SBP provides liquidity. Net OMOs outstanding have grown to represent approximately 25-30% of banks' securities portfolios.^[2]

Result: The SBP is still financing the government, but indirectly through bank intermediation rather than direct lending.

The legal prohibition on SBP lending to government has been circumvented. The fiscal impact is similar: government obtains financing that is ultimately backed by central bank liquidity creation.

Why This Is Dangerous

The sovereign-bank nexus creates multiple risks for financial stability.

Bank solvency depends on government creditworthiness. If Pakistan's fiscal position deteriorates, the value of government bonds could fall. Banks holding 60% of assets in these bonds would face immediate losses. A government debt restructuring would devastate the banking system.

Monetary policy transmission is impaired. When the SBP raises interest rates to fight inflation, the impact should flow through banks to borrowers, reducing demand. But Pakistani banks barely lend to the private sector. Rate increases affect government borrowing costs but have limited impact on private sector activity.^[2]

Maturity mismatch creates liquidity risk. Banks fund long-term government securities with short-term OMO borrowing. If the SBP were to reduce OMO availability, banks would face funding pressure. They might need to sell bonds at losses to meet obligations.

Mark-to-market risk is substantial. Approximately 90% of bank securities holdings are classified as Available for Sale (AFS) or Held for Trading (HFT), meaning they must be marked to current market values.^[2] Interest rate increases reduce bond prices, creating paper losses that affect bank capital.

Negative feedback loops can amplify stress. Government fiscal stress leads to falling bond prices. This impairs bank capital. Banks with impaired capital may reduce OMO access. Reduced liquidity forces bond sales. Bond sales push prices lower. The loop reinforces itself.

Implications for the Private Sector

The nexus explains why banks have no incentive to lend to businesses.

Consider a bank manager's choice. Government bonds offer yields exceeding 15% with zero credit risk, zero capital requirements, and automatic liquidity through OMOs. Private sector loans offer similar or lower yields but require credit analysis, carry default risk, demand higher capital, and tie up funds without OMO access.

The choice is obvious. Rational bank management will maximize holdings of government securities and minimize private lending.

This is not a failure of bank management. It is a rational response to distorted incentives created by fiscal policy. As long as the government needs to borrow 7% of GDP annually and offers attractive terms to do so, banks will prioritize government lending.

The Recent External Adjustment: Temporary Relief or Structural Change?

Pakistan's external accounts improved markedly in FY24 (July 2023 to June 2024). The current account deficit narrowed from 1.0% of GDP in FY23 to just 0.2% in FY24.^[3] In dollar terms, the deficit was $0.7 billion, the smallest since FY11 when Pakistan recorded a surplus.^[3]

The overall balance of payments swung from a deficit of 1.2% of GDP in FY23 to a surplus of 0.8% in FY24.^[3] International reserves recovered to approximately $9.4 billion by June 2024, providing roughly 2 months of import cover.^[3][5]

Remittances contributed to the improvement, growing by approximately 11% in FY24.^[3] The Pakistani rupee appreciated 2.75% against the US dollar over the fiscal year.^[3][5]

Is This Sustainable?

The improvement came primarily from import compression rather than export growth. An economy in recession imports less. This narrows the trade deficit mechanically without indicating underlying competitiveness gains.

Projections for FY25 and FY26 anticipate the current account deficit widening to 0.6% and 0.7% of GDP respectively as economic activity recovers.^[3] These remain manageable levels, but they suggest the FY24 adjustment was crisis-driven rather than structural.

Sustainable external improvement requires export growth. That requires investment. Investment requires credit. Credit requires banks to lend to the private sector rather than the government.

The chain of causation leads back to the same problem: fiscal dominance and the sovereign-bank nexus.

The Productivity Gap

Pakistan's failure to invest has produced a widening productivity gap with regional peers.

Labor productivity, measured as output per worker, grew by approximately 40% in Pakistan over the three decades from 1990 to 2020.^[1] This sounds positive until compared with peers:

Vietnam's productivity grew more than eight times faster than Pakistan's. Bangladesh, often compared directly to Pakistan given similar starting points, achieved more than four times Pakistan's productivity growth.

Why Has Productivity Stagnated?

Several factors explain the gap.

Low investment means old capital. Without new investment, firms operate with outdated machinery. Productivity improvements require capital deepening, where workers have access to better tools and technology. Pakistan's declining investment rate prevents this.

Informality limits productivity gains. An estimated 83% of Pakistan's wage workers are informally employed.^[1] Informal firms typically operate below efficient scale, lack access to formal credit, and have weak incentives to invest in worker training or technology.

Structural transformation has stalled. Productivity growth comes partly from shifting workers from low-productivity sectors (like subsistence agriculture) to higher-productivity sectors (like manufacturing). This structural transformation has been slow in Pakistan. Agriculture still employs over 35% of the workforce while contributing less than 25% of GDP.

Per Capita Income Divergence

The productivity gap translates directly into income divergence. Pakistan's per capita income grew at an average of 1.7% annually from 2000 to 2020.^[1] The South Asian average was 4%, more than double Pakistan's rate.^[1]

At 1.7% growth, per capita income doubles every 41 years. At 4% growth, it doubles every 18 years. Over a generation, Pakistan has fallen from rough parity with regional peers to a growing gap.

The State-Owned Enterprise Factor

Government crowding out extends beyond the financial system. State-owned enterprises (SOEs) absorb resources that could otherwise support private sector growth.

Federal commercial SOEs produce output equivalent to approximately 12% of GDP.^[1] Many operate at persistent losses, requiring budget transfers that worsen fiscal deficits.

SOEs compete with private firms for credit, skilled workers, and market share. But they operate under soft budget constraints. Losses are covered by government, allowing inefficient firms to survive. This crowds out more efficient private competitors.

Energy sector SOEs are particularly problematic. Circular debt in the power sector, discussed in related analyses, represents accumulated losses that drain fiscal resources. High electricity tariffs, maintained to reduce SOE losses, raise costs for private manufacturers and hurt export competitiveness.

What Would Unlocking the Private Sector Mean?

The World Bank estimates suggest transformative potential.

If Pakistan achieved its export potential of $88 billion, exports would nearly triple.^[1] This would require nothing extraordinary by regional standards. Vietnam exports over $350 billion annually. Bangladesh exports over $50 billion.

Achieving even half the potential, reaching $60 billion in exports, would create millions of jobs in manufacturing and supporting services. It would generate foreign exchange that reduces external vulnerability. It would expand the tax base, improving fiscal sustainability.

FDI potential is estimated at $2.8 billion annually.^[1] Realized FDI brings not just capital but technology, management practices, and access to global value chains. It has been the key driver of manufacturing export success in Vietnam.

Unlocking this potential requires breaking the crowding out cycle. Government borrowing must decline, freeing resources for private credit. The sovereign-bank nexus must be unwound, allowing banks to function as private sector intermediaries. Trade policy must shift from protection to export promotion.

None of these changes is technically complex. They are politically difficult because they disturb established interests. But the alternative, continued stagnation while regional peers advance, is also a choice with consequences.