IS PRIVATIZATION IN PAKISTAN PURPOSEFUL

IS PRIVATIZATION IN PAKISTAN PURPOSEFUL?

Dr. Akhtar Hasan Khan

The philosophy of privatization stems from the role of state in economic life. The thinking of the international financial institutions and free market economists is that, as in USA, the state should confine itself to regulation only and the operation and ownership of industrial enterprises and utilities should be left to the private sector. However, there is an opposite view expressed by a distinguished economic historian, Gershenkron, in his seminal article “Economic Backwardness in Historical Perspective¹”. Gerschenkron’s argument is that in those states which start late in the race of development, the public sector has to play a vital role in accelerating the pace of economic growth. As is in developing countries, the private sector is shy, inexperienced and not equipped to embark on rapid industrialization. Pakistan alongwith other developing countries followed the activist role for the state in industrialization and the rate of industrial growth in Pakistan has been very high.

The second main thrust for privatization is the belief that private sector units are more efficient than public sector units. This is not true across the board. In a study² which made a comparison between public industrial enterprises and private firms producing similar goods, the conclusion was that changing the ownership of industry from public to private is neither a necessary nor a sufficient condition for more efficient operation of specific industrial enterprises. However,

¹ Gershenkron, Alexander, Economic Backwardness in Historical Perspective, Praeger, London, 1962 ² S.N.H. Naqvi & A.R. Kemal, “The Privatization of the Public industrial Enterprises in Pakistan”,    

PDR Summer 1991.

on the other hand it is often correctly claimed that due to political interference and over-staffing, the efficiency of the public sector units is reduced.

The third argument for privatization is its fiscal impact. The favourable fiscal impact of privatization is expected from the sale proceeds being used to retire national debt, as well as elimination of losses of the public sector units as the losses were being financed from the budget. The opposite view is that the public enterprises after nationalization in 1973 doubled the payment of their taxes as compared to the pre-nationalization period. Moreover, if the public sector enterprises are making profit and giving the government return higher than the rate at which it is borrowing from the market, the privatization of profitable enterprises would have an adverse impact on the budget. Hence this argument does not hold for profitable public sector enterprises.

The fourth argument for privatization is to foster competition and to strengthen capital markets. If all the units in certain sectors like cement are owned by the state and these are sold to different parties, there would be healthy competition. However, if the market situation is such that there are public sector units as well as private sector units for the same commodity there will be no further fostering of competition by privatization. Capital market is strengthened, if the government share holdings are sold in the market as was done in case of PTCL and more recently in the case of Muslim Commercial Bank and Al-Falah Bank. Capital market is not strengthened at all, if one public sector unit is handed over to the private party without some of its shares being offered to the public. Hence it is necessary for strengthening and deepening of capital market that some percentage of the shares of public enterprises is sold to the public through stock exchange.

Another objective of privatization is to encourage direct foreign investment. The direct foreign investment in profitable public units is not likely to be beneficial for the economy, as against the benefit of an initial purchase price, one has to calculate the recurring remittance of profit in foreign exchange for years and decades to come. Direct foreign investment therefore should be attracted by policy and design into new and risky ventures rather than through the purchase of profitable enterprises. In fact purchase of existing operational units by foreign buyers is not an addition to the capital stock of the country.

I

Privatization is a complex exercise with multifaceted implications and has to be conducted with a number of caveats. The first is that it should be absolutely transparent process with full legal safeguards and watertight procedures, otherwise the valuable public assets may be sold at throw away prices and causing a huge loss to the national assets. It has also been observed that privatization should avoid crony capitalism as in Chile and Argentina, it has been associated with giving away expensive public assets at cheap rates to political cronies. Privatization gives tremendous patronage to the government in power which may be exercised to favour vested political interests rather than to serve long run national objective, negating the basic objective of improving efficiency in the economy.

The second imperative of privatization is sequencing and timing. It is essential that all the assets should not be sold in a short period, because in the short period the buying power of private sector may not be adequate to offer the correct prices for all the privatized assets. It may crowd out fresh foreign investment and lead to reduction in the rate of investment in the economy.

The third essential condition for the success of privatization is that the economy should be deregulated and unnecessary restrictions and procedures for industrial enterprises should be done away with. Privatization should therefore be part of a process to strengthen private sector by giving it assets as well as improving regulatory framework for their operation. To give units to the private sector but to keep it throttled by massive regulations would not improve the operational efficiency. Hence the sale of privatized units should be staggered over time.

Fourthly there should be a preference to privatize first the loss making assets, then the less profitable and finally the more profitable. In case the loss making units could not be sold independently these could be bunched with a profitable public enterprise.

Fifthly the investment climate must also be kept into view. Privatization after 11^th September, 2001 was not an opportune time because the international stock markets slumped and the investor’s confidence slided sharply after that eventful episode. As a result of terrorist activities in Pakistan and given the fact that Pakistan having a long border with the Afghanistan, the investment climate in Pakistan deteriorated more sharply than in other countries.

Finally it must be ensured that the party which is buying the industrial units does not use it for stripping the assets and selling the real state because if the party does this, there will be a serious loss of out put, employment and taxes to the national economy.

III

There have been two tides of privatization in Pakistan. The first tide is from 1992 to 1994 and the second tide from July 2001 to October 15, 2002. In the first period assets worth Rs.120 billion were divested and in the second period assets worth Rs.65 billion were divested. The consultants engaged by Asian Development Bank have conducted a thorough study of the first period. It is a detailed report but the following table sums up their findings with respect to the overall assessment of the privatization process.

Table:
		Better	Same	Worse	Total
	PMEs * Misc. Ghee Mills	9 3 2	13 10 12	16 1 5	38 14 19
	Rice Mills Banks Total Percentage	2 2 18 22	-2 37 44	6 -28 34	8 4 83 100%

Source: Impact and Analysis of Privatization in Pakistan: ADB Report October 1998.

* Public Manufacturing Enterprises.

The above table clearly indicates that only 22% of the privatized units were performing better than in the pre-privatization period, 44% approximately the same and about the third i.e 34% worse than before. It is quite clear that the compelling reason for privatization that of improving the efficiency of the units, was only attained by about 1/5 of the units, whereas the rest were working with

the same efficiency or worse than before. No wonder in the article^* quoted above the authors had reached the conclusion that, “in Pakistan there is nothing hardly

*

 Ibid Page 1.

good or bad about public sector or even the private sector for that matter”. On the

whole, operational efficiency deteriorated after privatization.

Moreover, the most tragic consequence of privatization was the closure of

many units which are listed below; ­

1) Naya Daur Motors2) Dandot Cement3) Zeal Pak Cement 4) National Cement5) General Refractories 6) Pak PVC7) Swat Elutriation 8) Nowshera PVC9) Nowshera Chemicals10) Pak China Fertilizer 11) Karachi Pipe Mills12) Metropolitan Steel13) Pak Switchgear 14) Quality Steel15) Indus Steel Pipe16) Fazal Veg. Ghee17) Haripur Veg. Oil18) Khyber Veg.19) Suraj Ghee Indus.20) Hydari Veg. Ghee

The closure of these units has played havoc to the national economy and

the first phase of privatization has contributed to the lower rate of industrial and

economic growth. The GDP growth which was above 6% in the 1980s declined to

around 4% in the post privatization period.

The reasons for closure are many. First the units were sold out without

checking the creditworthiness of the party. Schon Group whose horrible

reputation is household knowledge in Pakistan was given three units, National Fibre, Pak China and Quaidabad Woolen Mills. All these were closed after privatization. The ADB consultants have opinioned: “It has been suggested by some that these were not privatized transparently and Schon Group were able to access other offers before submitting their bids”. Moreover, they did not pay the first installment and the Privatization Commission did not take a strong line to forfeit the bogus investors. The Consultants were shocked to observe: “Both companies are being bailed out without underlying ownership problem being resolved”. Messrs. Saeed Qadir and Sartaz Aziz owe an explanation to the nation for the unwarranted favour shown to Schon Group and also to Tawakkil Group, if we do not doubt their integrity, to say the least.

Among the other major units which closed after privatization was Zeal Pak Cement. The buyer was not interested in running the factory but in stripping the assets. This is a frequent bane of privatization. Assets strippers buy, pay one installment, remove the machinery, sell the real state and then walk away. Obviously, this is not effective privatization.

All the engineering units except Millat and Al-Ghazi Tractors (both are running well) were closed after privatization, as their buyers had no intention of running them. Operating engineering units is not like running the rice mills and in fact the buyers lacked management and technical expertise to run engineering units. Hence privatization was a big blow to the engineering sector in Pakistan, which was already very weak and had a small base.

The Privatized units also formed cartels to exploit the consumers. A cartel was formed between D.G. Khan Cement and Maple Leaf Cement to exploit the consumers in that region.

Of the three privatized banks MCB is reported to be running better. Same is the case of ABL. Nevertheless the latest figures from January 2002 to June 2002 reveal that both these privatized banks have declared much less profit compared to Habib Bank Limited. The third privatized financial unit Bankers Equity Limited (BEL) has been closed after privatization as billions of depositors money was swindled by the party to whom it was privatized. The credentials of the party were not investigated and it was obvious that the purchase money was paid from the deposits of BEL. The chairman of the Board of Directors of BEL before privatization was the Governor of the State Bank of Pakistan and after privatization a well-known thug. A leading financial institution was closed as a result of privatization and it had the strong negative impact on financial markets.

Another rule for effective privatization, which was not observed in this period, is not to give more than one unit to a party. Considering the slogan of 22 families and the cry against concentration of industrial wealth in the 1960s, the Government should have learnt from the history and evolved a prudent policy – one unit for one party. However, two big units i.e. MCB and DG Khan Cement were given to Mian Mansha and three units to the scandalous Schon Group.

Analysis of the first tide of privatization has shown that it has not been able to achieve the intended goals of privatization. The procedure according to ADB Consultants was not transparent but smacked of cronyism and corruption. The credentials of the parties were not properly investigated. Even the anticipated fiscal impact was not realized because the proceeds of privatization were not credited to a separate Debt Retirement Fund but were put into Federal Consolidated Fund from where these were utilized for current expenditure.

VI

Kot Adu was major privatization during Benazir’s second term as Prime Minister. Kot Adu is WAPDA’s biggest generating unit with the following capacity ;­

KAPCO	MW
Combined Cycle 1-4, 9&10	624
Gas Turbines 5-8	40C
CC Unit 11 & 12	20C
Gas Turbine 13 & 14	264
	1,488
Combined cycle 15 – June 1997	1,621

There was no need to privatize an already existing big power unit which was running efficiently. Its units were either gas turbine or combined cycles which can use either oil or gas. Gas is far cheaper than oil for generating electricity and Kot Adu was mostly running on gas. However, the government decided to sell 26% stake in it at a price of US$215 million. Subsequently 10% shares were to sold for US$76 million and the government realized only US$291 million from the sale of 36% share.

The most interesting feature this privatization was that the government handed over the management of the unit to minority shareholders, which perhaps has never been done in the corporate history of the world. It was provided in the sale agreement that there would be nine directors, four independents, four nominees of the purchasers and one of WAPDA. As a result of court’s intervention it was decided that there would be seven directors, four nominees of WAPDA, two nominees of the purchasers and one CEO appointed jointly by WAPDA and purchasers. However, it meant that although the government is the largest shareholder yet it will have no representation on the board as the foreigner purchasers did not want government interference.

Initially it was decided that after privatization KAPCO will sell electricity to WAPDA at a tariff of 5.6 US cent per KWH. Subsequently this tariff was reduced to 4.9 US cent per KWH. WAPDA’s cost of generation at Kot Adu with gas feed stock was not more than 2.5 US cent per KWH. Hence, the government received US$291 million but WAPDA became a bankrupt organization after the sale of KAPCO and setting up of other independent power plants like HUBCO. The foreign party has been able to repatriate the total amount of US$291 million during the last six years and WAPDA is being forced to pay twice the cost at which it was generating electricity at KAPCO before privatization. This is the most senseless privatization in Pakistan. In fact the whole policy of IPPs has terribly ruined WAPDA and its consumers all over the country are suffering because WAPDA has to pay such high rates to the IPPs including KAPCO and HUBCO. The electricity tariff in Pakistan which is deemed to be the highest in Asia has also made the industry uncompetitive in world market.

V

The second tide of privatization was from July 2001 to October 15, 2002. The major privatization which took place during this period included; (1) sale of GOP “Working Interest” in six oil concessions, (2) sale of 51% GOP stake in UBL, (3) sale of Pak Saudi Fertilizer Ltd., and (4) two capital market transactions amounting to Rs13.6 billion.

It is interesting that whereas in the entire financial year 2001-2002, the total value of privatized transactions was Rs19.6 billion, alone in the last three and half months before handing over power to the elected representatives, the privatized transactions amounted to Rs15 billion. The privatization of this period is too recent to be analyzed fully in its operation and impact. One thing is clear that it was pushed by IMF as the privatization of all programmed public assets was part of the undertaking given to the Fund for its latest financing facility under the name of Poverty Reduction and Growth Facility (PRGF).

However, long-term national economic interest and strategic consideration were not kept in view while drawing up the list for privatization. The time honoured and prudent government policy dictated by national interest for all concessions was that to have “Working Interest” in the oil companies formed after oil discovery in order to ensure that oil is drilled both according to the national as well as private interest of the company. As a result of this “Working Interest” arrangement, GOP had a seat on the Board of Directors. Oil and gas companies therefore could not hide anything from the GOP regarding their output, royalty etc. Now GOP has sold its “Working Interest” leaving the field open to the oil and gas companies to play the game of multinationals. The sale of “Working Interest” was therefore not in national interest.

Pak Saudi Fertilizers was a very profitable public sector unit producing Urea. It has been sold to a group led by Fauji Foundation. The sale of unit from Public Sector Corporation to Fauji Foundation is not privatization, to say the least. It was a very profitable unit yielding handsome profit to GOP and now the profit would go to the Fauji Foundation.

The sale of shares of MCB & NBP and other capital market transactions were the correct decision as the privatization through gradual sale of shares to the public is the most preferred form of privatization.

The sale of UBL to Abu Dhabi and Best Way Group is altogether inexplicable. First GOP poured Rs30 billion into UBL to cover its non­performance loans and make it privatizable. This was not done in the case of earlier sale of MCB and ABL. After pouring such a huge amount of Pakistani tax payers money it has been sold to foreigners for Rs12.35 billion. In the first bidding Mian Mansha was shown to be the highest bidder but bidding was held again and Abu Dhabi and Best Way Group were on the top in the second round. GOP lost Rs17.65 billion in its privatization exercise. GOP has not explained as to why Rs30 billion of tax payers money was poured in UBL for privatization and what was the hurry in handing over this unit a week before the national elections.

Therefore, whereas the gross proceeds from privatization during the second period amounted to Rs34.7 billion but if we deduct Rs30 billion poured in UBL then the net receipts are only Rs4.7 billion. In the second phase the government has sold public assets which were highly profitable for a trivial net amount of Rs4.7 billion.

VI

Policy makers have a great advantage in a modern age of internet as with a click of the mouse they can learn from the experience of other countries in the field of privatization. International experience of privatization has been varied. Chile is a successful case of privatization but Yotopoulos³ has pointed out there was serious charges of sales to the cronies in Chile. There were similar charges of crony capitalism in Argentina where privatization proved a failed exercise. In India privatization has proceeded at a slow pace and is stalled at present due to protest from the unions of public enterprises, which were to be privatized. Stiglitz⁴, an American Nobel Laureate in his recent book on Globalization has pointed out that rapid pace of privatization in the USSR at the behest of IMF has led to sharp economic decline.

China’s economic achievement is unique in human history. A nation of more than one billion people has been able to quadruple its per capita income in less than two decades. The Washington Consensus and international financial institutions have been putting pressure on China to privatize its public enterprises, some of which are running at a loss. However, China did not pay any heed to the foreign advice but what it did was to stop fresh investment in public enterprises. Thirty years ago public enterprises accounted for about 90% of the national industrial output. At present they account for only 30%. As the fast expanding new investment especially by multinationals have over taken the public enterprises. In the process many loss making enterprises which could not modernize themselves have closed or automatically phased out.

³ Yotopoulos Pan (1989) Tide of Privatization Lessons from Chile World Development (1989)⁴ George Stiglitz Globalization 2002 Harper and Row

Pakistan should have followed China’s example and instead of undertaking sweeping tides of privatization conducted in a non-transparent manner, detrimental to national interest, we should have rather lured private investors alongwith foreign investors to set up new industry which would have gradually reduced the size of public sector enterprises.

It seems we have not learnt a lesson from our previous privatization and now the government intends to privatize major assets like PSO, OGDC, PTCL and HBL, and NBP. PSO, PTCL and OGDC are highly profitable organizations and their profits for last two years are as follows ;­

(Rs billion)

Organization	2000-01	2001-02
PSO	2.25	3.19
OGDC	16.49	16.37
PTCL	18.19	19.81

Source: Ministry of Finance.

PSO is Pakistan’s largest corporate unit and the only corporate unit included in Asia’s 500 leading enterprises. The other two oil distributors are foreign companies Shell and Caltex. If we sell PSO, foreign companies can throttle oil supply to different points in time of emergency. Hence both economic and strategic consideration demand that PSO should not be privatized.

OGDC produces 36% of domestic crude oil and 29% of natural gas in the country while the remaining production of oil and gas is by foreign companies. OGDC operations are spread all over the country and privatization of all these public enterprises producing oil and gas would again be a strategic blunder. Moreover, it is a revenue spinner and giving handsome profit to the government.

Secondly, if OGDC is privatized, a number of new drillings will be entirely in the hands of foreign companies whose decisions may not be in Pakistan’s interest.

It is an ideal competitive situation in which public sector PSO and OGDC are competing with foreign multinationals and both of them should be encouraged to drill more. Moreover, no developing country has handed over its entire oil and gas sector to foreign countries. In most developing countries the oil and gas sector is a public enterprise as the scale of operation is so large and the profit so huge, that none except Pakistan has found it in their national interest to privatize the entire oil and gas sector.

PTCL is again a revenue spinner and the only company with ground lines in each nook and corner of the country. Handing over this profitable strategic asset to a foreign company will be devastating for Pakistan’s economy and security.

HBL and NBP should not also be privatized. This would incapacitate monetary and credit policy of the government to realize national socio-economic goals particularly in the context of advancing credit to small borrowers to correct imbalances created by advances to large parties only by the private banks.

Privatization in Pakistan has not met its objectives, for the reasons noted above. At present it is in national interest to remove PSO, OGDC, PTCL, HBL and NBP from the list of privatization, as their privatization would be strategically dangerous and economically unjustifiable. If we go along with the announced pace of privatization our economy, which already in recession will suffer and we will lose our economic sovereignty. Moreover, IMF’s next demand will be to privatize Mangla and Tarbela dams, which would bring an utter ruin to the economy.

BIBLIOGRAPHY

1.      Gershenkron, Alexander, Economic Backwardness in Historical Perspective, Praeger, London, 1962

2.      S.N.H. Naqvi and A. R. Kemal, “The Privatization of the Public Industrial Enterprises in Pakistan”, PDR Summer 1991.

3.      Yotopoulos, Pan A. The Tide of Privatization: Lessons from Chile, World Development (1989)

4.      Annual Reports Privatization Commission of Pakistan 2000, 2001, 2002.

5.      Asian Development Bank, Impact Analysis of Privatization in Pakistan, October,1998.

6.      Stiglitz George, Globalization 2000.

7.      Economic Survey 2001-02, Government of Pakistan, Islamabad.

8.      Annual Report of the State Bank of Pakistan, 2002. 

What is Access to Finance

Poor Access to the Financial System

What is Access to Finance?

• Possibility that individuals or enterprises can access financial services including credit, deposit, payment, insurance, and other risk management services

• Those who involuntarily have no or only limited access to financial services are referred to as unbanked or underbanked respectively

Segmentation of Consumers

User Group	Market segment
Users	Current users (current market)
Non-users	Voluntary non-users
	Non-users, Lying within present access frontier
	Non-users, lying within the future access frontier
	The supra-market group, lying beyond the future access frontier

Formal & Informal Financial Services

Tier	Definition	Institutions	Principal clients
Formal banks	Licensed by central bank	Commercial & development banks	Large businesses Government
Specialized non-bank financial institutions (NBFIs)		Rural banks Post Bank Savings & loan companies Deposit-taking microfinance banks	Large rural enterprises Salaried workers Small & medium enterprises
Semi-formal	Legally registered, but not licensed as financial institution by central bank	Credit unions Microfinance NGOs	Microenterprises Entrepreneurial poor
Informal	Not legally registered at national level (though may belong to a registered association)	Savings (susu) collectors Savings & credit associations, susu groups Moneylenders	Self-employed Poor

Measuring access to financial System

• The main variables used for measuring access to finance
• Number of Bank accounts per 1000 adults
• Number of bank branches per 100,000 adults
• The percentage of firms with line of credit
• Also following factors should be considered
• Market Concentration
• % of Market capitalization
• traded value outside of top 10 largest companies

Why Access to Finance is Important

• Financial access provides credit for the most promising firms which promotes growth of enterprises
• Encourages more start ups
• Enables competitive firms to grow by exploiting growth and investment opportunities
• Benefits the economy in general by accelerating economic growth, intensifyingcompetition.
• Boost Demand of Labour
• Raises income for those in the lower end of the income distribution &reduces income inequality and poverty.

Pakistan current access to finance

• Policy measures cannot single-handedly increase financial access
• Financial institution willingness to expand access in Pakistan
• Slow technologic advances
• Weak legal foundations,
• Unsuitable financial processes and products.
• Poor socioeconomic conditions
• Gender bias, and
• Low levels of basic education and financial literacy

Formal Vs. Informal Financial Access

• Formal financial access: 14% of Pakistanis are using a financial product or service of a formal financial institution
• Informal financial access: 50.5% of Pakistanis have access to finance
•  19% of population is excluded:
• Lack of understanding,
• Awareness, or need, due to poverty
• Religious reasons

Source: Bringing Finance to Pakistan’s Poor

Tatiana Nenova

Cecile Thioro Niang

Anjum Ahmad

• Over half of the population saves, but only 8 percent entrust their money to formal financial institutions
• One-third of the population borrows, but only 3 percent use formal financial institutions to do so
• Microfinance has grown at 40 percent per year since 1999 - yet microfinance access extends to only 1.7million out of an adult population of about 80 million.
• International remittances have grown at 29 percent since 2001 - yet only 2.3 percent of Pakistanis send or receive remittances, while half of remittances, including domestic flows, are transmitted informally

Loans by Sector

• Focusing only on the consumer side, according to latest (unpublished) SBP figures, there are only 16 million personal (non-business) bank accounts and 5.5 million personal loans.

• 25 percent of the total bank deposits and 17 percent of the total borrowers are from rural areas. In value terms their shares are even smaller, 10 percent and 7 percent of the total value of deposits and advances, respectively

• The country records about 22 loan accounts per 1,000 people, compared with Bangladesh’s 55 and the world median of 81.
• The use of deposit services is equally low the country has 192 deposit accounts per 1,000 people, as compared with 229 in Bangladesh and 529 for the world median

Due to consolidation of banks, stronger banks emerged!

Such skewed distribution of farm credit negatively affects

the poverty level of agricultural households, and prevents faster development in rural areas.

Poverty Alleviation

• "Poverty alleviation" has become a common slogan. Without effectivestrong national financial system poverty reduction and economic growthare NEVER POSSIBLE.
• Financial system that develops unevenly lack transparency and no proper regulation is more vulnerable to financial shocks and prone to distress.
•  It is proved that these

     shocks and crises affect

     poor people.

The average Pakistani household remains outside  the
formal financial system, saving at home and 
borrowing from family or friends in cases of
dire need.  

• Policy efforts to increase access to finance in Pakistan have taken time to bear fruit, but now access is indeed expanding quickly in certain financial sectors (microfinance, remittances).
• Fourteen percent of Pakistanis are using a financial product, (including savings, credit, insurance, payments, and remittance services.

Financial access is low among the poorer, women, small and microenterprises.

• Most formal financial products remain high-end, limited to urban rich educated males.
• The formal sector could learn a lot from and partner with informal providers – their services are perceived as being more geographicallyaccessible.
• Poverty and lack of information on financial services lead to lack of interest.

Microfinance

• The formal microfinance sector reaches less than 2 percent of the poor, as opposed to over a quarter in Bangladesh, India, and Sri Lanka.
• A key challenge to microfinance institutions (MFIs) in Pakistan is raising considerable funding to grow.
• Mobile technology can help expand access considerably

Small
enterprise finance

• Small and micro enterprises have

     seen a worsening of access to finance,

                                 while

       medium-size enterprises have seen improvements.

• 3.6 percent of firms use loans for investment and only 13.9 percent use them for expenses.
• Indirect costs legal fees, collateral registration, and documentation makebank lending expensive for SMEs.
• A large-scale downscaling effort involving both the public and private sectors can forge rapid growth in SME lending.

Remittances

• Remittances to Pakistan are estimated at

      around $16 billion and growing fast,

     but formal flows do not reach the poor,

     women, and rural areas.

• Pakistan Post has a large rural network

     and is most common channel for

     domestic remittances.

• SBP has taken various measures that have significantly increased remittances through formal

The Way Ahead!

Private Sector

Public Sector

• Diversifying the product range and segmenting clients.
• Reaching out to the rural client by leveraging technology.
• Carrying out a thorough bank downscaling program and modernizing SME banking.
• Access to Remittances

• Creating awareness of the benefits of access to financial services.
• Strengthening institutions.
• Creating an enabling environment for access to the underserved.
• Promoting initiatives proving a demonstration effect of bank downscaling.

• Promoting the structuring of international flows into investments:
• Supporting remittance services of Pakistani banks abroad.

      Role of Public Private Partnership

DIASPORA FUNDS:  is a social investment fund that provides an innovative approach to leveraging the remittance to invest in small to medium size businesses that would help create jobs and in turn reduce the poverty

 Tapping into migration wealth could be an effective means of funding

“ Members of a country’s Diaspora tend to be wealthier than its resident citizens”  

FACILITATE E- OR M-PAYMENTS, AND THE BRANCHLESS BANKING

Conclusion

     In conclusion it is clear that the functioning of financial system is vitally linked to economic growth.

• A country with larger banks and more active stock markets grow faster.

measuring financial access requires ascertaining market concentration, for a high degree of concentration reflects greater difficulties for entry of newer and smaller firms. Other factors include the percentage of market capitalization and traded value outside of top 10 largest companies, government bond yields (3 month and 10 years), ratio of private to total debt securities (domestic), ratio of domestic to total debt securities, and the ratio of new corporate bond issues to GDP.

1

Fourteen percent of Pakistanis are using a financial product or service of a formal financial institution (including savings, credit, insurance, payments, and remittance services).

Informal access can occur through the organized sector (though committees, shopkeepers, moneylenders, hawala/hundi money transfers, and so forth), or informally through friends and family

In comparison, 32 percent of the population has access to the

formal financial system in Bangladesh, and this figure amounts to 48 percent in India and 59 percent in

Sri Lanka (World Bank, 2008c). Of the nearly 50 percent of Pakistanis who do not engage in either the

formal or informal financial system, we estimate about 19 percent have voluntarily excluded themselves

through lack of understanding, awareness, or need, due to poverty, or for religious reasons. Financial

exclusion precludes people from reducing risk, managing fluctuations in income, and investing in

microenterprises or in health and education.

2

shows the limited access to bank finance of enterprises and individuals.

3

External Debt Sustainability Analysis

14. External Debt Sustainability Analysis 1

1 This chapter draws substantially on the following papers: WB 2011, Stress Testing in the Debt Sustainability Framework (DSF) for Low-Income Countries; IMF 2011, Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis ; IMF 2010, Staff Guidance Note on the Application of the Joint Fund-Bank Debt Sustainability Framework for Low-Income Countries; IMF 2008, Staff Guidance Note on Debt Sustainability Analysis for Market Access Countries. 

November 30, 2012

                        I. Introduction  

                        14.1 The creation of debt is a natural consequence of economic activity. At any time, some economic entities have income in excess of their current consumption and investment requirements, while other entities are deficient in this regard. Through the creation of debt, both sets of entities are better able to realize their intertemporal consumption and output preferences, thus encouraging economic growth.

                        14.2 The creation of debt is premised on the assumption that the debtor will meet the requirements of the debt contract. But if the income of the debtor is insufficient or there is a lack of sufficient assets to call upon in the event of income proving insufficient, debt problems ensue. In such circumstances, or in the expectation of such circumstances, the benefits arising from international financial flows—for both creditors and debtors—may not be fully realized. Hence, the need at the country level for good risk-management procedures and the maintenance of external debt at sustainable levels.

                        14.3 The objective of external debt sustainability analysis (DSA) is to evaluate a country’s capacity to finance its policy objectives and service the ensuing debt. DSAs are an integral part to the Fund’s assessments of member countries’ policies, both in the context of program monitoring and country surveillance. To this end, the Fund has developed two frameworks for conducting public and external DSA, one focusing on low income countries (LICs), the other focusing on market access countries (MACs).

                        14.4 This chapter discusses the main concepts associated with external debt sustainability, the basic steps involved in the preparation of external DSAs, and provides a brief overview of the frameworks used at the Fund to carry out DSAs.

                        II. Basic concepts

                        14.5 Chapter 2 of the Guide discusses the definition of external debt as well as the accounting principles for the measurement of external debt. Accordingly, for the purpose of external DSAs, external debt refers to debt liabilities owed by residents of an economy (both the public and the private sector) to nonresidents. Foreign financial resources can be important to growing economies as they supplement domestic savings to finance investment. However, access to foreign finance could also lead to accumulation of unsustainable external debt, which is costly to a country and can disrupt the smooth functioning of international

                        capital markets. External DSA aims to help policymakers to identify imbalances as they are building up.  

                        14.6 A key component of external DSAs is to estimate the path of a country’s external debt stock over time. To compute the evolution of the debt, the starting values for the initial stock of public and private external debt, its maturity profile, and schedule of debt service payments are needed. A projection of future external borrowing and interest rates must be made. The projected path of the debt level is then compared with other indicators of a country’s capacity to repay external debt over the medium to long term.

                        14.7 DSAs are usually done on a gross debt basis.2 However, in countries with significant liquid assets (such as countries with substantial extra-budgetary funds), a DSA on a gross basis may overstate a country’s debt distress. In these cases, the public debt component of external debt could take these assets into account.  

2 Timely and consistent data on net investment positions data are not always available. Moreover, even if individual entities in the economy have external assets, they may not correspond to the entities that have external liabilities. Furthermore, the liquidity aspect of sustainability, the risk of not being able to roll over existing debts, is likely to be related to gross financing needs.

How is debt sustainability assessed? 

                        14.8 Debt sustainability is assessed on the basis of indicators of the debt stock or debt service relative to various measures of repayment capacity (typically GDP, exports, or government revenues). The basic equation is:

Debt indicator=                                

                        14.9 The various data series that can be used to populate the basic equation to calculate the various debt indicators are described ahead. Each of the indicators provides a different perspective on debt sustainability, suggesting that they should be used in combination.

Measures of indebtedness (the numerator)

                        14.10 Different measures of indebtedness are used to identify solvency and liquidity risks. Liquidity problems arise when a country has short term difficulties meeting its financial obligations as they come due. Solvency problems, on the other hand, arise when a country’s repayment difficulties are permanent or protracted. Delineating liquidity and solvency risks can be a challenge especially as liquidity problems can turn into solvency problems if not adequately addressed. 

                        14.11 Indicators based on debt stocks (e.g., gross external debt position) are used to identify possible solvency problems. Debt stock indicators reflect the capacity of a country to generate resources to repay debt. In the case of LICs, the long maturity and grace periods of concessional debt make debt stock measure based on the present value (PV) of debt more appropriate as it captures the favorable terms of concessional loans by discounting the stream of future debt-service payments (see Appendix III, Present Value). For MACs the analysis is done on the basis of nominal values. 

                        14.12 Indicators based on debt service (interest payments and amortization) are typically used to assess liquidity problems. They represent the share of a country’s resources used to repay its debt (and therefore resources not used for other purposes). Debt-service ratios provide the best indication of the claim on resources and the associated risk of payment difficulties and distress. In the same vein, low and stable debt-service ratios are the clearest indication that debt is likely to be sustainable.3 

3 In the case of LICs, debt service indicators may be less informative than for other economies because the repayment of concessional loans is usually backloaded. While long projection periods can mitigate this problem, the reliability of a projection tends to diminish with its length.

Measures of capacity to repay (the denominator)

                        14.13 Measures of capacity to repay include GDP, exports, and government revenues. Nominal GDP captures the amount of overall resources of the economy, while exports provide information on the capacity to generate foreign exchange. Finally, government revenues measure the government’s ability to generate fiscal resources. In some specific cases, remittances may be added to GDP and exports to assess external debt sustainability.

                        14.14 The choice of the most relevant indicator of capacity to repay depends on the constraints that are more binding in an individual country. In general, it is useful to monitor external debt and debt service measures in relation to GDP, exports, and fiscal revenue.  

                        III. Debt burden indicators

Stock based indicators

                        14.15 The debt stock, is measured by the nominal value of the debt or its present value (PV). The most commonly used indicators are:

                         Debt-to-exports ratio. Defined as the ratio of total outstanding debt at the end of the year to the economy’s exports of goods and services for that year. An increasing debt-to-exports ratio over time, for a given interest rate, implies that total debt is growing faster than the economy’s basic source of external income, indicating that the country may have problems meeting its debt obligations in the future.

                         Debt-to-GDP ratio. Defined as the ratio of the total outstanding external debt at the end of the year to annual GDP for that year. By using GDP as a denominator, the ratio may provide some indication of the potential to service external debt by switching resources from production of domestic goods to the production of exports. Indeed, a country might have a large debt-to-exports ratio but a low debt-to-GDP ratio if exportables comprise a very small proportion of GDP. This ratio, however, is vulnerable to the presence of over- or undervaluations of the real exchange rate, which could significantly distort the GDP denominator. Also, as with the debt-to-exports ratio, it is important to take account of the country’s stage of development and the mix of concessional and nonconcessional debt (i.e, to consider the relevance of nominal or PV indicators).

                         Debt-to-fiscal revenue. Defined as the ratio of the total outstanding external debt at the end of the year to annual fiscal revenue. This ratio can be used as a measure of sustainability in those countries with a relatively open economy facing a heavy fiscal burden of external debt. In such circumstances, the government’s ability to mobilize domestic revenue is relevant and will not be measured by the debt-to-exports or debt-to-GDP ratios.

Flow based indicators

                        14.16 Debt service provides information of the resources that a country has to allocate to servicing its debts and the burden it may impose through crowding out other uses of financial resources. Comparing debt service to a country’s repayment capacity yields the best indicator for analyzing whether a country is likely to face debt-servicing difficulties in the current period. Two main indicators are typically looked at: 

                         Debt service to export ratio, defined as the ratio of external debt-service payments (principal and interest) to exports of goods and services for any one year.4 It indicates how much of a country’s export revenue will be used up in servicing its debt and thus, how vulnerable the payment of debt-service obligations is to an unexpected fall in export proceeds. 

                         Debt service to revenue ratio, measures the burden of the external debt service in relation to the government’s revenues. It highlights the extent to which debt service hampers debtor countries in the use of their financial resources.  

4 This ratio, in addition to the total debt-to-exports and the total debt-to-GNP (national output) ratios, is provided for individual countries in the World Bank’s annual Global Development Finance publication.

Table 14.1 Common Debt Burden Indicators in assessing External Debt Sustainability

                        14.17 These debt burden indicators focus on the typical measures of repayment capacity (GDP, exports, and revenues). However, remittances can also affect the assessment of debt sustainability by improving a country’s capacity to repay its external debt. In countries where remittances are large and represent a reliable source of foreign exchange, the inclusion of remittance in GDP and exports becomes even more relevant.  

                        14.18 While the indicators mentioned above are commonly used in assessing external debt sustainability, there are other indicators that help gauge debt vulnerabilities associated with the composition of debt, developments in the current account, market perceptions,

                        international liquidity developments, as well as the country’s own record of servicing its debt. Some of these indicators are mentioned in the table below.

Table 14.2 Other Indicators for Vulnerability Analysis for the External Sector 1/

Purpose	Indicators
External solvency indicators	Gross financing need
External liquidity indicators	Reserves in months of imports of goods and services
Indicators of stock imbalances (solvency risks)	Non-interest external current account deficit that stabilizes external debt-to-GDP
Indicators of flow imbalances (rollover risks)	- Gross official reserves-to-short-term external debt (at remaining maturity) 2/ - Extended reserve cover 3/ - Foreign currency deposits to foreign assets of the banking system

1/ For additional information on external and public indicators, see IMF 2008.

2/ Defined as the ratio of the stock of international reserves available to the monetary authorities to the short-term debt stock on a remaining-maturity basis. This ratio indicates the extent to which the economy has the ability to meet all its scheduled amortizations to nonresidents for the coming year using its own international reserves. It provides a measure of how quickly a country would be forced to adjust if it were cut off from external borrowing—for example, because of adverse developments in international capital markets. It could be a particularly useful indicator of reserve adequacy, especially for countries with significant, but not fully certain, access to international capital markets.

3/ Gross official reserves in percent of the current account deficit adjusted for net FDI inflows plus total long-term external debt (original maturity) due in one year or less plus the stock of short-term external debt (original maturity) at the end of the last period plus foreign currency deposits in the banking system.

                        IV. Basic steps for undertaking an external DSA

                        14.19 External debt sustainability is assessed by undertaking a forward-looking analysis of the evolution of debt burden indicators under a baseline and stress test scenarios. In practice, this requires projecting the flows of income and expenditures, including those for servicing debt as well as exchange rate changes (given the currency denomination of the debt). Projections of the debt dynamics thus depend, in turn, on macroeconomic and financial market developments which are intrinsically uncertain and highly variable. While debt assessments can be presented in many ways, a typical DSA consists of three basic elements:  

                         Baseline scenario. This step implies the assessment of debt dynamics under the most likely path of key macroeconomic variables (e.g. GDP growth, net exports, foreign direct investment, and interest rates among others).  

                         Stress/sensitivity tests. The purpose of stress test is to test the robustness of the baseline by assessing the evolution of debt burden indicators under different scenarios. Stress testing therefore scrutinizes the resilience of the baseline to shocks and reveals the country’s vulnerabilities. Taking into account country specific characteristics in the design of stress tests is important to accurately capture the risks that a country is exposed to. The impact of stress testing is channeled in two ways: by changing the evolution of the measures of indebtedness and by changing the capacity to repay compared to the baseline scenario.

                         Interpretation of results. This step involves a discussion of the main risks resulting from the assessment of debt dynamics under the baselines and stress tests. This includes a discussion of policy implications resulting from the projected debt dynamics and the adjustments needed to ensure sustainable debt dynamics, where relevant. This step should bear in mind country-specific circumstances and include an assessment of whether and how other factors (e.g. the evolution of domestic debt, contingent liabilities or the financial sector), affect a country’s capacity to service future debt payments. The assessment of factors mentioned in paragraph 15.16 where relevant may be necessary in some cases to cover the risks and vulnerabilities facing external debt. 

                        V. What are the main drivers of debt dynamics?

                        14.20 As mentioned in the sections above, the evolution of external debt is embedded in the context of the overall macroeconomic framework. This involves the projection of key macroeconomic variables and deriving the implicit evolution of external debt.

                        14.21 The basic equation for the evolution of external debt takes into account a country’s sources of foreign exchange/inflows (exports of goods and services, net transfers and net income5) and expenditures/outflows (imports of goods and services). The evolution of the stock of external debt takes also into account non-debt creating sources of financing from the balance of payments (in particular the non-debt sources related to direct investment). Other factors (residual) contributing to the evolution of the external stock of debt include debt relief (exceptional financing), drawdown of foreign exchange reserves, and errors and omissions.6

                        14.22 The evolution of the external debt stock is determined by the following components: non-interest current account deficit, net foreign direct investment, endogenous debt dynamics, and a residual. The combined effect of the first three effects is labeled “Identified net debt creating flows” (Figure 14.1). The residual captures all factors that determine the projections of external debt, but cannot be explained by the “identified net debt creating flows”. The decomposition helps to identify whether the change in the debt burden indicators is largely driven by adjustment of the current account or is rather the result of the behaviors of interest rates, growth rates and/or price and exchange rate movements.

5 Net income and net transfers are referred to as the balance on primary and secondary income respectively in BPM6.

6 For a detailed explanation of the equation of external debt dynamics see WB 2011, Stress Testing in the Debt Sustainability Framework (DSF) for Low-Income Countries .

Figure 14.1 Evolution of external debt

                        14.23 The current account dynamics are important because, if deficits persist, the country’s external position may eventually become unsustainable (as reflected by a rising ratio of external debt to GDP). In other words, financing of continually large current account deficits through external debt will lead to an increasing debt burden, perhaps undermining solvency and leading to external vulnerability from a liquidity perspective, owing to the need to repay large amounts of debt.

                        VI. Assessing debt sustainability in the context of Fund program monitoring and country surveillance

                        14.24 The IMF has developed a framework for conducting public and external DSAs as a tool to better detect, prevent, and resolve potential crises. The framework also helps assess the evolution of debt under alternative policy paths.

                        14.25 As mentioned in previous sections, DSA results should be assessed against relevant country-specific circumstances, including the particular features of a given country's debt as well as its policy track record and its policy space. With this in mind, two types of frameworks have been designed: those for MACs and those tailored for LICs.

The DSA framework for market access countries

                        14.26 The IMF Board endorsed a standard framework for external and public debt sustainability for MACs in June 2002, with the goal of improving the consistency and discipline of DSAs.

                        14.27 The framework consists of a medium term (five years) baseline scenario, usually the set of macroeconomic projections that form the basis for understandings on a Fund-supported program or the articulation of the authorities’ intended policies as discussed with the staff in a surveillance context. Together with a detailed presentation of the baseline scenarios, the

                        framework also facilitates assessments of sensitivity of debt dynamics to a number of assumptions, essentially providing a tool to stress test the baseline.

                        14.28 In August 2011, the IMF Board approved a modernized framework for public DSA, which moved towards a risk-based approach, while maintaining some elements of standardization to ensure evenhandedness and cross-country comparability.7 The external DSA part of the framework has not been changed.

7 For more detailed information see IMF 2011, Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis.

8 More information could be found at the IMF website: http://www.imf.org/external/np/exr/facts/jdsf.htm 

DSA framework for low-income countries (LICs)8 

                        14.29 The World Bank and IMF jointly introduced a DSA framework for low-income countries in 2005. The conceptual framework underpinning the LIC DSA is essentially the same as that for the MAC DSA. However, its implementation involves different data and operational issues and reflects the prevalence of concessional financing from official creditors. For instance, it uses a 20-year projection horizon as opposed to the five-year period applicable in DSAs for MACs, reflecting the longer maturity of low-income countries’ debt. Also, debt indicators for low-income countries are expressed in present value terms because their debt is predominantly concessional. Furthermore, LICs face a number of unique challenges such as overcoming large infrastructure gaps, which raises questions on how best to capture the impact of public investment on growth and debt sustainability.  

                        14.30 LICs DSAs are prepared jointly with the World Bank and the framework is extended to include an explicit rating of the risk of external debt distress. LIC DSAs are published annually on the external Web sites of the IMF and the World Bank.

                        14.31 The DSA framework has been adopted as a tool to help policymakers strike a balance between achieving development objectives and maintaining debt sustainability. It guides the design of policies that help prevent the emergence, or reemergence, of debt distress in low-income countries. It is built on three pillars:

                         A standardized forward-looking analysis of public sector and external debt and its vulnerability to shocks (baseline scenario, alternative scenarios, and standardized stress test scenarios are computed);

                         A debt sustainability assessment, including an explicit rating of the risk of external debt distress; and

                         Recommendations for a borrowing strategy that limits the risk of debt distress.

                        14.32 There are important conceptual and methodological differences between the HIPC Initiative debt relief assessment (HIPC DRA) and the LIC DSA. While both are driven by the objective of preventing excessive indebtedness, the HIPC DRA is a tool to calculate debt relief under the HIPC Initiative. The HIPC Initiative thresholds for the PV of debt-to-exports and the PV of debt-to-revenue ratios are uniform across countries; their denominators

                        (exports and revenues) are derived on the basis of three-year backward-looking averages to limit the impact of transitory factors; and predetermined currency specific discount rates are used to calculate PVs within currencies, to avoid reliance on exchange rate projections. This analysis is described in more detail in Appendix V. The LIC DSA is forward-looking, uses single-year denominators, incorporates exchange rate projections and a uniform discount rate, and applies policy-dependent indicative thresholds. The HIPC Initiative and Multilateral Debt Relief Initiative (MDRI, see Appendix V) debt relief should be accounted for in the baseline or alternative scenario, depending on HIPC status.