Pakistan: Friends and funds unite

A SUPPLEMENT TO EUROMONEY/AUGUST 1997

Pakistan’s secretary of finance, Choudri Mueen Afzal, and his minister of finance, Sarjad Aziz, share an appetite for hard work. Oxford-educated Afzal says he puts in a six-day week, rarely getting home before eight in the evening, but agrees that Aziz, the author of the recent budget, is more industrious still. “He works harder than any other finance minister I know of,” says Afzal.

There is no shortage of things to do if the key goals of Pakistan’s economic policy are to be achieved. These are to reduce government expenditure and waste, push forward with privatization, and persuade multilateral lenders that Pakistan can be trusted with their money. Afzal has committed much time and energy developing the country’s profile in the international capital markets.

The country first entered the markets in December 1994 with a five-year floating-rate note to raise $150 million, lead-managed by Bear Stearns. Two years later, in June 1996, Pakistan issued a three-year floating-rate note for $150 million. This time, Citibank acted as lead-manager. Afzal has demonstrated his intention of making Pakistan a more frequent player by going to the markets twice since February.

“The first time,” says Afzal, “we issued an exchangeable bond against shares of PakTelecom. The holders of the bond had the option of taking shares in lieu of the bond and that ensured we got a good rate. We wanted only $150 million but we had expressions of interest worth more than $1 billion.” Afzal continues: “We closed it at $160 million at the end of February, just after the new government came in, because we didn’t want to pre-empt the privatization of PakTelecom.”

At the end of May 1997 the government went again to the market with a three-year floating-rate note. “We were looking for $100 million but finished with $300 million,” says Afzal, seeing this as proof of the market’s excellent response to the new government.

There will be further issues over the next 12 months, says Afzal, with one of his key aims being to lengthen the maturity of Pakistan’s debt. A bond collateralized against the receivables of PakTelecom, for instance, has a maturity period of seven years. “We hope to extend our maturities out to 10 years. We are looking at floating-rate notes in the Euromarkets and yankees,” says Afzal.

Building investor confidence is not easy in the wake of Pakistan’s recent economic problems. Afzal summarizes the situation he inherited in February: “Before the present government came in, the country had been going through a balance of payments crisis for six to eight months. Privatization had become a stop-start process, and there were also serious governance issues.”

GDP growth rates had fallen, going down from an average over the last two decades of 5.5% to 4% over the last five years. In 1996 the rate went down further to 3.1%.

Raising the rate of growth is Afzal’s key priority. “We feel the economy has the potential to grow at over 6%, but for that you need to generate higher savings rates, and you need to give more money to the private sector on the assumption that the private sector uses the rupee more efficiently than the public sector.”

External aid had dropped to a low level by the time the Sharif administration took office. “Donors felt that Pakistan had gone off the tracks with its macroeconomic policies,” says Afzal. The financial institutions were also in need of reform, according to Afzal. “Everyone was saying the right things about the banks, but they were not being managed properly. They were going from bad to worse, and if that had continued they could have caused a major financial crisis because of the bad-debt situation. The chief executives were generally incompetent and loan sanctioning was not being done on merit.”

Afzal shares the seemingly universal scorn for the mistakes made by the former government of Benazir Bhutto, but has praise for the interim government.

“This introduced a number of steps to check expenditure, to stabilize the position and to stop the reserves falling,” he says. “Once the new prime minister came in, the IMF and the donors wanted to see how he would stabilize the economy and give confidence to the donors and the markets. A set of policies was devised to get donor support, and to strengthen the external position.”

The first of these introduced banking and financial sector reforms. According to the secretary of finance: “These enabled all banks and institutions to appoint first-rate management, to employ chief executives at market rates, and to prepare themselves for privatization.” The second policy involved giving further powers to the central bank to conduct independent monetary policy and to improve bank regulation.

A similar approach is being taken to the capital markets. Says Afzal: “The basic objective is to strengthen the Corporate Law Authority and provide a better environment both for the stock market and the mutual funds. We also want to do away with the distinction between private- and public-sector mutual funds.”

The third policy dealt with taxation. “We have been struggling with the problem of working out tariff reductions,” explains Afzal. “Benazir Bhutto had agreed with the IMF and World Bank to bring down maximum tariffs to 55% or 60%. In fact, tariffs rose in 1995 to 65%.” A further duty of 10% was also introduced applicable to all but the 65% band.

The Sharif government took decisive action in March, reducing tariffs to 45% at the same time as rationalizing the structure. In the same month, the finance minister announced that a sales tax would come into force during the course of the next fiscal year. “On the direct taxes side,” says Afzal, “we have slightly lowered the rates and introduced modifications in wealth tax rates.”

In the past, the levels of tax avoidance and evasion in Pakistan have been high. “We want to see how we can increase the number of taxpayers, and how we can make tax revenues grow with the normal growth of GDP rather than having to think up new tax ideas every year,” says Afzal. “We are now busy with reforming tax administration, and have begun a two-part process of administration reform.”

Tax avoidance, says Afzal, will also be targeted. “Any owner of a telephone or motor car or a house will have to file a return. All returns will be checked not just by departments but by audit parties from the private sector. We have been in touch with audit firms, accounting firms and cost and management accountants, with whom we expect to have contracts.”

Afzal has a reputation for austerity and is well suited to the task of implementing the new clampdown on state and ministerial expenditure advocated by the Sharif government.

“Good work was started on this by the interim administration, and the present government has continued the process of control and reduction. Federal government expenditure (military and civil) was something like Rs180 billion.”

Had that pattern been maintained, “that figure would have risen to between Rs190 billion and Rs195 billion by the end of the year”, says Afzal. Instead, expenditure was kept down to Rs174 billion. “For the current year, we have kept expenditure at Rs182 billion,” says Afzal. “In nominal terms, we have cut civil expenditures by Rs2 billion or Rs3 billion.”

The government’s economic policy is underpinned by the broader philosophical conviction – long prevalent in the west – that the less government the better. Afzal has seen enough of excessive intervention in Pakistan to know its dangers. “We are creating a leaner, thinner government, a thinner public sector, and much more imaginative policy-making – which can bring in investment, not just from outside, but from within Pakistan.”

Winning respect abroad as well as at home is integral to Afzal’s economic philosophy, so nothing offends him more than the prospect of the country failing its international lenders.

“The balance of payments crisis resulted in a debt-servicing problem. The current account deficit had increased because of a loss of confidence in the government’s ability to tackle the crisis and the government’s failure to mobilize dollar support.”

There was a problem with rolling over short- and medium-term borrowing and that led to speculation of possible default by the government.

“The interim government started the stabilization process,” says Afzal, “and we are now reasonably confident that we will be able to meet our obligations over the next year.”

To a large extent, he explains, this is contingent on going ahead with the IMF programme for Pakistan. This, taken with other donor support from multilateral and bilateral institutions, he believes, should produce extra soft financing of between $700 million and $900 million annually for three years.

Afzal also seems to be spearheading the privatization process. “The prime minister and cabinet are very keen to go ahead as fast as possible with privatization,” he says. “They want to do the deals within a year to 18 months.”

This may be unrealistic, however. “Even when the three major banks have been turned around by the bright new chief executives, they could not be privatized one month after another; they have to be given time.”

Nevertheless, Afzal seems confident that most of the privatization programme should be completed in the next two to three years. “The government has moved quickly with the Habib Credit and Exchange and there will be some quick developments with the Women’s Bank.”

He is aware of the social and political risks of massive restructuring proposed by Sharif and believes discretion is required. “Downsizing is being handled very carefully. The government is aware that public-sector employees need to be supported. In the financial sector, we have an understanding with the World Bank, and this could be a model for many other countries.”

The understanding involves providing compensation to bank employees who lose their jobs.”We are considering paying for the golden handshakes through a bond system where the payment is not all made in one year,” says Afzal. “The bond will be redeemable over a period of eight or 10 years.”

Solutions like these will need to be found if the Sharif administration is to achieve its aims without causing social unrest. The government has made a good start, and there is room for cautious optimism, but Choudri Afzal and his minister, Sarjad Aziz, will be working late at the office for some time to come.

Fillip for foreign funds

Important fiscal changes have been introduced with the aim of encouraging
foreign investors to participate in Pakistan’s capital markets

Pakistan’s most notable financial reform is the complete removal of all taxes for foreign investors in local currency debt. This was announced in May and is likely to generate considerable international interest. The move is expected to put life into the relatively new and undeveloped local debt markets.

The key tax relief was the scrapping of the 60% withholding tax payable by foreign investors on Pakistani bonds. Foreign companies will also be free to trade Pakistani securities on the secondary debt markets. Repatriation of profits on bond income, however, remains subject to restrictions.

Nasir Bukhari, chief executive of stockbrokers Khadim Ali Shah Bukhari, looks forward to increasing international interest in Pakistan’s markets. “The arrival of foreign funds in the local currency debt markets will mean more integration of Pakistan’s financial markets with the rest of the world,” he says. “Local currency debt with short-term yields as high as 17.5% should be particularly attractive to foreign investors.”

While the debt markets remain relatively undeveloped, Pakistan’s equity markets have experienced a roller-coaster ride over the last decade. The market was buoyed in the early 1990s, when curbs on foreign ownership of shares were relaxed, and incentives were introduced to attract both direct and portfolio investment from overseas.

Turnover reached record heights in 1994 when 1.77 billion shares were traded, more than 10 times the level of 1988. But by the end of 1996 turnover had fallen sharply. The KSE-100 index was trailing almost 20% below the previous year’s level, and when set against the highest point reached over the previous three years, the fall in the value of shares was over 60%. Many investors, including some leading US banks, were tied up in shares whose prices had yet to recover. A number took massive losses and left the market. Badly bruised, many are only now beginning to reconsider Pakistan although a 4.2% surge in the index on July 21 was attributed to foreign buying.

Sajjad Razvi, Citibank’s country general manager, expects investors to remain fairly wary of the Karachi market for some time. “I have started to see the beginning of foreign investor interest,” he says, “but not in quantum leaps. The large amounts will only come when privatization takes root, not before that. The big-ticket infrastructure deals in areas like oil, gas, pipelines, telecoms and the banking sales will pull in large amounts of international money.”

Meanwhile, the hazardous investment environment in the past explains why the profile of investors in the Pakistan markets is heavily skewed towards government institutions. No more than 12.5% of total market is owned by foreign investors; about 55% of shares are owned by sponsors and the government and 25% by local institutions. The remainder is held by local retail investors.

Khalid Nasir, an executive at AKD Securities, says the government measures are expected to mitigate some of the perennial problems with Pakistan’s stock markets: low liquidity, a high level of speculative activity, and a high percentage of ownership by family members (which reduces takeover activity).

Regulation of the Pakistani exchanges has been a persistent bugbear and the government has announced it wants to strengthen the powers and independence of the Corporate Law Authority (CLA) to make it a security and exchange commission. Investors have also been encouraged by the government’s recent decision to give autonomy to the central bank.

Says Khalid Nasir of stock brokers AKD: “In the past, banking and financial regulation was also tainted by question marks over the neutrality of the State Bank of Pakistan. Thankfully that is now resolved.”

As the capital markets seek to attract the foreign investor, the Karachi Stock Exchange (KSE) is pushing forward with modernization of its trading systems. The exchange is set to launch an automated trading system and a central depository system comes into operation from September 3.

“The KSE will be comparable to other stock exchanges in the region,” says Arif Habib, president of the KSE. “That will encourage foreign investors to operate in our market on a larger scale, and it will encourage local institutions. It will also help the brokers to sell to retail investors.”

Although the Karachi exchange is by far the country’s largest stock market, activity on the Lahore exchange has picked up in recent years. As individual savings grow, the regional exchanges are expected to play a greater role in mobilizing capital.

Banks under the knife

Weighed down with bad debts and top-heavy bureaucracy, state-owned Habib Bank and the National Bank of Pakistan are being shaken up. The charge is being led by two dynamic chief executives

Shaukat Tarin did not ask for the job of restructuring the state-owned Habib Bank. He is doing it, he says, as a service to his country. Until recently head of Citibank in Thailand, Tarin received a call from prime minister Sharif asking him to come home and take on the task of modernizing Pakistan’s largest and best-known institution. He accepted the challenge and has set about it with all the fervour associated with a personal mission.

“More people should do what I’ve done,” he says. Not all staff at the bank would agree. Tarin is slicing through the bureacracy. “Our structure is totally archaic,” he says. “There are layers upon layers of inefficiencies.” He anticipates dispensing with the services of up to 8,000 of Habib’s 32,000 employees.

The same process is being undertaken at National Bank of Pakistan. The new chief there, Mohammed Mian Soomro, expects to dispense with 10% of his branches and introduce “a smooth and streamlined structure to enhance efficiency”.

The two men are approaching their jobs in different ways. At Habib, Tarinhe laid off the management cadre and brought in colleagues from foreign banks. “We are all foreign bankers here,” says Tarin. “I removed all my direct reports within the first 30 days, and replaced them with six or seven people from Bank of America, Citibank, American Express and Faysal Bank … basically people from the top range of international banks.” In contrast, Soomro, in the words of one observer, “is still relying on the old guard” at National Bank.

Both men must produce saleable entities for privatization in 12 to 18 months’ time. The priority at both banks is to reinstil a private-sector approach. Tarin’s goals are threefold: to reward merit with appropriate salaries, rather than the civil-service type grading system of payment; to functionalize jobs around discrete tasks; and to encourage staff to be more adventurous.

At the National Bank of Pakistan, Soomro also talks about restructuring salaries and re-educating staff. The short-term aim is to improve profitability. Tarin says the average yield on his balance sheet is close to zero, a pathetic performance when contrasted with the government short-term T-bill rate of 17%. Soomro puts his return on assets at 0.84% and his return on equity at 18%. “For every rupee spent, we must earn two rupees,” he says.

The bugbear of both banks’ balance sheets, and of the Pakistani banking system in general, is a massive overhang of bad loans. In March, the total value of bad loans afflicting Pakistan’s financial sector was estimated to be Rs130 billion ($2.02 billion), most related to losses in the textile industry and real estate. The urgent need to clear the slate led the State Bank of Pakistan to offer defaulters apparently beneficial terms. Borrowers have to repay the principal plus a further percentage to represent the accumulated interest. For loans which have been outstanding for over seven years, borrowers are required to pay the principal plus 5%; for loans outstanding for three to seven years the repayment obligation is principal plus 20%; and for shorter loans, the repayment is principal plus 40%. However, the offer failed to attract many takers when it closed in July, and the central bank has extended it to December. Those failing to settle face a summons before statutory banking tribunals with the power to liquidate companies.

Aizaz Sarfraz, a director of National Bank of Pakistan who sits on the committee for bad loans at Habib, says there is widespread suspicion of the process proposed by the bank. “People think there is a trick,” he says. “In fact, this process is a massive incentive for defaulters. A [non-performing] debt asset is of no use to the bank. Our main effort is to develop good business and to put the past behind us.” Sarfraz says the banks will have to make provisions for years to come to clear the debt overhang. To ensure the bad loan crisis does not recur, the central bank is in the process of strengthening the prudential regulations on capital adequacy and loan recovery.

While both banks must seek to recover what they can from past errors, they are turning their sights on new private-sector strategies. Here, the common thread is fee-based business such as corporate and trade finance. Habib boasts it has unparalleled name recognition, and an international branch network. National Bank has its close connection with the government and the local capital markets. Both banks are targeting the market niches now occupied by the profitable private and foreign banks which outstrip them by every ratio you care to name.