From stability to growth

After decades of what Pakistan’s finance minister, Shaukat Aziz, terms “stop-go policies” investors and international donor agencies are anxiously waiting to see if the government can make good on its promise to transform reform into stability and growth.

The countdown has begun: general Pervez Musharraf, who seized power from prime minister Nawaz Sharif in a two-hour bloodless coup nearly two years ago, has promised to restore democracy by October of next year. Musharraf says he intends to “ensure continuity” by staying on in his executive role, overseeing events from behind the scenes, presumably on the Turkish model.

Musharraf and his team will have their hands full trying to restore investor confidence in a country that was on the brink of default according to Aziz, with talk of isolation and a total breakdown in expenditure controls and relationships with bilateral and multilateral agencies. It is not an enviable task.

On the political front, Pakistan faces US and European criticism for being the only country to maintain an embassy in Afghanistan. Musharraf says it is vital to preserve stability on the long border shared with the Taliban regime, particularly given Pakistan’s long-standing hostility with India on its eastern border. The collapse of July’s Agra summit between Musharraf and Indian prime minister Atal Bihari Vajpayee highlighted the volatility of relations between the two nuclear powers, which have gone to war three times in the 54 years since they gained independence from the UK. Then there is the enemy within: Islamic fundamentalism is an ever-present threat to domestic peace and the religious rigorists have been behind much of the violent opposition to Pakistan’s moderate brand of Islam.

Musharraf has taken a hard line on Islamic extremism and recently outlawed two rival groups for inciting sectarian violence. Yet the mullahs remain a powerful force in Pakistan’s poor rural communities and there are fears that their militant views may be infecting the lower echelons of the armed forces.

The government’s long-term solution is to raise the level of education and prosperity of Pakistan’s heavily illiterate population, at least 30% of which lives below the poverty line. But it is a race against time and many observers believe that time is not on Musharraf’s side. General elections loom early in October of next year.

Two disgraced former leaders, Benazir Bhutto and Nawaz Sharif, will most likely be looking to stage a comeback from their respective gilded exiles. Either of the ousted prime ministers would arguably be eager to exploit people’s disaffection with a lack of tangible political and economic progress under Musharraf’s government.

The economic team, led by Aziz, very early on went to work on stabilizing the economy. “Governments are often tempted to take short-term measures and go for the quick fix,” Aziz says. “But Pakistan’s situation was such that it needed once and for all a fundamental tackling of the basic issues.”

The first task was to liberalize the foreign exchange rate and build up the country’s reserves, which at $3.2 billion gross are now almost two and a half times higher than when the government came into office. Aziz says he is comfortable with the level of reserves and points out that Pakistan is now current on all its payments. The government managed to slash the fiscal deficit by more than 1% of GDP for the year ended June 30 2001 and also kept the current account deficit below 2% of GDP. But growth, at 2.6%, was below target, in part because of a severe drought that brought agricultural output down by 2.5% for the period. Aziz remains optimistic that Pakistan will achieve 5.3% to 5.5% GDP growth in the current fiscal year, in compliance with the range set by the IMF as one of the conditions for granting a $1.5 billion medium-term facility.

Improving relations with the multilaterals

The outlook is positive, as Pakistan has qualified for a $700 million soft-term loan from the World Bank and has managed to get aid restored from the Asian Development Bank and several other bilateral organizations. “In the context of the current economic performance, the IMF loan should be a shoo-in,” says a Karachi stockbroker. “But it is politics that is driving the negatives, specifically recognition of the Taliban regime and the lack of progress on talks with India. One mustn’t forget that the US has a major voice in IMF disbursements.” And with $37 billion in foreign debt hanging over its head, Pakistan is likely to remain dependent on donor funds for some time to come.

One of the more ambitious and politically-risky undertakings was the drive to increase the tax base and attack widespread corruption. The introduction of a database and the more ruthless pursuit of tax evaders has improved efficiency and brought double-digit growth in tax collection for the second year. Dealing with corruption may prove to be a more volatile issue. Even the most cynical reluctantly concede that Musharraf’s team is beyond reproach, yet it is in the middle and lower ranks that graft and corruption continue to thrive on a breathtaking scale.

For example, Abdul Hafeez Shaikh, finance minister for Sindh province, the region that includes Karachi and accounts for more than 60% of the country’s tax revenue, reports startling data from the province. Last year, he says, the province’s marble and granite quarrying concessions together generated less than $2,000 in fees for the regional government. In addition, over the past six years the number of civil servants doubled to 450,000, all of them political appointees.

“We have tried to get a handle on expenditures,” he says. “Last year we did away with 13 out of 23 regional taxes, we slapped a ban on recruitment, official cars and the like, and we cut the number of government departments from 29 to 12. For the first time in 11 years the Sindh government is now in cash surplus.”

Accountability has become the buzzword throughout Pakistan. The government’s National Accountability Bureau (NAB) acts as a watchdog to implement the government’s anti-corruption crusade.

Most of the monitoring is done by the army and this, says a Pakistani economist, is a double-edged sword. “The army is being dangerously exposed to corruption,” he says. “This could undermine its prestige and it is important that it be withdrawn to barracks as soon as possible.”

Aziz concedes that much remains to be done. There is widespread disappointment about the lack of investment. He claims this is partly because of the increased level of documentation in the economy and the accountability drive.

“We have practised a high level of accountability,” he says. “All the reforms are public knowledge. The entire correspondence, discussions and paperwork with the IMF have been published on our website, as well as our monthly accounts. We are really opening up the system. The first task was to put our house in order and get our outward flows under control. Now the task is to achieve growth.”

The reform drive in Pakistan has cut particularly deeply into the banking sector, although the present government cannot take full credit for liberalization. This process was actually launched in 1997 when a lot of the oligarchic management was swept out and professionals were brought in to run the banks. Narwaz Sharif’s government laid the groundwork by reining in militant unions, making the State Bank independent and streamlining the bad debt recovery process. “In one liquidation case the prosecuting bank was called as a witness 18 years after litigation began,” recalls a Pakistani banker. “After the Sharif reforms, with a good lawyer you could have the proceedings wound up within one year.” The problem, this banker points out, was that the clean-up lost momentum when political cronies began to realize that the reforms were likely to act against their own interests and they turned on Sharif.

Since the military came to power in 1999 the three large state-owned banks have been encouraged to trim their top-heavy structures to prepare for privatization. Some 8,000 jobs have already been slashed and up to 9,000 more will go in the next year, in total a 50% reduction in the state sector workforce. The three banks have already shut 300 branches, and a further 500 closures are in the pipeline. There have been massive job cuts and branch closures. Stringent capital adequacy requirements have been introduced. By the end of next year minimum capital requirements will be doubled to PRs1 billion ($15.7 million), a move that is likely to squeeze out a number of the weaker players.

“Those banks unable to comply with the new capital requirements will have their licences revoked or will have to merge with stronger entities,” says State Bank of Pakistan governor Ishrat Husain, a 20-year veteran of the World Bank brought in by Musharraf to modernize the banking sector. “We are beefing up our surveillance and inspection capability to identify problem cases and weed out the non-performers sooner rather than later,” he says. Last year Husain cancelled Indus Bank’s licence on the grounds of malpractice and he is in the process of forcing a change of management at Prudential Commercial Bank. Husain says his message to the banks is clear: get into shape or merge. “I have been arguing the need for fewer but stronger banks,” he says. “I will leave it to the market to work it out as I am not an advocate of hostile takeovers.”

Encouraging bank consolidation

The government is moving to ease the tax burden on banks, with a reduction from 58% to 50% as of the 2002-03 fiscal year. Yet this still leaves the banks at a disadvantage to the corporate sector, where the prevailing rate of income tax is 35% to 45% respectively for state-owned and private limited companies. It is estimated that had the tax cut been introduced in the last financial year, average bank earnings would have been 7% higher.

Husain would like to see the three state-owned banks in private hands as soon as possible, and he has no qualms about foreign takeovers. “Unlike India, we have no objection to foreign ownership,” he says. “The aim is to improve the cost/income ratio so any bidder will find a clean balance sheet. To this end we have secured a $300 million loan from the World Bank to help restructure the sector.”

United Bank has already received a number of expressions of interest and it will go out to tender by the end of the year. The second of the three, Habib Bank, is scheduled to come up for privatization next year. It will be followed by National Bank of Pakistan once a substitute system has been put in place to replace a number of the state functions it now performs, such as paying civil servant salaries and pensions. “We have been restructuring the bank for the past four years,” says Habib Bank chief executive Zakir Mahmood. “After trimming our staff by 9,000 since 1997 we have now moved back to a period of sustained profitability, with just over PRs1 billion in pretax profit for last year, net of provisions.

“We have been going through a real transformation. We’ve done a lot of working on cleaning out our bad-debt portfolio which is now 55% covered by cash. As for my functions, I report to a board of directors like in any normal commercial bank.” Mahmood, who was brought in from Crédit Agricole Indosuez, acknowledges that the bank still faces an efficiency challenge that he says will be partly met by an improvement in IT. “By the end of next year the bulk of our processes will be in place and we envisage major cost savings through on-line banking.”

National Bank of Pakistan will soon begin offering up to 10% of its equity to retail investors as a trial before deciding on an IPO timetable. “Once the initial public issue is away we will list on the stock exchange,” says the bank’s chief executive, Ali Raza, who was formerly with Bank of America. “My job is to enable National Bank to make the transition from a public service institution to a commercial bank. To this end we’ve re-drafted our entire internal processes and overhauled our corporate and wholesale businesses.”

Raza says his work has been made feasible largely because the government has kept its distance. “I run the country’s largest enterprise and over the past year there hasn’t been a single instance of government interference,” he says. “I am measured solely against my personal performance. We are the most profitable of the three state banks, with a 16% ROE, but we have to work vigorously on our non-performing loans, which account for about 18% of our book. Our policy now is to help restructure problem borrowers rather than push them into bankruptcy. Last year were we were able to re-structure 80% of our NPL portfolio through a policy of determining their level of sustainable debt and writing off the balance.”

Raza says the banks are benefiting from the government’s efforts to create a level playing field. “We cannot expect immediate results but for once this is an enabling environment, not a short-term gimmick,” he says. “We can’t expect to see much economic growth in the next couple of years but we have a lot of critical mass.”

Foreign banks operating in Pakistan have taken note of the challenge ahead once the state banks are put into the private sector. For now, the major players, such as ABN Amro, Standard Chartered Grindlays and Citibank, enjoy the competitive advantage of more streamlined and efficient operations. This is reflected in their return on assets, which averages 1.6% for foreign banks, 1.3% for domestic private-sector banks and 0.23% for the state-owned entities.

The government has been poaching Pakistani bankers abroad, primarily from Bank of America and Citibank, to head local institutions and pull them out of years of lethargy. They are using their international skills to inject a new corporate culture and clean up the balance sheets of the private and public sector banks.

“The local banks are like awakening giants,” says Azhar Hamid, chief executive of Standard Chartered Grindlays. “They have been moving into areas that were previously the domain of foreign players, such as offering facilities to multinationals. We are not unduly concerned, as we are the largest foreign bank in the country with a very focused strategy. We are targeting consumer rather than corporate banking. Good local companies will sooner or later start floating their own paper and the days of taking money from the consumer and lending it to the likes of ICI are over. We are also looking at alternative delivery channels and expanding out ATM network. The plan is to add value to our corporate clients in terms of new cash management products, outsourcing bill payments and the like.”

Bank privatization is just one aspect of a strategic approach that sees selling off state-run businesses as crucial to economic growth. Up to now, though, Pakistan’s track record on privatization has hardly been the sort of stuff to excite foreign investors. Past efforts often ended up in litigation and since Musharraf’s military coup, not a single IPO of significance has been pushed through.

A new emphasis on privatization

The fact that the programme has been elevated to become the responsibility of a specialist minister reflects the importance the government places on privatization as a key to modernizing and kick-starting the economy, restoring investor confidence and providing funds for a cash-strapped administration.

The government has made clear its objective of withdrawing from the private sector: “We believe it is not the business of government to be in business,” says finance minister Shaukat Aziz. “Our major banks, oil and gas companies, telecoms and several others are being put in the marketplace. Between now and December if we do one or two big transactions, the privatization programme will restore its credibility, after what has admittedly been a slow start.”

Credibility on the privatization front is particularly crucial as Pakistan remains off the radar screens of foreign investors. Foreign direct investment plummeted 31.5% to $322 million in the past financial year.

Part of this decline resulted from Bank of America’s decision to pull out of Pakistan – itself not an encouraging development – with the repatriation of $40 million. Waseem Haqqie, chairman of the Board of Investment, is confident foreign direct investment will recover to at least $600 million this year and touch the $1 billion mark in 2002-03. “Our investment policy has been liberalized and we are offering better perks,” he says. “The policies now being framed are 100% transparent.” However, Haqqie acknowledges that the outside perception of Pakistan as a destination for FDI is “still not favourable” and that the country continues to pay the price of nationalization in the early 1970s, with about 40% of the economy still in state hands. In fact, the first government assets were not returned to the private sector until the 1990s, and none of these sales has attracted international investor interest.

Privatization minister Altaf Saleem says his 10-year programme aims to take the government out of such key sectors as banking, oil and gas, power generation and telecommunications. He is focusing on those deals that will add a maximum degree of reform to the system, while stressing that his efforts have an ultimate social objective. “This means improving the quality and reducing the cost of goods and services,” he says. “For instance, 3 million Pakistani households have gas heating in a country of 140 million people. The rest use kerosene, coal and other sources of more expensive fuel. This is because companies have no capital to invest and there is no price rationalization. So a few people enjoy subsidized gas while the poorest are paying more for their fuel. People think that privatization proceeds will be used for debt servicing, while in fact that is only our fourth or fifth priority. The real objective is to bring prices down to realistic levels and modernize the economy. It’s important for the government to exit any kind of business.”

The entire programme is focused on 50 state enterprises, most of which are in the power generation and utilities sectors. Some eight of these companies account for 75% of the $3 billion programme and Saleem says his objective is to have most of these transactions concluded by June of next year. “However, that is not the end of the story,” he says. “In future we will be looking at ports, airports and other public services.”

United Bank of Pakistan is the first of the family jewels to be put on the block. Saleem says the government has already received 21 expressions of interest for the bank, with plans to market 5% to private investors in the coming weeks. The bank, one of the big three state enterprises, achieved PRs461 million net profit last year. United Bank, along with Habib Bank, telecommunications company PTC, Oil and Gas Development Corporation (OGDC), Pakistani Petroleum and Pakistan State Oil make up the lion’s share of the privatisation programme.

PTC is far and away the star attraction in the line-up of government franchises on offer. The fixed-line operator’s credibility has suffered at the hands of previous governments. But Saleem says the telecoms group, which in 1994 divested a 12% stake, will offer between 20% and 51% of its equity to investors by the end of this year, depending on the level of interest.

“At the outset we had trouble attracting good financial advisers as people thought we were not serious about privatization,” he says. “There was a lot of scepticism in the first three or four months but we have instilled confidence in the market with a credible programme, not just lip service.”

Saleem has managed to bring in international heavyweights to advise on the sell-off of some of the government’s prize assets. Merrill Lynch and JPMorgan are advising on OGDC and Pakistan State Oil, a consortium led by Goldman Sachs and JPMorgan is working on PTC and PricewaterhouseCoopers is involved in the power sector.