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Cover Story

Senior Advisor
Financial & Risk Management,
Dec 06 - 12, 1999

The Hub Power Company

An exclusive article for PAGE special by Dr. Anjum

Pakistan is facing its greatest challenge in its 52 year economic history. Reviving a sick economy amidst poor investor confidence is an uphill task being faced by the new administration. Mr. Shaukat Aziz has outlined a plan of action which incorporates the recovery of loans, collection of taxes, privatization of state assets and restoration of investor confidence to attract foreign investment.

Loan Defaulters & Tax Evaders

The GoP's drive to nab loan defaulters and tax evaders is a long awaited attempt to reinforce the rule of law. The cleansing operation if successful could have monumental effects in changing the tax and loan culture of this country. In terms of dollars and cents, the revival of the economy has very little to do with the recovery of loan defaults. However, it has everything to do with accountability. A number of loan defaulters are also tax evaders as the complete breakdown of the rule of law encourages theft on both playing fields. It is estimated that total loan defaults amount to Rs. 211 billion of which about 50% is the principal and the rest is accumulated interest. Although there were threats of dire consequences and punishment, the Government has only managed to collect loose change amounting to Rs. 8-10 billion which is only 4% of the outstanding bad loans. This infinitesimal recovery is not inconsistent with our prior expectations. It is not an open secret that lot of this money has been transferred overseas in financial and real assets. Getting the money back would be a long and costly battle.

The smart way of going about it is to confiscate the defaulters' local assets and auction them to the highest bidders. Instead of dragging the issue which is so common in Pakistan, the retribution of justice should be swift. Delays in the judicial order would only create opportunities for evasion of justice. The economic effects of loan recoveries by banks are obvious. An improvement in the liquidity of banks would put downward pressure on interest rates on business and consumer loans. But lower interest rates are not the only determinant of business fixed investment, at least in a less monetised economy such as Pakistan. Keynesian "animal spirits" or entrepreneurs' expectations of return on investment are most important to spur investment activity. It is here where the policy makers would face their greatest challenge.

Raising the entrepreneurs' confidence in the profitability of domestic investment is not easy but it is doable. This confidence was eroded by successive shocks to the economy. It may be recalled that at one time just before the ouster of the 2nd Benazir government, the Karachi Stock Exchange Index had touched 2400 points. Soon after it plummeted below 1000 points with successive policy faux pas. The decline started with political instability surrounding Benazir's dismissal, followed by the IPP crisis perpetrated by Nawaz Sharif, the freezing of the foreign currency accounts in the wake of the unnecessary and ill timed nuclear testing, Nawaz Sharif's row with the judiciary and the dismal failure of the Nawaz government to revive the economy. The end result was that foreign exchange reserves sank to a couple of weeks of import financing and left with very little options Pakistan opted for loan rescheduling or a quasi default with IMF and multilateral agencies.

Once again Pakistan finds itself in a difficult position and is seeking IMF assistance to finance its current account deficit. Foreign assistance is like a credit card. It allows higher spending than income at the cost of accumulated and rising interest payments. Living without credit (foreign assistance is possible) but naturally at the cost of decreased consumption and investment until such time that enough national savings can be generated to finance consumption and investment requirements.

Taxation Issues

Tax revenues of Rs. 307 billion, inclusive of direct and indirect taxes, currently constitute 60% of the total Gross Federal Receipts of Rs. 501 billion. Of this, direct taxes (income taxes) are only Rs. 112 billion which is only 22% of the overall government receipts. The low direct tax base is the premier cause of all economic problems of the country. For a healthy economy the ratio needs significant improvement. If the government is able to enlarge the tax net by Rs. 50 billion, it would amount to a 16% increase in tax revenues (inclusive of indirect taxes). Realistically speaking, one does not expect any larger increase in the current fiscal year and even this increase would be a trend setter and a mammoth achievement.

However, to reduce Pakistan's dependency on external resources and inflationary indirect taxes, the direct taxes as a percentage of Gross Federal Receipts should be around 50% plus. This would give the government further revenue of around Rs. 140 billion from enhanced direct tax collection alone. Can the nation withstand an income tax collection of this proportion? The answer is an emphatic yes. It is common knowledge that the size of the black economy is large and shopkeepers, retailers, traders and a number of self employed people evade taxes. As if this was not enough, agriculturists are exempted from paying taxes. It is interesting that agricultural income is not income in the tax man's lexicon but making money through any other means is considered income.

The current tax collection of Rs. 307 billion is very small given the potential for tax revenue. By even the most conservative estimates another Rs. 100 billion plus can be easily collected, provided that the economy is documented and the exemption for the fat agriculturists is removed. This is where the resolve of the current regime would be severely tested. The worst method to enlarge the tax net would be to use the corrupt CBR inspectors. The task of documentation is easy and should be given to the private sector including the local government. The involvement of the various chambers of commerce is a politically expedient idea.

IPP Crisis

An efficient power sector producing affordable power is the need of the day and all Pakistanis are equally affected by the IPP crisis. It is most unfortunate that the IPP issue has been politicized and mishandled. The endless stalemate of a purely commercial issue continues to the detriment of the country's fragile and confidence torn economy.

Innovative and indigenous solutions of the IPP issues are indeed possible. However, a solution will only materialize once we do away with the rhetoric and discuss a purely commercial issue in economic terms minus the politicization that it has been subjected to over the last two years.

The Energy Policy needs to be reexamined bearing in mind Pakistan's country risk, capital constraints, foreign exchange reserves and projected economic growth. The restructuring of the energy sector requires the implementation of both demand and supply side measures. All arguments that Pakistan has excess electricity capacity would vanish with an increase in demand. Electricity consumption can be increased by four policy initiatives which are: (i) reduction in power tariffs (ii) rationalization of subsidies and power rates between domestic and industrial consumers (iii) supplying electricity to the 50% population of Pakistan which is currently deprived of electricity, and (iv) exporting electricity to India. These are demand side measures to enhance electricity demand.

Supply side measures to increase the supply and to make it more efficient are

(i) phasing out inefficient and old WAPDA & KESC plants and increasing the utilization factor of efficient IPP plants (ii) privatization of WAPDA expeditiously, so as to develop an efficient and cost effective transmission and distribution network.

Indeed there is massive resistance from within WAPDA against any move towards privatization. It is most amazing that infinite 'reasons' are being advanced against privatization of the state utility and other public sector corporations. In fact, the government's privatization plan has come to a virtual halt due to the lack of political will and mayhem at the top.

The privatization of state corporations and specifically of WAPDA should be a key policy initiative of the new administration. The health of the economy is intimately interlinked with the IPP issues. Poor economic growth is the cause of low electricity demand, which in turn reduces WAPDA's revenues and its ability to pay the IPPs. Without an economic revival the fiscal health of the energy sector would continue to be adversely affected.

In my opinion, it would not be possible to jump start the economy without the following three key policy measures: (i) enhanced revenues through increase in direct taxes (income tax) (ii) immediate privatization of banks, state corporations and utilities such as Telecom and WAPDA, and (iii) restoration of investor confidence as an immediate policy measure. Of these measures, higher revenue collection is of premier importance and should be the principal focus of policy makers.