Economy: positive short run, negative long run

June 13 - 19, 2005

The budget FY06 would have made many segments of the population happy. The business community is emphatic about the wide range of tax exemptions which the government has announced on the textile, fertilizers, leather and other export-driven sectors, the capital market would be relieved as no addition capital value tax has been imposed and salaried class would have liked the budget as it announced tax relief and increase in salary.

However, this leads to the probing question that with so many tax exemptions how would the government meet the tax revenue target of PkR690bn (which is up 17%YoY)? In the revenue receipts, the government is anticipating around PkR57bn from dividend income (PkR53bn received in FY05). However, if key entities like Pak Telecom and Pakistan State Oil are privatized this year, what would be the source of this revenue stream? It is not surprising that the government has increased its fiscal deficit target to 3.8% from 3.2% last year.

We believe that this is likely to further increase to above 4% as the revenue target is highly ambitious. A rise in the fiscal deficit would lead to accumulation of government debt (both foreign and domestic) at higher interest rates (as the US interest rates are also on the higher side). So whereas the budget is aimed at stimulating growth, we think that it would compromise on fiscal discipline and amplify macro-stress in the economy. We think the budget is influenced by political motivations as election 2007 is approaching.

NO CVT, NO TAX: The capital market is likely to react positively to the budget as no additional capital value tax was imposed. Besides the capital market, the budget reduced duty on the import of fertilizers, zero-rated export of various types of machinery, reduced tax and duties on tractors, cotton ginning machines, bulldozers, luxury cars, airline machinery, CNG kits and the list goes on. Indeed the business community is emphatic over the budget. However, on the expenditure side, the government has announced a budget of PkR1.09 trillion and the development expenditure alone has been increased by 35% to PkR306bn. The ambiguity, which we feel is, how would the government achieve an increase in the tax revenue (target: PkR690bn), with so many tax reductions and hardly any widening in the tax base? A leader business figure commented on a TV channel yesterday that reduction in tax rate would compel individuals to pay more tax and god willing lead to larger increase in tax revenue. Whereas, this may seem very ideal and romantic but the Laffer principle is unlikely to hold true.

COMPROMISING FISCAL DISCIPLINE: The fiscal deficit is likely to increase to around 4%-4.5% of GDP after this excessive budget. The government is planning to issue a Global bond of worth PkR30bn. However, since the US interest rates are now on the higher side, borrowing from the market would lead to accumulation of expensive debt. Similarly, domestic borrowing to meet the expenditure-revenue shortfall would keep the interest rates on the higher side and keep inflation strong. This would jeopardize long-run economic growth by increasing macro-stress in the economy. Last year, the government fed inflation to dangerous levels by over-stimulating growth through artificially low interest rates. As a result, now the monetary policy has been exhausted. An excessive fiscal policy may spur short-run growth but would certainly not insure long-term high growth path.




*Activation Tax Reduction promises gains for the consumers.
*15% CED on WLL and Payphones in order to change revenue collection mechanism.
*Policies too minute to stop the current trend in sector i.e. unbridled expansion.
*Universal Services Fund (USF) to incentives local loop operators not discussed.

ACTIVATION TAX REDUCTION: The reduction of mobile Activation Charges from PkR1000 to PkR500 was more or less a foregone conclusion. The government recognizes the tough conditions the cellular market is facing and it has sought to give some relief, especially to the new mobile operators who entered into the market when these activation charges could not be passed onto the customer. Indeed what we must realize is that this measure, as predictable as it may have seemed is set to benefit the customers as well. Once the cellular operators gain some financial breathing space, they may be set to offer even more attractive schemes especially at the time of connection where free airtime may be increased. Given the ultra-competitive environment in the industry, a reduction in activation charges is set to benefit the customer.

15% CED ON WLL AND PAYPHONE: This was the only measure worth an eye-blink for the telecom sector. Dwelling deeply into the reasons for such an imposition provides us with two explanations.

1. MEASURE TO REDUCE BUDGET DEFICIT: Given that the Government has come up with an ambitious program of expenditure of PkR1.09 trillion, concerns are present as to how tax revenue can be increased by a PkR100bn to PkR690bn as stated in the budget. Since real estate taxes have not been introduced and with duties cut on a range of items ranging from luxury cars to airline machinery, the government would be compelled to tax sectors on the verge of a boom such as WLL and prepaid calling cards.

2. REVENUE COLLECTION MECHANISM: Since the Privatization of Pak Telecom (PTCL) is in the pipeline; the government wouldn't want the Central Excise Duty (CED) of WLL and payphone operators to be channeled through PTCL. Even though some WLL companies have been working to set-up their own telephony backbones throughout the country, most payphone and prepaid calling card companies still rely at large on PTCL's backbone, and it was thorough PTCL's charging of CED on airtime that these companies were taxed. The only ambiguity lay in that, these operators used to purchase minutes in bulk from PTCL at a lower price and CED was charged on the value of this purchase, rather than at the retail level. Now this tax has been levied at the retail level.

3. IMPACT: The WLL sector will suffer a setback in that tax payments will increase. Passing costs on to the customers may not be an option once more than the present two companies enter the market.

PTCL EMPLOYEE QUAGMIRE: The news on this front is that the tempers on all sides have reached boiling point. The Government has placed itself in a fix, for having started tackle the issue, only when it got out of hand. Indeed the management can be blamed for utter complacency. The Divide and Rule policy over the 14 unions is apparently not working, and with everyone joining hands the functioning of the whole communication system hangs in the balance. With other privatization stories in the shed, this is the union's greatest chance to extract some fringe benefits and they will not lie low until compelled by the iron fist. So lets see how the drama unfolds and a violent ending would be the last thing that the capital market wants. A smooth conduct on the privatization front would see the market move towards our pre-privatization price objective of PkR71.


* Duties slashed on CBUs.
* No change on the import of CKD's.
* 6% withholding tax on purchase of new cars.
* Import of used cars still not materialized.

DUTY REDUCTION ON CBUS: The slash in duties will not influence Pak Suzuki Motor Company (PSMC), as the company eyes on the low-end segment. Indus Motors and Honda Atlas Cars will not be affected to a large extent by the government's decision to cut import duties as these manufacturers are themselves opting for CBU business and they have number of cars waiting on the port for custom clearance.





1500cc and below








1800cc and above


1800cc and above


NO CHANGE ON IMPORT OF CKD: It was earlier expected that the Government would keep a parallel stance while reducing the duties i.e. it will cut duties on CKD's if it decides to cut duties on CBU's in order to support and provide a cushion to the local industry. This decision is negative for the sector.

6% WITHHOLDING TAX: There was a 6% duty imposed on the purchase of new cars this action from the Government will not affect the local automobile industry. It was only done with a view to stop speculation done by the investors though this 65% WHT is adjustable at the year-end.

RECONDITIONED CARS: The allowance of import of used cars is still not materialized by the government as expected in order to protect the local industry from getting the hit. Once the import of reconditioned cars is allowed then the dealers and investors will start to import bulk of used cars and the country will become an international dumping ground for used cars.


* 3% reduction in corporate tax rate (to 38%).
* Imposition of 7.5% WHT on fee-based income.
* Imposition of 0.1% tax on cash based transactions of more than PkR25000.

IMPACT: The corporate tax rate on the banking sector has to be reduced by 300 basis points every year, until it reaches parity with the overall corporate tax level at 35%. As per the schedule, the effective tax rate in FY06 has been reduced to 38% from 41% in FY05. Whereas, this is positive for the banking sector, but this is already build-in in the financial projections. The government has imposed a 7.5% WHT on fees-based income, which would negatively impact this important source of revenue of the sector. In FY05 around 20% of total income of the banking sector was from fees-based income and this segment reported a 57%YoY growth. The government has also imposed a 0.1% tax on cash withdraws of more than PkR25000, which would be another negative for the sector, especially for banks which have a larger exposure on real estate lending.


Although the budget has laid added emphasis on the agriculture sector, which is the primary market for fertilizer consumption, there have been no major assertions within the budget that will hold any major impact on the fertilizer sector. The following the are specifics of the budget which are expected to impact the fertilizer sector:

*With an outlay of USD3mn for the agriculture development, a targeted growth rate of 4.8% in the sector does bode well for the fertilizer sector. The increasing trend of the support prices for major crops will enhance the farmers' purchasing power allowing them to allocate greater resources towards secondary farm inputs i.e. fertilizers. (Positive)

*Though the budget proposes to withdraw the 5% import duty on urea, the move will not have any major impact on the fertilizer companies or the fertilizer consumers. For FY04-05, the estimated import target is 500,000 tonnes through the Trading Corporation of Pakistan (TCP). Removal of the import duty will simply ease the subsidy burden on the government that it provided TCP for the import of the higher priced urea. Since local fertilizer companies receive the imported urea on no-profit/ no loss prices from TCP, and sell the imported fertilizer at locally manufactured prices, neither the firms nor the farmers will experience any positive impact. (Neutral)

*A PkR15bn increase (PkR35bn) in the water management projects has been proposed. Of this, PkR6bn has been allocated for the lining of watercourses. Currently there are 86,000 watercourses through out the country of which approximately 22,000 are being targeted for lining this year. Water is a complimentary input to fertilizer use and fertilizer use requires added water usage, which adds to the farmer's cost of using fertilizers. The efficiency increase in water consumption will impact the farmers' water usage cost thus enhancing their profitability and subsequently their purchasing power. (Positive)

*The new budget seems emphatic on farm mechanization. It proposes to reduce import duty on tractors from 20% to 15%. The current demand of tractors stands at 40,000 units while the local supply (Millat Tractors) is at 31,000 units with a current shortfall of 9,000 which is to be reduced to 4,000 next year with increased domestic production. The proposed duty cut will not be augmenting the farm mechanization drive since the tractors imported are of lower horse power and not used by domestic farmers. (Neutral)

*Farmers' purchasing power is further expected to be enhanced through increased micro credit outlay through Khushali Bank. They micro-finance users to increase to 3mn. Khushali Bank allocates specialized rural loan products dedicated to farm inputs. Credit accessibility plays a tremendous role in enhancing farmers' purchasing power. (Positive)

*Fauji Fertilizer (Bin Qasim) FFBL, has been allocated PkR1.01bn in continuation of the subsidy allocated to it by the government for the continuation of its DAP plant. FFBL is the only domestic DAP producer, and is the beneficiary of PkR5bn subsidy (over 5 years) in lieu of the lower support prices for DAP offered by the government. (Neutral)

Ali Farid Khwaja, Fariel Salahuddin, Usman Farooqui, Farhan Adil