CAN SME SECTOR AVAIL LEASING BENEFITS?
The obvious and glaring fact seems to be that the biggest market of leasing cannot afford the product.
MOMEY GUL, Correspondent
Aug 07 - 13, 2006
The expected economic efficiency is still a long-way away in Pakistan. The private sector, especially the SME, has not been able to satisfy the long-term capital needs of the economy. Lessers are suffering from chronic mismatch of funds and lack of availability of long-term financing. Foreign investors are a moody resource at the best of times and relying on foreign funds is a risky strategy.
In Pakistan, the net profit margin for the lesser ranges between 3 and 5 percent. The cost of lease to the lessee is 18-20 percent. Where is the bulk in between the two going? Who/what is earning this difference and who is being burdened with the cost of the difference? Are these the big question marks for planners. The cost of leasing for a Pakistani lessee stands around 20-25 percent yearly. The effective cost for a tax-paying lessee may be 16-20 percent. Assuming an 18 percent cost of capital (weighted average) for the lessee, the asset can only generate a net income for the lessee, if the lessee in turn earns at least 19-21 percent yearly from the asset. This would only be possible in high growth sectors of the economy.
Experience shows that it is rare to see a gross profit margin of 20 percent, especially in the manufacturing sectors who are the prime clients for leasing plant and machinery. The obvious and glaring fact seems to be that the biggest market of leasing cannot afford the product. The question then remains, "who is able to buy?" Leasing is significant business world over with total lease volumes reported through leasing companies are in excess of $500 billion annually.
USA is the predominant market where volumes exceed $200 billion, followed by Japan with $68 billion. The top five countries account for 75 percent of the world's leasing business. Significant volumes are also generated by banks but data are not available. China and India - two of the fastest growing economies - have leasing markets of $2.1 billion and $1.4 billion, respectively. However, it is disappointing that a large segment of the traditional SME sectors in Pakistan especially the cutlery, surgical instruments, fan industry and sports goods, barring a few exceptions, could not avail the facilities available to them. These sectors have not progressed to a higher level of quality standards, which they are capable of achieving in an environment where leasing industry will continue to innovate.
Car sales took off with leasing support and now leasing companies are beginning to enter agricultural sector through tractor lease, farm loans and operating leases for harvesters. Microfinance is another area which leasing companies have recently started focusing on. Lack of access to formal credit and equity sources is cited as the main constraint to SME growth.
Whilst extension of formal credit is still required on a bigger scale, the existing network is weaker. The problem for SMEs lies more in the area of rules, regulations, registration, taxation etc, which keeps them out of the formal sector, thence away from banks and financial institutions.
SME entrepreneurs say that they do not mind paying corporate taxes and fees levied by various departments but what is not acceptable is the time they lose in dealing with these departments and inspections. Since there is no remedy, they don't enter the formal sector, they remain unregistered, unrecorded and thus deprive themselves of financing which is readily available.
A lot needs to be done in simplifying rules and consolidating many regulations and much more needs to be done. More radical steps are required to encourage SMEs to become registered both as corporate entities and for tax purposes. The association of SMEs should actively encourage its members to obtain NTNs and to understand the requirements of prudential regulations. Better communication will certainly dispel the notion that these are troublesome steps. More to the point, they should be advised that staying out of the formal sector has become troublesome.
In Pakistan, governments had early appreciation of the potential of leasing for SME growth and active encouragement was regularly provided. Since the introduction of Prudential Regulations for SMEs by the State Bank, bank financing to this sector has increased substantially. According to a State Bank report, the amount of lending by banks to the SME sector amounted to Rs 251 billion in 2005, 72 percent higher than 2003. It is an accepted fact that the unorganised sector forms a substantial part of our economy. Removal of legal constraints will encourage more SMEs to enter the formal sector. The potential for further growth of the SME sector is immense and leasing with its numerous advantages, including the Islamic aspect, can play a crucial role in achieving this.
On the other hand, leasing in Pakistan has made progress and its share of new investment is estimated at 14 percent. Annual volume of the 31 members of the Leasing Association of Pakistan is around Rs 28 billion (or $0.47 billion) and total assets are Rs 84 billion. Banks are also active players in leasing as experts believe that their volumes are significantly higher. The simplistic approach gets a bit more complex in reality as we live in times of regulatory supervision and prudential rules. Thus audited financial statements, ratio compliance, positive cash flow, etc become essential tools of appraisal.
In Pakistan, considerable reliance is placed on alternative tests since financial statements from SMEs are not readily available. But the underlying difference between asset-based lending and collateral-based finance does not get distorted. Leasing does not require a lessee to have land or building for mortgage and usually does not seek additional security from the borrower. This distinction and advantage are significant particularly for SMEs which lack collateral and are thus not able to approach the formal banking sector. I feel government policies in most countries have not yet made this obvious connection between leasing and SMEs' financing needs.
In Pakistan under the new SME regulations issued by SBP, collateral requirement has been removed. This is a major step forward. Countries, which recognise leasing potential, have used it widely. Before the 1998 financial crisis of South East Asia, the Asian Tigers -Korea, Malaysia, Thailand, Indonesia and Taiwan - had vibrant and large leasing sectors. In Korea, leasing share of capital investment was around 28% in 1996 which translated into annual lease volume to $16.3 billion. Main beneficiaries of leasing in these countries were SMEs.
After the crisis, banking controls became stringent and leasing, too, became subject to these rules. Recently, there has been a modest recovery in the leasing sector in these countries but it is nowhere near what it used to be. Barring the excesses of the pre-1997 period in the Tiger economies, we can learn a lot from their experience of supporting SMEs.
Besides the most significant advantage of security just discussed, other benefits of leasing are: Simple documentation (since no mortgage registry is required); Tax benefits - full lease rental is an expense; working capital facility - sale and lease back unlocks capital; Medium-term finance -3 to 5 year leases are common leasing started in Pakistan in 1983 and has had the benefit of government support from those early days.
Rules have been clear and have undergone regular scrutiny and change as and when difficulties and impediments were highlighted. The leasing association is grateful for the support of the regulators- State Bank of Pakistan until December 1997 and thereafter SECP.
During 80s and the early part of 90s leasing companies were the main source of medium-term finance for SMEs and many small enterprises benefited widely from lease financing and came in contact with the formal sector for the first time. Innovative lease arrangements helped numerous businesses. Transport sector, which was almost entirely a captive customer of the informal lenders, was introduced to formal lending by leasing companies. Prudential rules were explained and transporters began preparing financial statements for the first time. Some even took the step of incorporating their businesses as limited companies. This sector is today amongst the best customers of leasing companies, and I believe banks as well.
In the early phase of automobile industry when assembly plants were established, there weren't too many reliable suppliers of spare parts. The growth of the car/truck industry depended on local availability of quality parts as deletion requirements increased. The vendor industry was caught in the traditional problem of funding shortage due to lack of collateral leasing. The companies solved the problem by giving them the required machinery or moulds on the strength of their agreements with automobile companies which assured future cash flow.
There are many other examples and I could go on for a long time. Our experience with recoveries from small businesses is within our acceptable levels and their record is as good, if not better, than big businesses.
Governments of growing economies are increasingly recognising the potential of SMEs in providing jobs and in assisting poverty alleviation programmes. In many countries close to 50 percent of the population is younger than 16-17 years of age hence facing the pressure for rapid job creation. Data for developing and developed countries indicate that SMEs account for between 60-90 percent of all enterprises. The same percentage of workers (60-80%) is employed by SMEs (excluding agricultural workers).
However, this is about 30 percent n Pakistan. Quite often the impression, even amongst the informed sections of the public, is that SMEs are a phenomenon of lesser developed economies that big enterprises don't exist in sufficient numbers due to lack of resources and skilled workers.
I said earlier that in some countries 90% of the enterprises are SMEs. This refers to Japan and Korea. Behind Toyotas, Hondas and Samsungs there are hundreds of small family-owned units supplying parts and accessories. These big corporations have assumed the responsibility of assisting and improving the skills and resources of the small suppliers and in turn increase their own productivity and quality. In Germany, too, 90 percent of all enterprises are classified as SMEs. Based on this, the same must be the case in the rest of Europe and USA.
All Figures are in Rs. Million 2003 2004 2005
No. of Companies
Paid up Capital
Investment in Lease Finance
All Figures are in Rs. Million 2003 2004 2005
No. of Companies
Paid up Capital
Investment in Lease Finance
Cash & Bank Balance