Pakistan: Selected Issues and Statistical Appendix

This Selected Issues paper on Pakistan reports that fiscal adjustment, supported by official and private inflows and debt relief, has led to a substantial improvement in public and external debt indicators. International reserves have recovered close to US$10 billion. Financial sector reforms have resulted in a healthy banking system. With these achievements, vulnerabilities have been greatly reduced, and Pakistan’s prospects look favorable. A continuation of prudent fiscal policies, as anchored by the financial responsibility law, is needed to ensure that debt ratios continue on their downward trajectory.

Abstract

This Selected Issues paper on Pakistan reports that fiscal adjustment, supported by official and private inflows and debt relief, has led to a substantial improvement in public and external debt indicators. International reserves have recovered close to US$10 billion. Financial sector reforms have resulted in a healthy banking system. With these achievements, vulnerabilities have been greatly reduced, and Pakistan’s prospects look favorable. A continuation of prudent fiscal policies, as anchored by the financial responsibility law, is needed to ensure that debt ratios continue on their downward trajectory.

V. How Vulnerable is the Corporate Sector in Pakistan?21

A. Introduction

82. Pakistan’s corporate sector has witnessed a remarkable recovery in recent years. Market capitalization of enterprises listed on the Karachi Stock Exchange (KSE), profits of listed enterprises, and advances of commercial banks to the corporate sector have all risen sharply (Table V.1). Large-scale manufacturing production increased, cumulatively, by almost 70 percent over the past five years to 2004/05.

Table V.1.

Pakistan: Indicators of Corporate Sector Performance, 1999/2000–2004/05

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Sources: Karachi Stock Exchange; State Bank of Pakistan; and IMF.

83. These developments in good part reflect the success of the government’s reform program. This program has focused on macroeconomic stabilization and market-oriented structural reforms, and has induced a strong positive response from the private sector. By re-building confidence and promoting greater efficiency, the program laid the foundation for a sustained recovery in growth. Implementation of the program also benefited from a favorable external environment, including low interest rates abroad and at home and sizeable foreign exchange inflows.

84. The objective of this paper is to examine the vulnerability of the corporate sector in Pakistan, as the economy enters its third year of strong growth. The speed and scale of the corporate sector’s recovery has raised the question of sustainability and the sector’s ability to withstand shocks. While sustainability will in part depend on overall economic growth in the coming years, the corporate sector’s vulnerability to shocks would also depend on more structural factors related to the sector’s governance system and balance sheet. Section B looks at corporate governance and transparency in Pakistan, and compares these with best international practices and standards. Section C examines various indicators of financial vulnerability, and assesses their implications, based on regional and cross-country comparisons. A sectoral analysis of these indicators for Pakistan provides further insights. Section D draws some conclusions.

B. Corporate Governance and Transparency

85. In a market economy, strong corporate governance and transparency should reduce corporate sector vulnerabilities.

Ownership structure

86. The Asian crisis of the late 1990s drew attention to ownership and control structures as an important factor for corporate governance. In Pakistan, government and domestic private sector ownership are estimated to account for about 34 percent and 53 percent, respectively, of the top 40 listed companies, while foreign ownership accounts for the remaining 13 percent.22, 23 Within the domestic private sector, family control through direct holding or through associated companies of the controlling family is especially high (see Box V.1) and is often obtained through the extensive use of “pyramiding” and cross-shareholdings practices. Hence, although superficially ownership concentration appears to be lower in Pakistan than in East Asia, concentration of control could actually be higher. This concentration, combined with high thresholds to initiate corporate actions, has been found to limit the effective protection of external investors.24 International evidence suggests that a concentration of control can extract value from the firm for the benefit of the controlling group, at the expense of minority shareholders. This can undermine good governance, corporate efficiency, and incentives to mobilize additional capital through equity issuance, and thus capital market development.25, 26

Concentration of Corporate Ownership and Control

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Source: Cheema (2003).

Average for Indonesia, Malaysia, Philippines, and Thailand.

Average for Indonesia, Malaysia, and Thailand

Corporate governance

87. Pakistan has made considerable progress in strengthening the corporate governance framework in recent years. In 2003, the Securities and Exchange Commission of Pakistan (SECP) issued a Code of Good Governance. Compliance with this code is mandatory for listed nonfinancial and financial companies, as well as for nonlisted commercial banks.27 The SECP has also strengthened its enforcement capabilities. The de-listing of several companies from the KSE is indirect evidence of the more demanding standards now imposed by the new code.

88. The draft Corporate Governance Assessment (2005) by the World Bank generally gives high marks to Pakistan. The assessment notes in particular: (a) the existence and quality of an effective overall corporate governance framework; (b) the affirmation of shareholders’ basic rights; and (c) the legal rights of stakeholders in corporate governance. However, the assessment also identifies several weaknesses, including: (a) the only partial compliance with disclosure of arrangements whereby a person has acquired more than 10 percent of voting shares; (b) the lack of facilitation for the exercise of ownership rights by all shareholders (in particular, institutional investors); and (c) the lack of ability of the boards of listed companies to exercise objective and independent judgment.

Creditor rights and insolvency framework

89. Creditor rights have generally been much weaker in emerging markets than in mature economies and Pakistan is no exception. But after significant reforms in recent years, it scores generally better than many other South Asian countries with regard to legal rights, credit information, disclosure, the cost of enforcing contracts, and closing a business. Exceptions are the costs of creating collateral, and the number of procedures and time to enforce contracts, for which Pakistan lags somewhat behind its South Asian neighbors.28 Generally, weaker creditors rights undermine the prospects for achieving a better financing mix, in particular, financing through marketable securities.

Financial transparency

90. Pakistan has now largely adopted the International Financial Reporting Standards. Full enforcement of these standards, which regulate the quality and timeliness of financial data made available by corporations, has, however, been constrained by a lack of human resources and technical ability. Related party transactions among nonbank companies are reportedly not always properly disclosed in practice.29

C. Indicators of Financial Vulnerability

91. Since the Asian crisis, considerable work has been undertaken to identify possible early indicators of corporate vulnerability. This section looks at how Pakistan fares with regard to key financial vulnerability indicators. Two data sources are used. First, the Fund’s Corporate Vulnerability Utility (CVU), whose main advantage is to allow reasonably consistent cross-region and cross-country comparisons. For Pakistan, this database covers some 65–80 major firms listed on the KSE. While this sample represents only about 10 percent of the number of firms listed on the KSE, it accounts for close to 80 percent of the overall market capitalization. This paper will focus on China and India as comparator countries, and on Developed Asia, Emerging Asia, and Global as comparator regions. Second, the SBP compiles detailed information on the accounts of the nonfinancial companies listed on the KSE, offering a much broader database, as well as a more detailed sectoral classification. The SBP is also the main source of information for the financial sector, mainly banks. Details on the sectoral coverage of the SBP database in terms of contribution to overall market capitalization are provided in Box V.2.30

Sectoral Contribution to Market Capitalization

As of end-December 2004, the SBP maintained information on the accounts of all 504 nonfinancial companies listed on the KSE. In terms of market capitalization, the last few years have seen a massive growth in the fuel and energy sector, now accounting for about half of market capitalization, at the expense of the textile, chemical and pharmaceutical, and transport and communication sectors. Notwithstanding significant absolute increases in their own market capitalization, these sectors have seen their share in overall market capitalization decline by almost half, to 7, 11, and 17 percent, respectively. The now much smaller share of the textile sector in overall market capitalization is in sharp contrast with the sector still accounting for more than 60 percent of Pakistan’s exports.

Pakistan: Sectoral Contribution to KSE Market Capitalization, 1998–2005

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Source: State Bank of Pakistan.

End-March 2005, Pakistan Economic Survey, 2004/05.

Leverage

92. Leverage in Pakistan is broadly in line with most other emerging economies. According to the CVU, the nonfinancial corporate sector of Pakistan has, at around 75 percent, a debt/equity ratio roughly in line with that of Emerging Asia, lower than Developed Asia and Global, but significantly higher than India (Table V.2a and Figure V.1). Along with the other comparator countries and regions, with the exception of China, Pakistan has seen a decline in debt/equity ratios since the late 1990s. However, there appears to have been a modest reversal in this trend since 2003, in line with the acceleration in bank credit growth. Similar trends are observed in the SBP data with respect to the total liabilities/equity ratio and “gearing” (i.e., total fixed liabilities/total capital employed—whether through equity or debt). This trend is seen in most sectors, with the exception of sugar an cement.

Figure V.1.
Figure V.1.

Pakistan: Nonfinancial Corporate Sector Leverage Indicator, 1998–2003

Citation: IMF Staff Country Reports 2005, 408; 10.5089/9781451830675.002.A004

Table V.2a.

Pakistan: Corporate Sector Leverage Indicators (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Total fixed liabilities/total capital employed.

Table V.2b.

Pakistan: Corporate Sector Leverage Indicators (Financial), 1998–2004

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Debt

93. Corporate sector indebtedness and foreign currency exposure are low compared with most other emerging economies. In percent of GDP, in Pakistan indebtedness is estimated to have decline from a peak of 19.5 percent in 1999 to 17.4 percent in 2002, but has rebounded to 20.3 percent through 2004 (Table V.3 and Figure V.2), due to the increase in loans from the banking sector. In fact, bank loans now account for as much as 95 percent of total corporate debt. Foreign currency denominated debt accounted for more than 20 percent of total debt in 2003, but had declined to about 15 percent by 2004. The fast growth in the issuance of Term Finance Certificates (TFCs) since 2001 came to a halt in 2004, as banks were able to offer loans at highly competitive rates. By international standards, the level of corporate debt in Pakistan in percent of GDP is more in line with emerging Europe and Latin America than emerging Asia (Box V.3). This reflects the still relatively under-developed state of financial markets in Pakistan, rather than low leverage. Indeed, Table V.2a and V.2b in fact show that the debt/equity ratio (a measure of leverage) in Pakistan is in line with Emerging Asia. Through 2003, the percentage of total debt denominated in foreign currency in Pakistan was similar to that in other emerging markets of Asia, but by 2004, Pakistan had managed to reduce this percentage to well below comparator countries.

94. The share of short-term debt in total debt for the nonfinancial corporate sector in Pakistan is relatively high by Global and Developed Asia standards, as well as compared with India. At about 50 percent in Pakistan, it is close to Emerging Asia and significantly lower than in China. The SBP data further suggest an upward trend in the share of current liabilities in total liabilities in recent years (Table V.4). The sectors apparently responsible for this trend are fuel and energy, transport and communication, as well as chemical and pharmaceutical.

Figure V.2.
Figure V.2.

Corporate Sector Indebtedness and Shareholder Equity, 1997–2004

Citation: IMF Staff Country Reports 2005, 408; 10.5089/9781451830675.002.A004

Corporate Indebtedness: Some International Comparisons

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Sources: IMF Global Financial Stability Report (April 2005); and SBP.
Table V.3.

Pakistan: Corporate Sector Indebtedness, 1997–2004 1/

(In billions of Pakistani rupees)

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Sources: SBP; and IMF staff calculations.

Excludes debt to government, government-guaranteed external debt, and borrowing from the SBP.

Loans from banks and other financial institution.

External debt and domestic loans in foreign currency.

Table V.4.

Pakistan: Corporate Sector Debt Indicators (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Equity

95. Mobilization of capital through equity has accelerated somewhat, but equity remains modest in comparison with debt in Pakistan (Table V.5). However, the data needs to be interpreted carefully because of a significant impact of the privatization process. Hence, although listed capital increased by almost PRs 200 billion between 2001 and 2005, fresh equity capital mobilized in the period was less than PRs 13 billion through 2004.31 In 2002, and to some extent in 2003, shareholder equity did increase significantly, by PRs 157 billion and PRs 55 billion, respectively. However, half of the increase in 2002 resulted from the retention of profits in the nonfinancial sector. In 2003, most of the increase in shareholder equity reflected the increased capitalization of banks. In percent of GDP, overall shareholder equity, which had declined to 10.2 percent by 2001, rebounded to 13.2 in the following two years, but was still only marginally higher than in 1998. The findings appear to be consistent with the view that structural factors, including the state of corporate governance, may continue to hamper the growth of the equity market.

Table V.5.

Pakistan: Corporate Sector Equity Capital Mobilization, 1998–2005

(In billion of Pakistani rupees)

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Sources: Karachi Stock Exchange (KSE); Security and Exchange Commission of Pakistan (SECP); and SBP.

On the KSE. The amounts also reflect the impact of privatization.

Through end-March 2005.

SECP. The amounts cover primary offerings only (hence exclude privatization). May include some already paid-up capital.

SBP data base.

SBP data base (excluding insurance companies).

Nonfinancial and financial.

Liquidity

96. Corporate liquidity is lower in Pakistan than in most comparator regions and countries. This is evident from both the current ratio (current assets/current liabilities) and the Quick ratio (current assets minus inventories/current liabilities) (Tables V.6a and V.7). In the financial sector, liquidity also appears to be lower in Pakistan than in comparator regions or countries (Table V.6b).32 Based on the Quick ratio, the cement, sugar, paper and board, and textile sectors have especially low liquidity, although the ratio for the textile sector did improve significantly in 2003 (Table V.7).

Table V.6a.

Pakistan: Corporate Sector Liquidity—Current Ratios (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and State Bank of Pakistan.

Market capitalization weighted.

Table V.6b.

Pakistan: Corporate Sector Liquidity—Current Ratios (Financial), 1998–2004 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Table V.7.

Pakistan: Corporate Sector Liqudity—Quick Ratios (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

97. The interest coverage ratio has sharply recovered to about 25 percent in 2003. This reflects the decline in interest rates as well as the recovery in profits. Its level is now roughly in line with all regional comparators, but considerably below India and considerably above China (Table V.8). A low interest coverage ratio has continued to characterize the cement, sugar, and textile sectors according to the SBP data. Transport and communication and paper and board have seen a significant improvement in this ratio in recent years, while the engineering and chemical and pharmaceutical and engineering sectors have continued to show high coverage.

Table V.8.

Pakistan: Corporate Sector Liquidity—Interest Coverage Ratios (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP

Market capitalization weighted.

Profitability

98. Historically, Pakistan has tended to achieve high rates of return on assets and equity. For the nonfinancial sector, these returns have continued to rise in recent years, following a dip in 2000, to around 15 and 30 percent, respectively (Tables V.9a and V.10a). These returns are almost identical to those achieved in India, but significantly higher than the returns realized in the other comparator regions and countries. The high rates of return on assets suggest that in Pakistan (and in India) capital is relatively scarce. Sector-wise, the chemical and pharmaceutical, engineering, fuel and energy, transportation and communication, and paper and board sectors have enjoyed high and growing profitability in recent years, while the profitability of the sugar, cement, and even textile sectors has remained relatively low. This is a cause for concern for the textile sector given its share in Pakistan’s exports and the possibility of external shock.

99. CVU data for the financial sector show a steady recovery of the rate of return on assets in Pakistan from the low point in 1998. While the rate of return was lower in Pakistan in 1998 than in any comparator region or country, it was higher than in any comparator region or country from 2002 onward (Table V.9b). Similar trends are evident for the rate of return on equity (Table V.10b).

Table V.9a.

Pakistan: Corporate Sector Profitability—Return on Assets (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Table V.9b.

Pakistan: Corporate Sector Profitability—Return on Assets (Financial), 1998–2004 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Table V.10a.

Pakistan: Corporate Sector Profitability—Return on Equity (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Table V.10b.

Pakistan: Corporate Sector Profitability—Return on Equity (Financial), 1998–2004

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Valuation

100. Valuations on the Pakistan stock market are still quite low. The market-to-book ratio in Pakistan’s nonfinancial sector has been lower than in almost any comparator region or country, despite the increase witnessed in 2003 (Table V.11a and Figure V.3). Following a similar increase from very low levels, the market-to-book ratio for the financial sector, at 1.7 in 2003, was more in line with the comparator regions and countries, and higher than in India, though still significantly lower than in China (Table V.11b).

101. Low valuations in Pakistan are even more evident looking at the price-to-earnings ratio. The average ratio of about 8 in the nonfinancial sector was, despite a steady rise since 2001, in 2003 still less than half of that in most comparator regions and countries (Table V.12a and Chart V.3). The situation was almost the same for the financial sector, although in 2003, the price-to-earnings ratio for the financial companies in India fell below that in Pakistan (Table V.12b).

102. Low valuations may reflect risks and uncertainties. The low valuation may reflect a higher level of risk and uncertainty that the market attaches to earnings expectations in Pakistan relative to other countries. This could reflect political and security risks, but also a still imperfect governance and transparency framework and other shortcomings of the business and legal environment. Hence, the market-to-book value or the earnings ratio may not reflect so much doubts on the ability of a firm to generate strong earnings, but the risks and uncertainties about external factors affecting that firm. This perspective could help explain apparent contradictory findings: the simultaneous prevalence of low market-to-book and price-to-earnings ratios and of high rates of return on assets and equity. The latter uses only contemporaneous information and does not reflect future risks and uncertainties.33

Figure V.3.
Figure V.3.

Pakistan: Valuation Indicators for Nonfinancial Corporate Sector, 1997–2003

Citation: IMF Staff Country Reports 2005, 408; 10.5089/9781451830675.002.A004

Table V.11a.

Pakistan: Corporate Sector Valuation—Market-to-Book Ratios (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.

Table V.11b.

Pakistan: Corporate Sector Valuation—Market-to-Book Ratios (Financial), 1998–2004

(In percent)

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Sources: IMF; and SBP

Market capitalization weighted.

Table V.12a.

Pakistan: Corporate Sector Valuation—Price-to-Earnings Ratio (Nonfinancial), 1998–2003 1/

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Sources: IMF; and SBP.

Market capitalization weighted.

Table V.12b.

Pakistan: Corporate Valuations—Price-to-Earnings Ratios (Financial), 1998–2004

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Sources: IMF; and SBP.

Market capitalization weighted.

103. The apparent contradiction between the high rates of return on assets and equity and low market-to-book ratios in Pakistan is reflected in Tobin’s q values.34 Although rising significantly in recent years, and above 1 from 2002, Tobin’s q values have remained lower in Pakistan than in most comparator regions and countries (Tables V.13a and V.13b).35 This contrasts with India, which has relatively high values for Tobin’s q, at least for the nonfinancial sector, as would be expected when capital is scarce. The prevalence of both relatively high rates of return on assets and relatively high Tobin’s q values in India is consistent with the view that the scarcity of capital reflects a financing constraint. In Pakistan, given the relatively low Tobin’s q values despite relatively high rates of return, the scarcity of capital could reflect a relatively high cost to invest.

Table V.13a.

Pakistan: Corporate Sector Valuation—Tobin’s q Values (Nonfinancial), 1998–2003 1/

(In percent)

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Sources: IMF; and SBP.

Market capitalization weighted.