WHATEVER valid reservations critics may have about the budget proposals for fiscal year 2019, it cannot be denied that it will stimulate capital formation and provide an impetus for fresh investment in an expanding economy.

Former chairman of the Pakistan Stock Exchange Arif Habib sees the budgetary measures as “investor-friendly”, and Pakistan Business Council CEO Ehsan Malik says they “will help capital formation.”

These measures include: annual reduction in corporate tax from 30 per cent to 25pc over five years from fiscal year 2018-19; removal of tax on bonus shares, which will serve as substitute for payments of cash dividends; encouraging companies to retain earnings rather than distribute dividends; reduction of super tax on banking and non-banking companies; and slashing of duties and taxes on imported raw materials.

To sustain economic growth when federal development spending is estimated to drop to Rs750 billion in the next fiscal year, the private sector is being stimulated to return to its traditional role of being an engine of economic growth. However, this captures one side of the picture.

Syed Mazhar Ali Nasir senior vice president of Federation of Pakistan Chambers of Commerce and Industry regrets that the budget does not include “import substitution measures to ensure industrial growth”.

Over the past five years, high debt servicing expense and adverse terms of trade eroded domestic capital formation

The issue of excessive government debt remains under the spotlight mainly because of its spillover effects on fiscal and current account deficits, but the slow pace of savings, investment and domestic capital formation make borrowings inescapable.

On the eve of the budget, Mr Habib said the cost of doing business coupled with corporate taxes “leave little to the bottom-line” and “are a hurdle in capital formation”, making our products uncompetitive in the international markets.

The weak competitive strength of exports induces the authorities to provide cash/loan subsidies and duty drawbacks to boost exports. If these incentives do not work, currency devaluation follows. As a result, the terms of trade deteriorate sharply.

The benefits of rupee depreciation are passed on to foreign importers as a stronger dollar can buy more goods. The gap between managed floating exchange rate and the purchasing power parity of the rupee widens. This results in huge transfer of resources abroad. Capital formation shrinks.

“The rupee depreciation in December and hike in policy rate in January are expected to potentially induce corporations to practice more conservative leverage”, says the second quarterly report of the State Bank of Pakistan (SBP).

Owing to the high cost of doing business, companies with surplus cash are increasingly resorting to self-financing to reduce financial charges on borrowings from banks.

For example, the SBP report notes that the steel sector is relying increasingly on internal funds for capacity expansion instead of getting support from the banking system. The major players in the steel sector are also tapping the equity market.

Additionally, some big groups mobilise stakeholders’ investment for expanding capacities instead of raising debt. Capital formation as a result of budgetary measures would boost self-financing. Incidentally, the two bouts of devaluation have coincided with a weakening dollar against other currencies.

The appreciation of other currencies against the greenback was one of the three factors for major increase in public debt by Rs1.4 trillion during first half of FY2018. The surge was also attributed to revaluation losses due to rupee depreciation against the dollar and higher external borrowings.

Finance Minister Miftah Ismail sees no further devaluation in the near future, and to shore up the foreign exchange reserves the government plans to float Panda bonds in China in September or October while raising a one billion dollars loan from a Chinese bank.

The SBP report says anecdotal evidence suggests that owing to political uncertainty and foreign exchange strains, businesses have adopted a wait-and-watch approach and postponed some of their projects.

There has been a 36.1pc drop in import of power machinery during the second quarter of fiscal 2018. Economist Dr Mushtaq Khan sees the International Monetary Fund hinting that “Pakistan needs to refocus on stabilising the macroeconomy.”

Investors will need a more devalued rupee for buying capital goods in dearer dollar. Over the past five years, helped by affordable and relatively stable exchange rate and by China-Pakistan Economic Corridor capital spending, the gross fixed investment increased from 13.4pc of the gross domestic product from FY2012 to 14.2pc in FY2017.

But over the same period, as the consumer’s share hit the peak at 94pc of GDP last fiscal year, the savings rate plummeted from 8.7pc to 7.5pc.

The gap between lower domestic savings and investments has been met by increasing reliance on foreign capital while unabated high debt servicing expense and adverse terms of trade erode domestic capital formation.

To quote Dr Khan, the external sector has entered “the vicious borrowing cycle”. In this environment the budgetary proposals are likely to mitigate somewhat the impact of adverse transfer of resources abroad on capital formation and investment.


Published in Dawn, The Business and Finance Weekly, May 7th, 2018