The Leasing Sector in Pakistan and its Role in Capital Investment

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Management of Financial Institutions - MGT 604

Lecture # 34

The Leasing Sector in Pakistan and its Role in Capital Investment

From the Third World perspective where a major source of economic capital is a form of

foreign or local debt, Leasing acts as a hybrid form of debt cum investment. In the 80's,

when Pakistan floated its first leasing company, the characteristic of `asset-based' financing

made it a more `Islamic' form of lending. (Asset based lending is a permitted form of debt-

financing in Islam). From the perspective of developmental finance, Leasing provided an

alternative to interest based debt.

Leasing as investment indicator

Hypothetically, since leasing is directly related to the acquisition of an asset, indicating the

Aggregate Investment in Leasing (AIL) of the leasing sector, in a country and at a point in

time, would indicate the amount of incremental and fresh capital investment in a year.

Hypothetically, we may ignore `leakages' such as rescheduling and duplicate leasing.

The aggregate figure for `Investment in Leasing' for the leasing sector in Pakistan has been

ranging between PKR18bn to PKR25bn over the past three years. We do not have statistics

regarding the exact percentage of new investment in plant and machinery or other income

generating assets. I think I can safely estimate about 90% of the AIL is plant and machinery.

Of-course, the AIL is only indicative of new capital investment if compared with the same

over the previous year. A fairly rough estimate of incremental capital investment would

therefore be an average of Rs3billion per year. This does not mean all new investment in a

year. That would be much higher since part of the AIL would be paid back, depending on

the life of the lease contract.

The cost of leasing for a Pakistani lessee averages around 20-25% per annum. The effective

cost for a tax-paying lessee may be 16-20%. Assuming an 18% 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% per annum from the asset. This would only be possible in high

growth sectors of the economy. In my experience, it is rare to see a gross profit margin of

20%, 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?"

The other target markets of leasing are commercial-trade/service enterprises and small

pockets of manufacturers. Commercial-trade/service enterprises for obvious reasons do not

invest in capital machinery. Small pockets of manufacturers boil down to the ubiquitous

multinational or the established Pakistani Group who invests in a new project or modernizes

existing operations. The reason why this market may find leasing cost effective is because

their overall cost of capital is effectively low enough to absorb the cost of leasing; in effect

they use an already cash rich company/division to finance a new venture. The other

possibility is that the new project has foreign equity interest, which acts as a source of

comfort for the Pakistani lessor and provides support for import costs. A third reason for

choosing leasing is as hedge against investing equity. In a macro-economic scenario where

debt is the lynchpin of most investment, an investor would like to reduce the risk of

investing equity.

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Management of Financial Institutions - MGT 604

Leasing as working capital

Due to the reasons stated above, the product is being used as a source of working capital

and quite often as a competing product with short term loans from commercial banks. A

sale and lease back transaction is an instant source of funds, payable over the long-term.

However, these days an SLB transaction is being used as a vehicle for a direct lease quite

often. Because of the enhanced rate of tax at source on direct leases levied from July 98 as

against a nil rate for sale and lease-back transactions, lessees prefer to show the lease as a

Sale and Leaseback transaction. At the time of processing and obtaining approval, the asset

may not have been purchased; but once the lessee is assured of the financing, the asset is

purchased and necessary documents processed.

Lessors as financial intermediaries

With the demise of the development financial institution of Pakistan, a source of cheaper

funds for long-term capital investment has dried-up. The private financial sector has grown

tremendously in the last decade after the IMF's directives of liberalization and de-regulation

were effected. Greater economic efficiency, in terms of resource mobilization and

allocation, was expected after the deregulation of the economy.

However, the expected economic efficiency is still a long-way away. The private sector has

not been able to satisfy the long-term capital needs of the economy. Lessor are suffering

from chronic mismatch of funds and lack of availability of long-term funds. Foreign

investors are a moody resource at the best of times and relying on foreign funds is a risky

strategy. Contrary to the idea that the South Asian nuclear tests were responsible for driving

away investors and the low popularity of Pakistan's investment market, the absence of

investors, be they foreign or local, is a symptom of deteriorating economic conditions over

the past 3-4 years.

The true cost of leasing or the `economic' cost of leasing

Based on the principles of a `free market', the true cost of leasing (from an economic

perspective) is its return to the economy as a whole. If there is a marked and substantial

difference between the rate of return of the lessor and the cost of the lessee (like in

Pakistan), there may be inefficiency in the sector--a big gap in demand and supply or some

other dis-equilibrium. Of-course, this is not true for manufacturing sectors and other

services and products where the value added to a product is perceived to be high. In the

financial services, value added cannot be high due to the nature of the product. In Pakistan,

the net profit margin of the lessor ranges between 3% and 5%. The cost of lease to the

lessee is 18-20%. 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?Poor credit policy,

corruption, high uncertainty, and poor quality of information available are a few of the

symptoms and reasons for the disparity in returns. The `real' reason may well be the

outflow of capital from developing countries to the developed countries like the USA,

because of the `dollarization' of their economies ... and consequent rapid devaluation of

their own currency.

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