ASIAN DEVELOPMENT BANK

PRIVATE SECTOR ASSESSMENT PAKISTAN

December 2008

CONTENTS Page EXECUTIVE SUMMARY i SECTION I 1 THE PRIVATE SECTOR IN PAKISTAN – AN OVERVIEW AND CURRENT STATUS 1 1.1 INTRODUCTION TO THE PRIVATE SECTOR ASSESSMENT 1 1.2 THE PRIVATE SECTOR IN PAKISTAN – A HISTORICAL PERSPECTIVE 1 1.2.1 The Golden Years: 1947 – 1970 1 1.2.2 The Public Sector Ascendant: 1972 – 1977 2 1.2.3 The Domino Years: 1977 - 1990 2 1.2.4 The Winds Of Change – 1990-1999 4 1.2.5 Reaping The Harvest – 1999 To Date 5 1.3 STRUCTURE AND COMPOSITION OF PAKISTAN’S PRIVATE SECTOR 7 1.4 EMPLOYMENT AND THE PRIVATE SECTOR AT THE NATIONAL LEVEL 10 1.5 SECTOR WISE CONTRIBUTION OF THE PRIVATE SECTOR 12 1.5.1 Agriculture 13 1.5.2 Mining and Quarrying 14 1.5.3 Manufacturing 14 1.5.4 Construction 16 1.5.5 Electricity Generation 17 1.5.6 Services Sector 18 SECTION II 23 PUBLIC POLICY AND STRATEGY AND THE RISE OF THE PRIVATE SECTOR 23 2.1 MAJOR AGENTS OF CHANGE 23 2.2 PRIVATIZATION 23 2.2.1 The “Privatization For The People” Program 25 2.2.2 Lessons Learnt from Pakistan’s Experience with Privatization 26 2.3 DEREGULATION AND ECONOMIC LIBERALIZATION 26 2.4 REGULATORY STRUCTURES: PROGRESS AND ISSUES 29 2.5 GOVERNMENT STRATEGY FOR PRIVATE SECTOR DEVELOPMENT 31 SECTION III 33 KEY CHALLENGES AND THE WAY FORWARD FOR PRIVATE SECTOR DEVELOPMENT IN PAKISTAN 33 3.1 MAJOR MACROECONOMIC AND INFRASTRUCTURE CHALLENGES 33 3.2 GOVERNANCE AND INSTITUTIONAL BOTTLENECKS 38 3.3 CONSTRAINTS TO DOING BUSINESS IN PAKISTAN 39 SECTION IV 49 THE MISSING LINKS 49 4.1 THE SME and INFORMAL SECTORS: 49

4.1.1 Employment Trends in the Informal Sector 49 4.1.2 Estimation of the Informal Sector's Contribution to GDP 51 4.2 THE FUTURE OF THE INFORMAL SECTOR IN PAKISTAN 51 4.3 SMALL AND MEDIUM ENTERPRISE SECTOR 52 4.4 CLIMATE CHANGE AND IMPACT ON THE ECONOMY AND THE PRIVATE SECTOR54 SECTION V 56 THE ROLE OF THE PRIVATE SECTOR IN INFRASTRUCTURE DEVELOPMENT 56 5.1 PRIVATE SECTOR INVESTMENT IN INFRASTRUCTURE: 56 5.2 CONSTRAINTS IN PAKISTAN TO PRIVATE SECTOR INVESTMENT IN INFRASTRUCTURE 57 5.2.1 Undeveloped Financial Markets and Instruments 59 5.2.2 Structural and Policy Constraints: 60 5.3 PUBLIC PRIVATE PARTNERSHIPS (PPP) FOR INFRASTRUCTURE DEVELOPMENT61 5.3.1 Constraints for PPPs 61 5.3.2 Issues, Challenges, and Way Forward on Private Sector Participation in Key Infrastructure Sectors in Pakistan 62 5.4 RECOMMENDATIONS FOR PROMOTING PPP IN PAKISTAN 69 SECTION VI 70 6.1 ADB AND PRIVATE SECTOR DEVELOPMENT IN PAKISTAN 70 6.2 ASSISTANCE TO THE PUBLIC SECTOR FOR DEVELOPING THE PRIVATE SECTOR70 6.3 PRIVATE SECTOR ASSISTANCE THROUGH THE PRIVATE SECTOR OPERATIONS DEPARTMENT (PSOD) 73 SECTION VII 78 THE PRIVATE SECTOR SPEAKS 78 SECTION VIII 80 RECOMMENDATIONS FOR FUTURE ADB INTERVENTIONS 80

APPENDICES APPENDIX 1: PAKISTAN'S INVESTMENT INCENTIVES AT A GLANCE 85 APPENDIX 2: PAKISTAN'S INSURANCE SECTOR 86 I. Life Insurance Sector 86 II. Non Life Insurance Sector 87 APPENDIX 3: LIST OF PRIVATIZATIONS IN PAKISTAN 1999 – APRIL 2007 89 APPENDIX 4: CONSTRAINTS AND INTERVENTIONS FOR ENHANCING PRIVATE SECTOR PARTICIPATION IN THE ENERGY SECTOR 91 APPENDIX 5: CONSTRAINTS AND POSSIBLE INTERVENTIONS FOR PRIVATE SECTOR PARTICIPATION IN ROADS, RAILWAYS, AND PORTS 95 APPENDIX 6: CONSTRAINTS AND POSSIBLE INTERVENTIONS FOR PRIVATE SECTOR PARTICIPATION IN THE WATER SECTOR 98

LIST OF TABLES

Table 1: Capital Market Growth and Development 6 Table 2: Structure of Savings and Investment (As Percent of GDP) 7 Table 3: Foreign Investment Inflows in Pakistan (Million $) 9 Table 4: Sector Wise FDI Inflows (Million $) 9 Table 5: Employment by Major Industry (%) 10 Table 6: Sectoral Concentration of Informal Labor Force Employment (%) 11 Table 7: Distribution of Enterprises by Employment Size 2005(percent) 12 Table 8: Sectoral Share in GDP (%, Constant Factor Cost) 13 Table 9: Asset Structure of the Insurance Industry 21 Table 10: Insurance Density in US$; insurance penetration (in percent) 22 Table 11: Government’s Incentives for Investment 27 Table 12: Country Wise Foreign Investment Inflows ($ million) 28 Table 13: Leading Foreign Investor Companies – Average Returns 29 Table 14: State of Pakistan’s Competitiveness 2007 42 Table 15: Formal and Informal Sectors- Distribution of Non- Agriculture Workers (%) 50 Table 16: Informal Sectors Workers- Distribution by Major Industry Divisions 50 Table 17: Pakistan. Revised GDP and Annual Value added of the Informal Sector (1999-2000) 51 Table 18: Credit to SMEs (Rs. million) 54 Table 19: Impact of Climate Change 55 Table 20: Comparative Infrastructure Indicators for Pakistan 56 Table 21: Sectors for Private Sector Investment in Pakistan (1999 – 2006) 57 Table 22: Total Installed Generation Capacity (MW) 62 Table 23: Potential Private Sector Hydropower Projects (Rs. million) 63 Table 24: Pakistan’s Teledensity in Comparison with other Regional Countries (%) 65 Table 25: Public Sector Interventions with PSD Focus: Some Examples 71 Table 26: Completed Assistance to the Private Sector ($ million) 74 Table 27: Ongoing Private Sector Assistance ($ million) 75 Table 28: Feedback from the Private Sector 78 Table 29: Recommendations for ADB Interventions for PSD 80

LIST OF FIGURES

Figure 1: Real Fixed Investment as percent of GDP 8 Figure 2: Main Sectors of Private Sector Investment FY2007 8 Figure 3: Sectoral Share in Generation of Electricity (%) 17 Figure 4: Increased Ownership of Local Private Banks 19 Figure 5: Ownership of NBFIs 20 Figure 6: Insurance Sector Profitability- 2005 21 Figure 7: Foreign Stake in Domestic Stock Market (as percent of aggregate market capitalization) 26 Figure 8: GDP Growth (%) 34 Figure 9: Domestic Saving Rates in 2005 35 Figure 10: Electricity Demand and Supply Curve 37 Figure 11: Pakistan’s Governance Rankings 39 Figure 12: Pakistan’s Performance on the Doing Business Survey 40 Figure 13: Ranking of Investment Climate by City (perceptions of firms outside the city) 42

Figure 14a: GCI Rank on Institutions 45 Figure 14b: GCI Rankings on Infrastructure 45 Figure 14c: GCI Rankings on Health and Primary Education 45 Figure 14d: GCI Rankings on Market Efficiency 46 Figure 14e: GCI Rankings on Technological Readiness 46 Figure 14f: GCI Rankings on Business Sophistication 46 Figure 14g: GCI Rankings on Innovation 47 Figure 14h: GCI Rankings on Macroeconomy 47 Figure 14i: GCI Rankings on Higher Education and Training 47 Figure 15: Teledensity of Pakistan (%) 65 Figure 16: ADB’s Private Sector Assistance in Pakistan: Ongoing Portfolio 76

ABBREVIATIONS

ADB Asian Development Bank CMDP Capital Market Development Program CPS Country Partnership Strategy DFI Development Finance Institution FDI Foreign Direct Investment GENCOs Generation Companies GCI Global Competitiveness Index GDP Gross Domestic Product GDR Global Depository Receipt GoP Government of Pakistan HBL Habib Bank Limited IFI International Finance Institution IMF International Monetary Fund IPO initial public offering IPP independent power producers MCA Monopoly Control Authority MTDF Medium Term Development Framework KESC Karachi Electric Supply Corporation KPT Karachi Port Trust KSE Karachi Stock Exchange NCBs Nationalized Commercial Banks NEPRA National Electric Power Regulatory Authority NHA ` National Highway Authority NICL National Insurance Company Limited NRL National Refinery Limited OGDCL Oil and Gas Development Corporation Limited OGRA Oil and Gas Regulatory Authority PC Privatization Commission PEMRA Pakistan Electronic Media Regulatory Authority PPID Pakistan Private Infrastructure Development PPL Pakistan Petroleum Limited PPP Public Private Partnerships PRCL Pakistan Reinsurance Corporation Limited PRSP Poverty Reduction Strategy Paper PSA Private Sector Assessment PSD Private Sector Development PSO Pakistan State Oil PSM Pakistan Stock Market Fund PSO Pakistan State Oil Company Limited PSOD Private Sector Operations Department PTA Pakistan Telecommunications Authority PTCL Pakistan Telecommunications Company Limited REITs Real Estate Investment Trusts SBP State Bank of Pakistan SECP Securities and Exchange Commission of Pakistan SLIC State Life Insurance Corporation SME Small and Medium Enterprises SOE State Owned Enterprise TA Technical Assistance

UBL United Bank Limited WAPDA Water and Power Development Authority WLL Wireless Local Loop

NOTES

(i) The fiscal year (FY) of the Government of Pakistan and its agencies ends on 30 June. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2008 ends on 30 June 2008.

(ii) In this report, "$" refers to US dollars.

EXECUTIVE SUMMARY

i. The Pakistani Private Sector: Since its inception in 1947, Pakistan has relied on the private sector as the primary producer of goods and services. The early 1970s, however, witnessed a crippling shift towards a command economy and a subordinated private sector manifested through a policy of nationalization. The 1980s and onwards witnessed a reversal of this paradigm and the private sector again began to emerge and lead investment and economic activity. Beginning in the early 1990s, the Government of Pakistan pursued a strategy of privatization, deregulation, liberalization and good governance to promote private sector development. However, macroeconomic instability and political turmoil and uncertainty stood in the way of the successful implementation of this strategy. Under a new Government in 1999, major structural, governance, and economic reforms began to be implemented with a focus on generating macroeconomic stability and creating an environment to encourage the private sector to become the growth engine in the economy. The Privatization Act 2000, creation of a Ministry of Privatization and Investment, setting up of a Board of Investment, legislative changes to the State Bank of Pakistan (SBP) Act empowering the SBP/SBP Central Board to formulate, conduct and implement monetary policy, the creation of a Monetary and Fiscal Board to ensure formal monetary and fiscal policy coordination, and a Fiscal Responsibility and Debt Limitation Act 2005 mandating reduction in revenue deficit and reducing total public debt were important steps that underscored the Government’s recognition of the importance of macroeconomic stability and a clear and transparent legislative framework to support a conducive business environment in the country. The improved economic conditions and investment climate generated both the fiscal space as well as opportunities for private sector led economic growth through acceleration of the process of privatization, enhanced private sector investment, and greater foreign direct and portfolio investment. As a result of the successful experience with privatization, in Pakistan today, over 77% of the commercial banking sector, 100% of the textile and telecommunications sector, and a significant part of the cement, sugar, automobile and fertilizer sector are in the private sector. Within infrastructure development, besides telecommunication, the private sector has been active in the power sector. It is a major contributor to power generation and has also entered into the electricity distribution sector after the privatization of the Karachi Electric Supply Corporation (KESC). Upstream and downstream oil and gas remains a mix of public and private sector entities. However, key public sector entities including the Oil and Gas Development Corporation Limited (OGDCL), Pakistan Petroleum Limited (PPL) and Pakistan State Oil (PSO) are all on the Government’s privatization list. Gas distribution is also slated for privatization. In the financial sector, in addition to commercial banking, the domestic capital markets have also developed at a rapid pace with the Karachi Stock exchange (as on June 29, 2007) emerging as the most important institution of capital formation in Pakistan and voted as the most strongly performing stock market in emerging Asia. ii. Key Private Sector Development Issues:

a. Macroeconomic stability achieved in recent years has been critical in restoring private sector confidence and catalyzing greater foreign and domestic private investment. But in FY2008, the macroeconomic situation deteriorated significantly because of the impact of higher oil and food prices and delayed policy response by the Government in view of the difficult political conditions and the transition to a new government that affected the reforms in the country. The result has been burgeoning trade, current account, and fiscal deficits, a high rate of inflation, massive devaluation of rupee, major drawdown of foreign reserves to finance the deficits in an environment of weak capital inflows, and a rising level of domestic and foreign debt. Macroeconomic ii

fundamentals need to be protected and economic stability restored to ensure the continuity of the present growth momentum based on sustained levels of private sector activity and investment.

b. Private sector investment and growth in recent years has been mainly based in the services sector especially telecommunications and financial sectors. Pakistan’s manufacturing base over the years has remained narrow with a concentration of investment in capacity enhancements and up gradation of facilities largely only in the traditional textile sector. This sector accounts for 46% of total industrial output and contributes 60% to Pakistan’s total exports. Such a high reliance on one single subsector to deliver on industrial development is of concern. The situation also raises the issue of whether Pakistan can sustain economic growth with a primarily services sector oriented growth momentum without a corresponding deepening and broadening of its manufacturing and industrial base. A structural transformation of the economy that focuses on development of the commodity based sectors including industry and agriculture is needed to ensure long-term sustained economic growth.

c. The enabling environment for private sector development needs to be further strengthened within an improved policy and regulatory framework that consists of a defined industrial policy, competitive policy, an investment policy, and stronger and capacitated regulatory institutions in key sectors of the economy. As one example of the latter, there is a need to strengthen the capacity of the Securities and Exchange Commission with respect to regulating the non-bank financial sector including the insurance sector.

d. A key constraint to private sector growth is the critical infrastructure deficit, particularly in the power sector. The demand-supply gap for power has increased substantially over the years without a corresponding increase in public and private investment in power generation and strengthening of transmission and distribution systems. There is a need for accelerated investments in the sector alongside reforms and a strengthened regulatory and policy environment leading to uninterrupted and sufficient availability of power for industrial, commercial, and domestic use. The private sector is being considered by the Government as an increasingly significant partner in the financing and delivery of infrastructure in the power and other sectors. However, policy, legal and structural frameworks allowing public private partnerships need to be developed and strengthened in many key sectors including, power, transport and water to encourage private sector participation in infrastructure provision.

e. Pakistan provides good protection to investors but lacks efficient contract enforcement structures which complicate and increase the cost of doing business. Together with ineffective property rights regulations, low effectiveness of public sector agencies, weak regulatory mechanisms, and overall security situation, these governance related bottlenecks retard Pakistan’s international competitiveness. In addition, inefficiencies and rigidities in the land and labor markets remain major constraints for greater growth and dynamism of the private sector.

f. Lack of human resource development and availability of educated, healthy and skilled labor are big issues in the competitiveness and growth of Pakistan’s private sector. This results in distortions in terms of factor utilization by sectors, contributes to unemployment and lowers factor productivity.

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g. Despite some financial deepening, Pakistan’s capital markets still lack financial instruments and institutions specializing in long term debt, project, and infrastructure finance. This constraint has far reaching impacts for private sector participation in infrastructure development and is one of the key reasons for slow industrial growth and a narrow industrial base. iii. Government’s Policy and Planning Framework: As mentioned, Government policies and mechanisms to promote private sector development have since the early 1990s focused on privatization, deregulation, and liberalization as the cornerstones of its policy to achieve sustained growth and structural transformation of the economy. The 1992 Economic Reforms Act was a major milestone as it gave full legal protection to investors as well as to the privatization process. Subsequently, the 2000 Privatization Act and creation of a number of new regulatory agencies like the Securities and Exchange Commission Pakistan (SECP), Pakistan Telecommunication Authority (PTA), National Electric Power Regulatory Authority (NEPRA), Oil and Gas Regulatory Authority (OGRA), Pakistan Electronic Media Regulatory Authority (PEMRA) and Private Power and Infrastructure Board (PPIB) to act as focal points to attract foreign and domestic private investment underline the importance of private sector development within the Government’s policy and planning framework.

The privatization process has had a major impact on private sector development as it not only transferred ownership to the private sector, but also helped create appropriate regulatory and governance structures for the sectors that were being privatized. During the period from November 1999 to December 2006, from 49 transactions, assets worth PKR 418.6 billion were privatized prominent amongst which were the privatization of Pakistan Telecommunications Company Limited (PTCL), Habib Bank Limited (HBL), United Bank Limited (UBL), Karachi Electricity Supply Company (KESC), National Refinery Limited (NRL) and a number of fertilizer and cement companies. Today the telecommunications sector and the commercial banking sector are in private sector hands and over 50% of the industrial sector has been successfully privatized. The gas distribution system is also being prepared for privatization. The privatization program, however, suffered a setback in early 2007 when the Pakistan Steel Mills privatization was struck down by the Supreme Court of Pakistan. Following this decision, the Government has focused on floating its shares in public entities in domestic and foreign capital markets via global depository receipts (GDRs) such as the shares floated for the United Bank Limited and the Oil and Gas Development Corporation on the London Stock Exchange. The impact of such privatization on the economy which, in essence, generates portfolio investment needs to be, however, reviewed carefully given the volatility attached to such foreign inflows especially with a potentially weakening Rupee. The experience in FY2008 in which portfolio investment witnessed a net inflow of only $41 million relative to a net inflow of $3.3 billion in FY2007 is a manifestation of the unsustainability of portfolio investment inflows.

Pakistan’s liberal investment policy remains one of the most attractive in South Asia allowing 100% ownership to foreign investors in a vast number of sectors and allowing remittance of capital, profits and dividends etc without any regulatory approvals. This has been key in attracting both foreign direct investment as well as portfolio investment. This could be, however, further improved by creating a level playing field between domestic and foreign investors and allowing domestic investors to tap international capital markets directly through, for example, utilizing currency swaps and hedging mechanisms.

The Medium Term Development Framework (MTDF:2005-2010) of the Government places a special emphasis on private sector development as a key element of the strategy to achieve sustained growth. Under the MTDF, private sector development is being supported through

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improving the business climate to catalyze the private sector; strengthening the knowledge base and competitiveness of the economy through investments in human resources and in skills and vocational training; strengthening product quality controls and enforcement of international standards; fostering public-private partnerships; and vitalizing Pakistan’s capital markets. Likewise, Pakistan’s Vision 2030 incorporates private sector development as a “key element” of the Government’s long-term thinking on sustainable development in the country and notes the need to reduce the cost of doing business to promote private sector activity in the country. iv. ADB Experience with Private Sector Development: During the last CSP (2002-2006), ADB’s strategy to promote private sector development was operationalized through two windows. The first were public sector programs that focused on helping to improve the business environment and supported a more enabling policy and institutional framework for the private sector. This included support for reforms and privatization in the finance, industry, power and related sectors to create a level playing field for the private sector, and initiatives to develop SMEs, rural finance, and agribusiness to deepen and diversify private sector activities.

With respect to the Latter, the development of an SME policy was supported, and a Business Support Fund for SMEs along with a support fund for agribusinesses, were set up under ADB- assisted operations. ADB also supported reforms in the capital markets and stock exchanges, as well as strengthening of regulatory structures and capacity development in the financial sector. Support for privatization during the CSP period includes the KESC and the SME Bank. The targeted privatization of gas sector entities as well as that of the insurance sector could not materialize, however, because of legal and structural impediments. In 2006, ADB provided a large program through which the private sector strategy was operationalized for supporting private participation in infrastructure development. The second window was direct assistance to the private sector in terms of loans and equity investments. In the event, this window remained largely dormant and only one private sector project: a Small and Medium Enterprise Partial Credit Guarantee facility $65 million was approved during the CSP period in 2003. Starting in 2007, the private sector window was once again revived with the largest-ever private sector loan to Pakistan for the post-privatization rehabilitation, upgrade, and expansion of the KESC. v. Intended Private Sector Outcomes and Key Outputs Supported by ADB Under the New Country Partnership Strategy (CPS):

Outcomes: Improved business environment for private sector development. Greater private sector participation in key areas of infrastructure development and delivery of services. Higher international competitiveness of the private sector.

Key Outputs: (a) Supportive legal, regulatory and structural reforms for the private sector with continued emphasis on the financial services sector and the industrial and agriculture market development sectors. (b) Comprehensive policy and regulatory framework for private participation in infrastructure development and delivery of municipal and other services. (c) Greater private investment in key prioritized areas of infrastructure and finance supported through a larger number of private sector operations that produce synergies with public sector projects and programs (d) Analytical work centered on developing Pakistan’s industrial policy including a major study on the private sector business potential on the National Trade Corridor.

v vi. Private Sector Development Links to CPS Focal Areas:

Focal Area 1: Reforms and Investment in Energy and Infrastructure Sectors. Private sector participation in key infrastructure sectors is being supported through the Private Participation in Infrastructure Development Program. A number of direct private sector projects in infrastructure sectors particularly in the power and energy sectors will also be supported. Private sector projects in the transport and communication sectors and the water sector will be also explored.

Focal Area 2: Reforms to Strengthen Governance and Promote Structural Transformation. Support is being provided for second generation reforms to create a level playing field for the private sector targeting critical areas of infrastructure and finance. This includes support for policy and regulatory reforms under the ongoing and proposed Private Participation in Infrastructure Development (PPID) Program. In the financial sector, support is being provided for second generation reforms for capital markets development (including in areas of long term project finance, corporate debt markets, pension funds and REITs) and access to financial services including microfinance, and SME. Support for reforms is also being provided to enhance the competitiveness of Pakistani economy through a cluster “Accelerating Economic Transformation Program”, that is supporting key reforms in the agriculture, energy, industry, and financial sectors to raise productivity and efficiency in the commodity producing sectors, address bottlenecks in the power sector, and improve supervision and regulation in the banking sector. Crosscutting support for creating an enabling environment for private sector development also forms a key part of the province-focused proposed resource management and government efficiency improvement programs.

Focal Area 3: Development of the Urban Services. Private sector participation will be supported in the development of urban infrastructure including water and sanitation through privatization, concessions, or public private partnerships. Private sector delivery for municipal services will be also supported. Assistance will be provided for reforms and investments in market infrastructure to strengthen value chains and the role of the private sector in business development.

Focal Area 4: Effective Implementation of Projects and Programs and Capacity Building. The emphasis on developing synergies between private and public sector operations in the key focal areas of the CPS, particularly infrastructure development, will lead to improved development effectiveness and results. Technical support from relevant PSD experts will be solicited in the design and preparation of projects that have scope for involvement of the private sector. This will improve the “quality of entry” at projects and result in improved implementation. Greater coordination and harmonization with other development partners will be ensured to build synergies and greater complementarities in the design and delivery of private sector related operations.

SECTION I

THE PRIVATE SECTOR IN PAKISTAN – AN OVERVIEW AND CURRENT STATUS

1.1 INTRODUCTION TO THE PRIVATE SECTOR ASSESSMENT

1. The private sector assessment (PSA) for Pakistan undertakes to assist in the development of a coherent country strategy for private sector development (PSD). The PSA within the framework of the Pakistani private sector’s history and recent performance reviews its performance, achievements and challenges. This framework and review, in the context of the PSA, provides for the Pakistani private sector:

• a forward looking strategic vision on its evolving role; • an idea of its effectiveness as an agent of structural economic transformation; and • an identification of its development needs and the development of appropriate, sustainable and realistic interventions at policy and implementation levels to effectively deal with existing and emergent challenges.

2. The PSA attempts to advise on appropriate policies, strategies and interventions to promote a competitive, strong and dynamic private sector that will contribute to long term economic growth and sustained poverty reduction. The assessment builds upon ongoing country economic and sector work and generates input in the preparation of ADB’s new country partnership strategy (CPS) for Pakistan.

1.2 THE PRIVATE SECTOR IN PAKISTAN – A HISTORICAL PERSPECTIVE

1.2.1 The Golden Years: 1947 – 1970

3. Pakistan emerged in 1947 with the historical traditions of a free and competitive private sector. From the days of the Mughal Empires to the British Raj in India, the state was seldom, if ever, a producer of goods and services. Muslim historical traditions and legislature had adequately protected property rights and fostered a spirit of free enterprise and the development of a vibrant private sector. These traditions of a primarily private sector led economy were passed on when Pakistan was created in 1947. The public sector at the time of partition consisted only of the Railways, Telephone and Telegraph Department, the Post-Offices, Karachi Port Trust, Radio Pakistan and some coal and salt mines. Government policy, circa 1948, delimited public ownership to arms and ammunition, hydro-power generation, rail, telephone and wireless equipment, and industries of national importance in which the private sector was “unable or unwilling to invest”.

4. Prior to the creation of Pakistan, British banks were the dominant financial institutions. In the 1940s indigenous banks emerged. The State Bank of Pakistan (SBP) came into being in 1948. It was in the early 1950s with the setting up of two government-owned banks - National Bank of Pakistan (NBP) and Agricultural Development Bank of Pakistan (ADBP) - that the state began to encroach upon the private sector in the financial arena. Initially, the role of the state was curtailed as evidenced by the first two Five Year Plans that emphasized the importance of the private sector as the “engine of growth” and stated that public sector enterprises would only be established where the private sector did not invest, and even these would eventually be divested to the private sector.

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5. The private sector centric policies continued under Field Marshal Ayub Khan’s government that ruled Pakistan from 1958 to 1969. It was a period of unprecedented growth, and the industrial sector grew at a pace that far outstripped China and S. Korea and was on par with Japan. The Ayub Khan period also saw the first manifestation of privatization as a public policy tool when some industrial units that included jute, paper and sugar mills that were set up and successfully run by Pakistan Industrial Development Corporation were divested to the private sector. The focus then, as now, was to stimulate the growth and development of the private sector. By the end of the 1960s, however, the public sector began its slow and inexorable advance into the territory dominated until now by the private sector, starting in the machinery sector with the establishment of the Heavy Mechanical Complex, Taxila and the Machine Tool Factory, Landhi. Meanwhile, the political and economic fallout of the 1965 and 1971 wars was surprisingly well weathered by the private sector and the economy continued to grow and make gains. The inflow of western aid and the rising importance of Pakistan as a major domino in the Cold War were significant in propping up the economy during these periods.

1.2.2 The Public Sector Ascendant: 1972 – 1977

6. From 1972 to 1977, the then Pakistan Peoples Party's Government initiated a broad and sweeping nationalization program under the political slogan of reversing concentration of wealth that had occurred under the private sector led model of the 1960s, and ensuring meeting of basic needs of all citizens. Government policies during this period were fueled by the fashionable socialistic development paradigms of the time and were in line with the growing trend of experimentation with command economy driven visions of economic growth, empowerment of workers and rapid social sector development in many countries. These policies curbed, bridled and delimited the private sector with ultimately disastrous results.

7. In 1972, 32 basic industries and 3 life insurance companies were nationalized; in 1973 26 vegetable ghee companies; and in 1974 all domestic private sector banks and remaining insurance companies were nationalized along with petroleum marketing and shipping companies. 1976 saw the control of the State extend to even the SME sector with flour mills and cotton ginning factories nationalized, culminating with the nationalization of rice husking units in 1977. The private sector driven structure of the Pakistani economy had within a span of 5 years been torn apart and reconstituted under a public sector led economic model. From an engine of growth in the 1960s, the private sector became the bogeyman of the 1970s.

8. By 1976, however, the same forces that had ushered in the wave of nationalization and an ever expanding public sector role, realized that they may have gone too far. It was however, too late. The damage to the private sector had been done and the flight of capital and expertise that ensued set Pakistan’s future growth back in a major way. On an equally alarming note, the much anticipated social sector revolution did not take place. Consequently, the anticipated upward movement in per capita incomes did not materialize and the then-in-vogue equivalents of current quality of life indicators dealing with health care, poverty and education did not show improvement. In fact, the economy began to slow down and the political turmoil that followed wiped away whatever gains had been achieved in the preceding years. The “hidden hand” of the market was lost, private sector investment evaporated, and production and resource allocation decisions made in the private sector resulted in a marked slow-down of the economy.

1.2.3 The Domino Years: 1977 - 1990

9. The government of General Zia-ul-Haq that came into power in 1977 began the process 3 of unraveling the huge and expanding public sector and regaining the confidence of the private sector. The first major legal initiative to restore the confidence of the private sector - the Transfer of Managed Establishments Order was promulgated in 1978. This order provided the legal cover for the return of the nationalized units back to their owners. As a consequence, all the rice-husking units, flour mills and cotton ginning units were denationalized along with two light-engineering units and a steamship company.

10. The private sector was further encouraged by the introduction of fiscal incentives in 1982-83 such as tax holidays and exemptions and rebates in custom duty. The Companies Ordinance also came under review and in 1986 the Companies Ordinance was totally revamped and rationalized. The Sixth Five Year Plan (1983-1988) specifically adopted privatization as a central theme, confining Government’s role to that of a facilitator of private sector investment and an investor of last resort. After carrying out detailed reviews, the Government decided to rationalize and consolidate the management and size of the public sector. Mergers and regroupings of holding corporations and financial restructuring of individual enterprises were carried out and chronically sick enterprises were earmarked for closing down or liquidation. Four Pakistan Industrial Development Corporation units, four small Pakistan International Airlines Corporation (PIAC) motels and three sugar and three textile units owned by provinces were disinvested, while several other enterprises were liquidated. While the first steps towards privatization related to sick units, clarification that this policy was not restricted to loss-making enterprises only came through a Government announcement of a plan to sell shares of profitable units to the general public, with a view to facilitating widespread participation in the ownership of public enterprises. Accordingly, 10% shares of PIAC were floated in 1988.

11. However, other than the relatively small industrial units mentioned above, it was striking however, that no major divestments from the public to the private sectors took place during this period despite the fact that legal cover had been provided through the Transfer of Managed Establishments Order 1978. It would appear at the same time that the private sector itself, not yet recovered from the shocks of nationalization, had no will, capacity or interest in privatization. The financial system to a great extent also remained public sector owned during this period with a concentration of over 90% of all financial services. This public sector dominated banks-driven financial structure, resulted in the creation of a massively inefficient financial sector. The public sector owned banking system twisted price signals, misdirected credit flows and subverted credit cycles. This was also the period when state-led the Development Finance Institutions (DFIs) began loosening credit controls and building up infected lending portfolios. The politicization of the banking sector and loosening of controls, inefficient staffing practices, and provision of cheap subsidized capital to targeted "priority" sectors further distorted the financial markets and led to inefficient allocation of resources. This culminated in distorted agricultural and industrial sector growth and had far reaching systemic consequences that contributed to the subsequent economic crises in the 1990s.

12. Continuing state control of the financial and other economic sectors eroded governance structures and systems and led to a concentration of economic power in the hands of the political elite and public sector officials. With the financial sector becoming a captive tool to further political and personal ends, a burgeoning ‘default culture’ emerged that led to rampant corruption and opaque public sector policy and decision making. Window dressing, weak regulation, and creative accounting kept the extent of the portfolio infection hidden, but this was still estimated in 1989 to be very large engulfing over 70% of DFIs portfolios and over 40% of commercial bank loan portfolios.

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1.2.4 The Winds Of Change – 1990-1999

13. By the end of the 1980s, efforts to turn around the public enterprises with expert management and substantial injection of capital had proved to be unsuccessful. Public Sector Enterprises continued to suffer from the classic ills associated with state-owned industry – inefficiency, mismanagement, over-staffing, low productivity, poor quality, high costs, mounting losses and rising debt. Many enterprises managed to survive only because of preferential policies such as tariff protection, special access to credit, government guarantees, tax exemptions, and subsidies.

14. The cracks in the financial system had begun to appear in the early to mid 1980s but it was in the early 1990s that a financial sector meltdown seemed a distinct possibility. Most of the DFIs had loan portfolio infections of over 40% with the Nationalized Commercial Banks (NCBs) following suit. The policy of state control over governance and management of financial and economic holdings had clearly failed to deliver in terms of socio-economic development. What it created was an inefficient and bankrupt financial sector that desperately needed reform. The banking sector was plagued with inefficient management, overstaffing and high costs of financial intermediation. This placed a high priority on reform of the banking sector. Industrial growth was misdirected by distorted price signals emerging from a still centralized planning system. Agricultural growth remained stagnant with little or no change in traditional production technologies and systems. Manpower quality deteriorated as the best and brightest migrated.

15. Aid flows, especially from the USA on which the Pakistani economy had become dependent since the Soviet Union’s invasion of Afghanistan in 1979, slowed and became a trickle soon after the Soviets were defeated and left Afghanistan. Funds for social sector and poverty reduction programs were significantly reduced. The law and order continued to deteriorate and political instability settled in.

16. With a stagnant economy, increasing population, and diminishing options, policy makers were forced to rethink the role of the state and the private sector in the economic sphere. The turn of events prompted the Government to initiate a major reform program aimed at reviving private sector confidence and investment through providing an enabling business environment. The winds of change sweeping the world at the time planted seeds of reform, deregulation, liberalization and privatization. Pakistan was to be fertile ground for these agents of change and a program of economic structural transformation rooted in the private sector slowly took shape. These agents of change were cultivated by the state out of necessity as the public sector had finally run out of steam. Pakistan’s structural transformation model was based on the three basic precepts of deregulation, good governance, and privatization with the aim to unleash private sector forces to promote investment, growth, and employment creation.

17. Consequently, the foreign exchange regime was opened up in 1991, new banking licenses in the private sector were issued, and the huge quantum of red tape necessary to undertake business activity was rationalized. Protection to the investors and the private sector was provided for in the 1992 Economic Reforms Act that provided legal cover against re- nationalization and protected the rights and interests of private sector domestic and foreign investors. Privatization began to be viewed by 1991 as a potentially important policy tool to attracting private sector investment and participation from the domestic and foreign markets The first steps were taken and they were big ones. A number of industrial units and two large banks – Allied Bank Limited and Muslim Commercial Bank were privatized in 1991-1992.

18. Good governance was the glue that was to hold the structural reform initiative together. 5

Regulatory bodies and their roles were reviewed. As a consequence, in 1994 the State Bank of Pakistan gained complete autonomy and shortly afterwards began a major reform process which resulted in strengthened regulation, guidelines and improved information disclosure guidelines for the financial sector. As part of this process a number of independent regulatory bodies were set up that included the Oil and Gas Regulatory Authority (OGRA), National Electric Power Regulatory Authority (NEPRA), Pakistan Environmental Protection Agency (EPA) and the Pakistan Telecommunication Authority (PTA). The Corporate Law Authority [now the Securities and Exchange Commission of Pakistan (SECP)] was strengthened and its role expanded. It was within this tripod (deregulation, liberalization and privatization) of interwoven reform agents that the Pakistani private sector re-birthed as the primary economic engine of growth.

1.2.5 Reaping The Harvest – 1999 To Date

19. Continuing with the pro-private sector policy framework of the 1990’s, under the new Government in 1999, major structural, governance, and economic reforms began to be implemented with a focus on generating macroeconomic stability and creating a friendly business environment for the private sector (for example see Appendix 1 on incentives provided for attracting investment). The Privatization Act 2000; the creation of a Ministry of Privatization and Investment; the setting up of the Board of Investment; the Insurance Act 2001; new lender friendly recovery laws to strengthen bank credit cycles; new legal structures for setting up and operation of non-bank financial institutions; streamlined tax systems and more efficient import and export regimes; legislative changes to the State Bank of Pakistan (SBP) Act empowering the SBP to formulate, conduct and implement monetary policy; the creation of a Monetary and Fiscal Board to ensure formal monetary and fiscal policy coordination; and the Fiscal Responsibility and Debt Limitation Act 2005 mandating reduction in the revenue and fiscal deficits and the total public debt were all important steps in this direction that further strengthened and supported the Foreign Private Investment (Promotion & Protection) Act 1976 and the Protection of Economic Reforms Act, 1992. The impact of these far reaching measures was improved macroeconomic stability, improved growth rates, and a more enabling investment climate that generated both fiscal space and opportunities for private sector led growth. The improved macroeconomic dimensions of the Pakistani economy led to a resurgence of investors’ interest in the process of privatization and resulted in higher domestic and foreign direct investment as well as portfolio investment.

20. Privatization remained a key economic reform during this period. Privatization transactions completed over the past eight years include complex strategic sales of commercial banks with the highlights being the two commercial banking giants- Habib Bank Limited (HBL) and United Bank Limited (UBL), the privatization of Pakistan Telecommunications Company Limited (PTCL), and the successful divestment of Karachi Electric Supply Company (KESC) and the Pak-Arab and Pak-American Fertilizer companies. The Government also started a well received “privatization for the people” program under which public sector entity shares were divested into domestic stock markets. Shares of 7 entities that included the National Bank of Pakistan (NBP), Oil and Gas Development Corporation, Sui Southern Gas Company (SSGC), Pakistan Petroleum Limited (PPL), Kot Addu Power Company (KAPCO), PIAC, and UBL were divested via Initial Public Offerings (IPOs), Public Offerings (POs) and Global Depository Receipts (GDRs). These capital market transactions played a major role in deepening and broadening the capital markets. Over 2.6 million Pakistanis bought shares worth Pak Rs. 24.3 billion through these transactions.

6

21. Today, over 77% of the commercial banking sector, 100% of the textile and telecommunications sector and a significant majority of the cement, sugar, automobile and fertilizer sector are in the private sector. The private sector is also a major contributor to power generation and has entered into electricity distribution sector after the privatization of KESC. Upstream and downstream oil and gas production and distribution remains with a mix of public and private sector entities with a focus, however, on the privatization of OGDCL, Pakistan Petroleum Limited (PPL) and Pakistan State Oil (PSO), which are all on the Government’s privatization list. Gas distribution is also slated for privatization.

22. The domestic capital markets also developed at a rapid pace with the Karachi Stock Exchange (KSE) emerging as the most dynamic. Between fiscal year FY12003 and FY2008, listed capital on the KSE increased from Rs. 313 billion to Rs. 635 billion, market capitalization from Rs. 756 billion to Rs. 3.5 billion, and the KSE index from a high of 4,606 to 14,202 (Table 1).

23. FY2008 have been difficult years for Pakistan politically and economically with the situation created by the judicial imbroglio that began in March 2007, declaration of emergency on 3 November, the assassination of Benazir Bhutto on 27 December, and the uncertainty during the run-up to the general elections held on 18 February 2008. The large quantum jumps in international oil and food prices, the slow down of capital inflows both because of the global financial melt down and Pakistan’s domestic situation have had a strong adverse impact on economic stability in Pakistan. Along with the reemergence of macroeconomic imbalances particularly the rising current account and fiscal deficits and high inflation, this situation has led to greater volatility in stock markets, a downgrading of sovereign credit ratings, and an outflow of portfolio investment. Instability in economic fundamentals could result in impairing the present growth momentum. It is essential that the new Government continues to prioritize improved economic decision making and pursue important governance and sector reform to reduce the cost of doing business and improve the business environment for private sector investment.

Table 1: Capital Market Growth and Development

Source: State Bank of Pakistan. Annual Report 2007-08. Karachi

1 Fiscal year in Pakistan runs from 1 July to 30 June. 7

1.3 STRUCTURE AND COMPOSITION OF PAKISTAN’S PRIVATE SECTOR

24. The private sector in Pakistan is the major producer of goods and services in the economy, the major contributor to investment, and the largest employer. While disaggregated sector-wise data identifying specific contribution by the private sector in the various sectors of the economy is not available, it is possible to generate an estimate of the private sector contribution to GDP at an aggregate level. Working from the national income accounts data with figures for private sector consumption and investment and assuming that the bulk of exports originate in the private sector, the private sector’s contribution to GDP at current factor cost is estimated at an overwhelming 84 percent of total GDP.2 If allowance for the undocumented informal economy is made which is totally in the private sector, the latter’s contribution to GDP would be even higher.

25. Of Pakistan’s total gross fixed investment of 21.3% of GDP in FY2008, private sector investment is estimated at 15.6% of GDP. 3 Contributing about 73% of the total investment in Pakistan in FY2007 compared to about 65% in FY2001, private sector investment grew rapidly, until FY2008 when it fell on account of the worsened economic fundamentals amidst deepening political uncertainty (Table 2 and Figure 1). The overall increase in private investment in recent years has been complemented by a significant increase in public sector investment in infrastructure and social sectors. Primary sectors which have had robust growth in private sector investment include manufacturing, mining and quarrying, construction, transport and communication, and wholesale and retail trade (Figure 2).

Table 2: Structure of Savings and Investment (As Percent of GDP)

Source: Ministry of Finance. Economic Adviser’s Wing Calculations (P=Provisional)

26. With the growth increase in investment untill FY2007, accompanied by a deceleration in national savings, the savings-investment gap has significantly widened. The improvement in national savings in FY2007 did not reverse this trend, and on the back of rising investment, the saving-investment gap widened to 5% in FY2007, before spreading further around 8% in FY2008 (Table 2). Unless national savings can be increased at a faster pace, the saving- investment gap could increase further in the coming years given the large investment requirements attached to achieving the targeted 7%-8% growth rate in the medium-term. On the

2 Staff estimates. 3 Ministry of Finance, Government of Pakistan. Pakistan Economic Survey 2007-08. Islamabad.

8 other hand, financing of this gap through external resources on a sustainable basis is also not viable given its implications for overall macroeconomic stability. The failure to increase national savings could, therefore, in the medium-term stall investment and block growth.

Figure 1: Real Fixed Investment as percent of GDP 18.0

16.0 15.7 15.6 14.0 14.2 13.1 12.0 11.3 11.3 10.9 10.0 10.2

8.0

6.0 5.7 5.7 5.7 4.8 4.0 4.2 4.0 4.0 4.3

2.0

0.0 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 Public Investment Private Investment P

Source: Pakistan Economic Survey 2007-08.

Figure 2: Main Sectors of Private Sector Investment FY2007

Areas with Nominal Growth

30

25

20 h t

row 15 G

% 10

5

0 Manufacturing Construction Transport Wholesale and Retail Trade

Source: Pakistan Economic Survey 2006-07.

27. Foreign Direct Investment: With limited domestic savings constraining domestic investment, the Government resorted to promoting foreign direct investment through encouraging greenfield investments, privatization of public assets, and portfolio investment. Total foreign investment jumped to a record $8.4 billion in FY2007 against only $559 million in FY2003 before coming down to 5.2 $billlion in FY2008 (Table 3).

9

Table 3: Foreign Investment Inflows in Pakistan (Million $) Private Public Greenfield Privatization Total Foreign Year Total FDI Portfolio Portfolio Investment Proceeds Investment Investment Investment FY2002 357 128 485 (10) (483) (8.4) FY2003 622 176 798 22 (261) 559.1 FY2004 750 199 949 (28) 339 1,260.7 FY2005 1,161 363 1,524 153 458 2,134.6 FY2006 1,981 1,540 3,521 351 613 4,485.0 FY2007 4,873 266 5,139 1,821 1,468 8,428.0 FY2008 5019.6 133.2 5153 19.3 20.8 5193.0 Source: Board of Investment. 2008. (http://www.boi.gov.pk)

Table 4: Sector Wise FDI Inflows (Million $) Sector FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 Oil and Gas 80.7 268.2 186.8 202.4 193.8 312.7 545.1 634.8 Financial -34.9 3.6 207.4 242.1 269.4 329.2 930.3 1607.6 Business Textiles 4.6 18.5 26.1 35.4 39.3 47 59.4 30.1 Trade 13.2 34.2 39.1 35.6 52.1 118 173.4 175.5 Construction 12.5 12.8 17.6 32 42.7 89.5 157.1 88.5 Power 39.9 36.4 32.8 -14.2 73.4 320.6 204.6 70.3 Chemical 20.3 10.6 86.1 15.3 51 62.9 46.2 78.0 Transport 45.2 21.4 87.4 8.8 10.6 18.4 30.2 73.0 Communication NA 12.8 24.3 221.9 517.6 1937.7 1898.7 1625.3 Others 140.9 66.2 90.4 170.1 274 285 1094.6 769.7 Total 322.4 484.7 798 949.4 1523.9 3521 5139.6 5152.8 Privatization - (127.4) (176.0) (198.8) (363.0) (1,540.3) (266.4) (133.2) Proceeds FDI Excluding 322.4 357.3 622.0 750.6 1,160.9 1,980.7 4,873.2 5019.6 Pvt. Proceeds Source: Board of Investment: 2008. http://www.boi.gov.pk

28. Much of the foreign direct investment came into the services industry (Table 4), particularly telecommunications and services industry. FDI in the telecommunication industry was catalyzed by the privatization of the Pakistan Telecommunication Company Limited (PTCL) and the entry of foreign cellular phone companies in the market. In the financial sector, the privatization of large commercial banks brought in a significant level of FDI as did subsequent mergers and acquisitions in the banking sector. Despite the politically turbulent and economically difficult FY2008, FDI remained resilient and totaled at $5.2 billion. As in the past, the bulk of FDI in FY2008 came into the sectors of telecommunications, oil and gas explorations, financial businesses, construction, trade, cement, and automobiles and transport. Portfolio investment, however, was a different story. Portfolio investment fell drastically from $3.3 billion in FY2007, to $ 40 million in FY2008, as domestic political and economic crisis

10 adversely impacted the confidence of short-term investors and the global economic slowdown deterred portfolio investment inflows into the country.

1.4 EMPLOYMENT AND THE PRIVATE SECTOR AT THE NATIONAL LEVEL

29. The size of the labor force swelled to over 50.33 million in FY2007, up from 45 million in FY2004. The number of the employed increased to almost 47.7 million from 42 million during the same period. Employment increased in the construction sector, and only marginally in the agriculture and manufacturing sectors, but stagnated or fell in the transport, trade and community and social services sectors (Table 5). Labor force participation rates have also demonstrated a small increase, rising from 30.4% in FY2004 to 31.8% in FY2007. Participation rates appear to have increased in both urban and rural areas and for both males and females.

Table 5: Employment by Major Industry (%)

Source: Federal Bureau of Statistics, Pakistan Labor Force Survey 2006-07. Pakistan, Islamabad

30. The private sector employs 7 million workers in the formal sector4, and 18.6 million in the informal sector5. In the last five years, an estimated 8.6 million new jobs were created in the private sector. With this increase in employment, the overall unemployment rate has decreased from 8.3% in FY2002 to 6.5% in FY2005.6 The informal sector is second only to the agriculture sector as the largest generator of jobs in the private sector (Table 6). The sectoral concentration of informal labor force employment shows the retail and personal service sectors as the leading employers in the informal sector, followed by manufacturing, and community and social services. With increased diversification of the economy to service oriented sectors, Box 1 indicates that most jobs are being created in the telecommunication sector, hospitality industry, IT and banking. At the same time, job generation is on the decline in public sector corporations, nationalized banks, the public education sector, ministries and their related departments.

4 World Bank. 2007. Doing Business in South Asia. Washington D.C 5 Federal Bureau of Statistics. 2007. Pakistan Labor Force Survey 2006-07. Islamabad 6 Ministry of Finance. 2006. Pakistan Economic Survey 2006-07. Islamabad 11

Table 6: Sectoral Concentration of Informal Labor Force Employment (%) Agriculture Labor Force 43.37

Non- Agriculture Labor Force 56.63 Informal Labor Force 41.25

Mining and Quarrying 0.04 Manufacturing 8.80 Electricity, gas and water 0.01 Construction 5.69 Wholesale, Retail Trade, Restaurants and Hotels 14.23 Transport and Communication 4.57 Financing, Insurance, Real Estate and Business Services 0.59 Community, Social and Personal Services 7.31 Source: Federal Bureau of Statistics. 2007. Pakistan Labor Force Survey 2006-07. Islamabad.

Box 1: Emerging Employment Scenario in Pakistan

Source: Article by Dr. Ishrat Hussain, Monthly Industrial Bulletin, January 2006

31. The vast majority of jobs in the private sector are generated in the small enterprise sector. Table 7 shows that small enterprises, comprising 1-4 people, employ almost 95% of the total labor force. On the other hand, Pakistan has an insignificant ”medium” sector that employs only 5% of the labor force. The proliferation of small businesses that employ the bulk of the labor force in Pakistan and which in most cases do not graduate to the “middle” category indicates lack of economies of scale, difficulties in accessing finance to grow in size and

12 complexity, and insufficient absorption of technology needed to scale up operations and generate greater employment opportunities possible in large sized companies.

Table 7: Distribution of Enterprises by Employment Size 2005(percent) Relative Distribution (%) Employment Size Pakistan Punjab Sindh NWFP Balochistan Islamabad

Small (1-4) 94.45 95.07 93.86 92.32 96.72 87.87 Medium (5-49) 5.49 4.89 6.04 7.63 3.22 11.67 Large (50 & above) 0.06 0.04 0.10 0.05 0.06 0.46 Source: Federal Bureau of Statistics. 2005. Economic Census 2005. Islamabad

1.5 SECTOR WISE CONTRIBUTION OF THE PRIVATE SECTOR

32. As already mentioned, there are no disaggregated statistics pertaining to sector-wise contribution of the private and public sectors. In what follows, an attempt is made to provide a general idea of the role and contribution of the private sector in the major sectors of the economy based on available information and credible assumptions.

33. The contribution of the key sectors to the economy is captured in Table 8. The agriculture sector with a 20.9% contribution to GDP is almost wholly private sector owned. Most of the mining and quarrying activities are also in the private sector. Within manufacturing with a 19.1% contribution to GDP, 100% of the textile sector (which consolidates 46% of the value added in the manufacturing sector) and a significant majority of the cement, sugar, automobile and fertilizer industries are in the private sector. So is the case with the construction sector. In the services sector, the private sector owns over 77% of the commercial banking sector, a majority of the general insurance sector, a significant portion of the transport and storage sector, and almost 100% of the wholesale and retail trade. The private sector is also a major contributor to power generation and has entered into the electricity distribution sector after the privatization of KESC. A brief description of the role of the private sector in each of these key sectors follows.

13

Table 8: Sectoral Share in GDP (%, Constant Factor Cost)

Source: Ministry of Finance. Pakistan Economic Survey 2007-08. Islamabad.

1.5.1 Agriculture

34. Agriculture, which is the largest sector of the national economy in terms of its contribution to total employment, is almost wholly in the private sector. Agriculture fuels Pakistan’s export base as it is the main supplier of raw materials for the export oriented industry (mainly textiles) and supports nearly two thirds of merchandise exports7. The private sector owns agricultural land and generates primary and value added agricultural output. Public sector involvement in the agriculture sector is mainly concentrated in providing and maintaining irrigation infrastructure and developing waterways for cultivation as well as providing agriculture extension services and supporting agriculture research.

35. The major issues pertaining to the agriculture sector from a private sector perspective include inefficient agriculture and agriculture markets, distorted agricultural input and output pricing, and a continued inability to price and manage water. A recent IMF paper8 concluded that in addition to removing market distortions, there is a need for fundamental improvements in the market mechanisms in the agriculture sector, including reduction in government interventions and enforcement of more competitive behaviors.

36. Comprehensive private sector led agricultural growth requires strengthening the linkage with modern infrastructure, appropriate technology adoption, and the manufacturing base. A review is required of what value addition processes can be adopted to generate a more competitive and efficient agriculture sector. Key value adding areas where the private sector could play a critical role include horticulture and livestock which have the potential to increase agricultural productivity and incomes while also promoting the creation of intermediate and high

7 World Bank. 2006. Pakistan – Growth and Export Competitiveness. Islamabad 8 Lorie.H and Kiran. K. 2006. What Determines the Domestic Prices of Agricultural Commodities in Pakistan. Islamabad

14 level agricultural service support systems and agro industrial activity in the SME and large Industrial sectors. With an expanded focus on livestock and horticulture, the private sector could profitably also invest in integrated transportation and delivery systems like standardized, palletized containerized transportation networks for transportation of high value livestock and horticultural produce. An expanded role of the private sector is also possible in food processing and agro-farm machinery industries. Private sector investments could also be considered in private sector hybrid seed production facilities. Inadequate cold chains are another weak area where the role of the private sector can be encouraged.

1.5.2 Mining and Quarrying

37. The mining and quarrying sector is mainly private with a diminishing public sector presence with only four public sector enterprises involved in mining. The stated policy of the Government is to privatize even these companies. However, most private mining operations in Pakistan are small in scale and not equipped in terms of size and complexity to effectively exploit Pakistan’s rich mineral sector potential. There are 52 minerals under commercial exploitation at present. Mineral deposits are owned by the respective provinces which can lease out concessions to private sector parties and pay appropriate compensation in the event a discovery is made on private land. The implementation of a National Mineral Policy (NMP) in 1995 paved the way to expand and develop the mining sector through attracting private sector investment. International mining companies have responded favorably to the NMP and presently four of them are engaged in mineral exploration, development and exploitation projects including for copper, coal, and zinc deposits. Import of machinery for the mineral sector has been allowed free of tariffs and restrictions on repatriation of profits by foreign investors were lifted in 2000.

38. There is however, no regulatory body to oversee the activities of mining firms in Pakistan, and over-mining remains a major threat with significant consequences for the environment. In a recent review of the mining sector9, it was concluded that that the major obstacles to the growth and development of this sector were inefficient mining methods and tools and techniques, lack of coordinated regulation and intervention at the federal and provincial government levels, opaque and cumbersome leasing procedures, poor definition and enforcement of property rights with respect to the surface land, inefficiency in the duty drawback/tax rebate system, lack of access to financing for the SME sector, and a poor transportation network. Further work is necessary to identify priority areas for reform in the mining sector in the country. To this end, an analysis of joint ventures and foreign investment in the mining sector globally should be undertaken to develop appropriate policy, regulatory and contractual structures based on international best practice to promote private sector investment in the sector.

1.5.3 Manufacturing

39. The manufacturing sector in Pakistan is almost totally in the private sector with the exception of a few heavy capital goods industries identified as important from a strategic perspective. Major manufacturing sub-sectors in Pakistan include: textile which is the largest in terms of value added; food, beverage and tobacco; cement; and automobiles.

40. Textile Sector: Privately owned, Pakistan’s textile sector is its most important component of the manufacturing sector. It contributes 46% to the value added of manufacturing

9 World Bank. 2006. Pakistan – Growth and Export Competitiveness. Islamabad 15 sector as a whole and generates 8.8% of GDP. It is responsible for 60% of Pakistan’s total exports, and provides employment to 38% of the manufacturing labor force10. To prepare for the post-quota global trading environment that demands greater efficiency and an enhanced competitiveness level, the textile sector invested close to $6 billion for balancing, modernization and restructuring (BMR) during 1999-2006, with a focus on spinning, weaving, textile processing, and making up sectors. After faring well for the first year in the post quota environment, textile exports dramatically slowed down and showed only a very marginal growth in FY2007. The stagnancy setting in textile exports is further confirmed by its continuing poor performance in FY2008. This is a concern not only from the perspective of the textile industry but also for the overall export performance of the country and the subsequent impact on the trade account and the balance of payments. It also brings to the fore the need to have a diversified industrial and export base to reduce dependence of the economy on any single sector in the contemporary competitive global trading environment.

41. Food, Beverages and Tobacco: The major components of Pakistan’s food, beverages and tobacco industry are vegetable ghee, sugar, cigarettes, cooking oil, wheat milling, tea, beverages and cigarettes. In FY2008 the sector grew by around 9%, with sugar, tea, and beverages growing at particularly strong rates of 34.2%, 12.4%, and 24.3% respectively. The sector constitutes more than 14% of the large scale manufacturing in Pakistan. Pakistan’s major exports include rice, seafood, fruits, vegetables, tobacco and raw meat.

42. Automobile Sector: Pakistan’s automobile sector is wholly private sector owned. There are 18 automobile assembling units in the private sector set up as joint ventures. There are also 47 units producing motorcycles. The automobile industry, however, continues to be of modest size in terms of its contribution to GDP and employment particularly when compared to other Asian economies like the Japan, Korea, Malaysia, China and Thailand which have all exploited the catalytic role of the automobile industry in promoting broad based manufacturing sector growth. The sector unfortunately has not had the desired impact in Pakistan for various reasons. It continues to remain protected with high import duties and other barriers to entry and competition which make it uncompetitive. The deletion program mandates a certain portion of domestically produced content. In doing so, the program provides non-tariff based protection to both domestic assemblers of motor vehicles as well as domestic producers of parts and components. These policies discourage domestic and foreign competition and allows for small, inefficient yet profitable domestic automobile producers. Unless these structural issues are resolved, it might not be possible for an efficient Pakistani automobile sector to emerge at this stage.

43. Fertilizer Industry: The fertilizer industry is totally in the private sector after successful privatizations in recent years. It consists of 6 companies of which 4 are listed on the stock exchanges. Fauji Fertilizer is the major player in the market with a market concentration of 44% with Engro following at 17% market concentration. Engro is on its way to expanding its capacity and by 2010 it is expected that its market share will increase to 35%. The structure of the fertilizer industry is thus expected to become a virtual duopoly, raising potential competition related issues, especially when the fertilizer industry is also marked by price distortions. The Government subsidizes input costs for the industry by selling feedstock gas for urea (the major fertilizer produced in Pakistan) at approximately 50% of that charged for commercial usage. This subsidy has had a significant impact on increasing fertilizer use as a majority of the farmers use urea without conducting proper soil tests to identify fertilizer and micronutrient requirement. The danger is that excessive fertilizer use can have a detrimental impact on land quality and

10 Ibid

16 agricultural yields, while the runoff into waterways and water reservoirs has potentially serious environmental and health consequences. The impact of the fertilizer subsidy on market structure and long-term agricultural productivity needs to be studied and an appropriate policy response formed to mitigate its adverse impacts.

44. Cement Industry: The cement industry consists of 27 firms all owned by the private sector of which 21 are listed on the stock exchanges. The cement industry is witnessing a major boom on the back of both greater domestic consumer demand for housing generated by higher incomes as well as by the Government’s increased spending on public sector development projects. The proposed mega infrastructure projects will continue to fuel growth in this sector. In FY2007 cement sales grew by 31% to 17.53 million tons against the current total capacity of 24 million tons which is expected to rise to 37 million tons by the end of 2007 in light of capacity expansion underway. Cement exports also increased significantly in FY2007 to $103 million – from $98 million in FY2006. Cement exports increased further very strongly to $354 million in FY2008.

45. Key Issues Private Participation in the Manufacturing Sector: Several generic constraints impact the level and quality of private sector participation in the manufacturing sector. The first constraint stems from the lack of quality manpower which requires the addressing of the skills gap for higher labor productivity and improving international competitiveness. The second constraint is lack of electricity and power. Electricity shortage and power outages place a huge burden on the manufacturing sector. The existing power subsidy structure subsidizes power for agriculture and domestic consumption by charging proportionately higher tariffs from the manufacturing sector. In the absence of vitally required investments, the growing energy demand in the country will only exacerbate the power supply deficit to the manufacturing sector situation in the future. The third constraint is the inefficient factor markets especially for land and labor. Inefficient and archaic land registration and transfer laws as well as rigidities in labor laws affect investments and growth in the manufacturing sector. The new Employment Services Act should hopefully address the issue of labor market flexibility by allowing temporary labor contracts as well as rationalizing many of the existing laws governing labor welfare and levies. Finally, availability of long term finance remains an issue. This, coupled with undeveloped corporate debt markets, generates an unfulfilled need for both long term debt instruments as well as project finance. The SME sector in particular faces a critical shortage of financial intermediation services. One of the important factors retarding access to finance is the land registration and transfer system which has effectively removed land from the pool of acceptable collateral in many cases.

1.5.4 Construction

46. The construction sector in Pakistan is also almost wholly in the private sector. It employs 2.5 million people. A recent revival in this sector has been led by international private developers, mainly from the Middle East on the back of the growing housing requirements of an expanding population. Also, given the expanding public sector development program and huge investment requirements, the future prospects of the sector remain bright. The sector has the potential to export services worth US$ 1 billion per year11. In 2007, the Karachi Stock Exchange (KSE) listed its first real estate development company. But there remain various issues of concern in the construction sector from the point of view of encouraging greater private investment. First, due to lack of available financial services, very little credit penetration has taken place with the bulk of investment in property still being financed through direct equity. In

11 Board of Investment. 2007. Available: http://pakboi.gov.pk 17 addition, due to high transfer fees, the transactions are undervalued. Another major issue is an inefficient land registration system requiring interface with multiple official agencies that employ archaic, complex and non-transparent record keeping. This adversely impacts property rights and gives birth to legal issues that are known to drag on in courts for long periods and that remove, in most cases, a very major asset – land – from the mix of viable collateral utilizable by financial institutions. The SECP with the assistance of the ADB has recently developed licensing structures for Real Estate Investment Trusts (REIT). However, under the existing land registration and fee structures, the REIT structure may end up finding itself restricted to invest only in large mega-projects. Initially, a closed-end structure is being introduced owing to high redemption and systemic risk. This structure comprises of: i) a REIT Management Company (RMC), ii) trustees; and iii) unit holders with buy-build-sell REITs and rental REITs formats. Although many fiscal and legal issues remain, REITs have been launched by the SECP using firewalls until such time that the appropriate legal and fiscal framework, particularly at the provincial levels, can be developed.

1.5.5 Electricity Generation

47. The total installed electricity generation capacity in the country is about 19,478 MW, of which 30% is generated by the private sector (Figure 3). After the restructuring of the Water and Power Development Authority (WAPDA), four generation companies (GENCOs) have started functioning as public limited companies.

Figure 3: Sectoral Share in Generation of Electricity (%)

Private Sector 30%

Public Sector 70%

Source: Private Power Infrastructure Board: http://www.ppib.gov.pk

48. There are currently 16 Independent Power Producers (IPPs) in the country generating 3943.81MW of electricity, which have been implemented on a build, own and operate (“BOO”) basis, under the private power policy announced by the Government in 1994. The Hub Power Project is the largest IPP, with a gross generation capacity of 1292 MW (Box 2).

18

Box 2: HUBCO- A Landmark Deal The Hub Power Station is the first and largest power station to be financed by the private sector in South Asia. Financial closure of the Project took place in January 1995. This was the first such project to be successfully co-financed by the Government, the World Bank as well as international private sector lenders and investors. It set the standards for the formulation of a private power framework in Pakistan which has since generated substantial interest from international investors in the sector. Several other medium sized power projects have been consequently completed and are now in operation. The Hub Power Company is listed on Karachi, Lahore, Islamabad and Luxembourg Stock Exchanges, has the largest market capitalization of any private company in Pakistan, and has over seventeen thousand (17,000) Pakistani and international shareholders.

1.5.6 Services Sector

49. The services sector in Pakistan consists mainly of wholesale and retail trade, transport, storage and communications, and financial and insurance services. The services sector in recent years has been the largest contributor to growth and employs approximately one third of the workforce of Pakistan. The services sector has been steadily gaining a larger share of the economy over the past few years, lending support to overall growth during years of poor performance by the commodity-producing sectors.

50. Wholesale and Retail Trade: Mostly private, wholesale and retail trade has shown a growing trend and employs a large part of the services sector labor force, with most jobs based in the informal sector. Sub-areas in the wholesale and trade sector include, among others, import and export of goods, activities of purchase and sale agents, and those of brokers and auctioneers. A significant portion of the domestic economy is linked to trade through its forward and backward linkages.

51. Communications: Road transport and trucking is almost fully in the private sector. The public sector still dominates the air and railways. The public Pakistan International Airlines (PIA), however, faces growing competition from private airlines12 that have come up strongly in recent years. To attract private sector interest in the electronic media, the Government issued a Pakistan Electronic Media Regulatory Ordinance in 2002, which allowed the establishment of television channels in the private sector. Today, more than 50 private TV channels are on air in Pakistan. Likewise, new FM band radio licenses have been issued and a number of private channels are on air. In the telecommunication sector, with the creation of an enabling investment environment in the sector, the mobile phone industry is dominated by the private sector with several foreign affiliated companies providing a range of telecommunication services. Largely, due to the mobile phone revolution in the private sector, telephone density in Pakistan has increased dramatically from 4.4% in FY2003 to 46.9% in FY2007.

52. Finance: Besides the State Bank of Pakistan, the finance and insurance sector includes scheduled commercial banks, DFIs, and leasing and insurance companies.

53. Commercial Banks: The banking sector has seen a major shift in ownership from the public to the private sector following a successful financial sector privatization program. The share of private sector banks in aggregate assets of the banking industry surged from below 44 percent in 2000 to above 77 percent in 2005. The entire increase in the private sector ownership

12 Shaheen Air International, Aero Asia Airlines and Air Blue 19 was due to a gain in share of the local private banks (LPBs) (Figure 4). Privatization hastened a decline in asset concentration within the banking sector and enabled consolidation of the erstwhile weak financial institutions.

Figure 4: Increased Ownership of Local Private Banks

Source: State Bank of Pakistan. 2005. Pakistan Financial Sector Assessment 2005. Karachi

54. Since 2002, the Islamic financial sector, in particular Islamic banking, has made rapid progress in Pakistan. Financial institutions have been allowed to establish full-fledged Islamic Banks (IB) in the private sector, set up subsidiaries of existing commercial banks, and start stand-alone Islamic banking branches of existing commercial banks.

55. Non Banking Financial Institutions (NBFIs): The ownership structure of the NBFI sector has also changed considerably between FY2001 and FY2005 (Figure 5). All major public sector DFIs have been either liquidated or merged with the banking institutions, and the public sector closed-end mutual funds were taken over by the private asset management companies. With the transformation of leading public sector DFIs, market enabled mutual funds have taken over the leading position in NBFIs. As part of the transformation process, the Industrial Development Bank of Pakistan (IDBP), which was an active specialized institution, changed into a specialized scheduled bank. The SME Bank which was previously a DFI has now become a licensed commercial bank. The remaining DFIs are mostly foreign sponsored holding companies such as Pak Libya Holding Company and Pak-Kuwait Investment Company. Attempts to privatize IDBP and the SME Bank are underway. At this point, however, only the SME Bank has a serious possibility of privatization after having being granted a commercial banking license.

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Figure 5: Ownership of NBFIs

Source: Source: State Bank of Pakistan. 2005. Pakistan Financial Sector Assessment 2005. Karachi

56. In leasing, the biggest company - the National Development Leasing Corporation (NDLC) - is a singular public sector company, while the majority of its shares are in the private sector. Joint ventures in the leasing sector comprise partnerships between the Government and some governments in the Middle East and are in the public sector with no immediate plans on divesting equity to the private sector. No public private partnerships exist at this time in the leasing sector.

57. The Insurance Sector: Pakistan’s insurance sector comprises life insurance, non life insurance, the reinsurance and takaful13 industries. As highlighted in Table 9, public sector ownership of the life insurance sector in 2006 (last year for which such data is available) was very high at almost 65%. The reinsurance sector is totally in the public sector. The private sector dominates the non-life insurance with only one public sector institution active in this sector. As of September 30 2006, there were 5 life insurance companies, 52 non-life insurance companies, 1 takaful operator and 1 reinsurance company.

58. Both the life insurance and non life insurance companies expanded their business considerably in recent years, leading to rising profits of the insurance industry which totaled Rs. 6.9 billion in 2005 compared to Rs 4.0 billion in 2004. Figure 6 indicates the profitability of the insurance industry in 2005 and, in particular, highlights the high profit margins in the life insurance sector. Considering that the life insurance sector remains in the public sector and relatively slow to roll out new products and adopt state of the art risk and actuarial models, any injection of private sector dynamism could further boost the size and profitability of the life insurance sector.

13 Takaful, the Islamic alternative to insurance is based on the concept of social solidarity, cooperation and mutual indemnification of losses of members. It is a pact among a group of persons who agree to jointly indemnify the loss or damage that may be inflicted on any of them, out of the fund they donate collectively. 21

Table 9: Asset Structure of the Insurance Industry

Source: Source: State Bank of Pakistan. 2006. Pakistan Financial Stability Review 2006. Karachi

Figure 6: Insurance Sector Profitability- 2005

Source: Source: State Bank of Pakistan. 2005. Pakistan Financial Sector Assessment 2005. Karachi

59. Pakistan’s insurance density14 is still very low, increasing from 2.7 in 2001 to 4.0 in 2004 with insurance penetration15 remaining virtually constant during this period (Table 10). At these levels, Pakistan’s insurance industry is substantially underdeveloped compared to many other countries. Amongst the factors retarding its growth are highly skewed market concentration patterns - the legacy of nationalization, a weak regulatory structure and governance systems and a virtually nonexistent market for long term debt and investment instruments. The SECP under the Insurance Ordinance 2000 took over as the formal regulator of the insurance industry. The SECP is still in the process of creating the requisite infrastructure and in-house capability to

14 Insurance density is defined as gross premium per capita. 15 Insurance penetration is defined as gross premium as percent of GDP.

22 regulate the sector. Without strengthening regulatory capacity, it is not advisable to privatize the large state owned insurance companies. More details on Pakistan’s insurance industry are provided in Appendix 2.

Table 10: Insurance Density in US$; insurance penetration (in percent)

Source; Sigma, World Insurance in 2001, 2002, 2003, 2004 23

SECTION II

PUBLIC POLICY AND STRATEGY AND THE RISE OF THE PRIVATE SECTOR

2.1 MAJOR AGENTS OF CHANGE

60. Since 1999, the Government’s policy of economic structural transformation based on deregulation, decentralization, economic liberalization, and privatization, has aimed to expand and enhance the role of the private sector. With the implementation of the Government in reform program on the mentioned lives, Pakistan was ranked among the top ten reforming countries in the world in 200616, although the rating slipped subsequently in 2008.

61. Privatization has been the most important component of the Government’s strategy for invigorating economic growth, attracting investment, and creating opportunities for the private sector. In addition to strategic sales where management control is divested, the Government has used privatization to develop, broaden and deepen domestic capital markets. For this reason, the Government has sold minority shares via the stock market in selected companies before or after the transfer of management control. Listing and selling companies in the local stock exchanges is likely to give a much-needed boost to the stock markets and help tap into domestic and foreign savings. Listing companies in the stock exchange will also improve corporate governance, as companies will be forced to comply with the stringent reporting requirements of the stock exchange and SECP.

2.2 PRIVATIZATION

62. Pakistan’s privatization experience is considered as being among the most successful in South Asia. Privatization picked up in 1999 when a number of structural bottlenecks were removed. The Privatization Act 2000 was promulgated, the macroeconomic environment was reformed, regulatory frameworks were established17, a Ministry of Privatization and Investment was created, a high-powered Cabinet Committee on Privatization (CCOP) was formed, and the Board of the Privatization Commission was strengthened.

63. A number of strategic sales in the financial, energy, electricity and manufacturing sectors have been since concluded. Until December 2006, assets worth PKR 418.6 billion from 49 transactions had been privatized, prominent amongst which included the privatization of Pakistan Telecommunication Company Limited (PTCL), HBL, UBL, KESC, NRL, and a number of fertilizer and cement companies. As a case in point, Box 3 highlights the successful privatization of Pakistan’s financial sector. The privatization program also played a major role in the development of the capital markets by using domestic and foreign stock exchanges for divesting equity of public sector enterprises. Major assets remaining on the privatization list include two of the largest exploration and production companies in the oil and gas sector, that is, the oil and Gas Development Company Limited (OGDCL) and Pakistan Petroleum Limited (PPL), as well as the Pakistan State Oil Company Limited (PSO). Also stated for privatization are key assets in the power sector such as electricity distribution companies and a power generation company, besides several heavy industrial units and prime real estate properties. A list of Government privatizations from 1999 onwards is in Appendix 3.

16 World Bank. 2006. Doing Business in 2006. Washington D.C 17 Regulatory agencies for electricity, oil and gas, and telecommunications were set up and existing regulators such as the SBP and the SECP were strengthened.

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64. The privatization process has catalyzed reforms for further liberalization of the economy as well as taxation reforms. The banking sector privatizations, for example, gave the impetus for tax reform where tax rates for banks were brought down in line with corporate rates from over 50% to 35%. The PTCL transaction was key in liberalizing the telecom sector by opening up the sector to competition and in helping to create an effective regulatory environment. Privatization, through the mechanism of strategic sales, has also contributed to injecting best management practices from the private sector. Privatization of state-owned entities is expected to cut waste, reduce corruption, and improve the coverage and quality of services- such as in the financial sector.

65. The privatization program, however, suffered a setback in early 2007 when the privatization of the Pakistan Steel Mills (PSM) was struck down by the Supreme Court of Pakistan. Following this decision, the Government has focused on floating its shares in public entities in domestic and foreign capital markets via global depository receipts (GDRs) such as the shares floated for UBL and the Oil and Gas Development Corporation (OGDC) on the London Stock Exchange. The impact of such privatization which in essence generates portfolio investment on the economy needs to be, however, reviewed carefully given the volatility attached to such foreign inflows especially with a weakening rupee.

66. Recent attempts to privatize Pakistan State Oil, a major privatization transaction, have also run into legal problems. Past transactions like that of the telecommunications giant PTCL and the KESC are also coming under some critique with the detractors of privatization citing amongst other reasons poor service delivery by the private sector in the post privatization situation. In the case of KESC, post privatization electricity outages have resulted in violent demonstrations in Karachi.

67. Factors that appear to have derailed the privatization process are multidimensional. The privatization program successfully handled “category one”18 and some “category two”19 privatizations that included the banking sector transactions. But when it came to more complex sectors like infrastructure, telecommunications, and power, issues pertaining to future service delivery could not be adequately addressed during the strategic sale process. The success yardstick for privatization continued to be the successful divestment of an entity and not its continued post privatization service delivery. Another major factor that appears to have negatively impacted the privatization program is the lack of continuity, stability and institutional memory at the Privatization Commission (PC) itself. After a period of almost six years of well managed operations, the PC saw, within a time span of a year, three different ministers at its helm and at least four secretaries. The PC has also witnessed a very high turnover in its consultants during the same period. At the same time, PC’s communication with stakeholders suffered as public perceptions of the privatization process and its transparency turned negative.

68. The Government was unable to mount an effective defense against the storm of criticism unleashed by the PSM judgment. Privatization, fundamentally being a political act requires a broad based support at both the political and other institutional levels, and issues generating

18 Category one privatizations generally constitute simple transactions generally of small profitable industrial units that are easy to divest and which do not generate regulatory market concentration, and competitiveness issues. 19 Category two privatizations are more complex, require complex structuring and require that regulatory, competitiveness, monopoly power and market concentration issues amongst others be addressed. Complex transactions in the financial services, energy, telecommunications and some components of the power distribution sectors fall under this category. Category three privatizations need to tackle a number of strategic, social and political issues as well as those issues identified for category two transactions. The examples of category three sectors are health care, education, water supply, railways, ports, airlines etc. 25 controversy need to be promptly addressed. Another structural issue was that the modes of privatization so far followed were restricted to capital market operations like IPOs, POs, GDRs and strategic sales. In light of the experience gained, the Government must also begin to view privatization from a broader perspective and go beyond the current simple divestment structures of strategic sales and capital market transactions and experiment with public private partnership based approaches, management contracts, mutualization, concessions, and atomized private sector holding structures.

Box 3: Pakistan’s Banking Sector Privatization Program

By 2004, following successful privatization, over 77% of Pakistan’s banking sector had come under private ownership, and following its lethargic performance in the post-nationalization period, developed greater efficiency and rising profitability. The table below compares Pakistan’s banking sector performance in 1997 when 80% of the banking sector was in the public sector with that of 2004 when only 20% was left in the public sector post privatization. The various indicators measuring asset quality in terms of reduction in the proportion of non-performing loans, return on assets, and incomes, demonstrate a very significant turn around and improvement. From investment banking to commercial banking to consumer banking a major overhaul of financial services is underway. The growth in the consumer banking industry, in particular, has been spectacular and provided opportunities to the middle class to avail housing and automobile loans at affordable rates. However, starting in the FY2007, with rising interest rates, the performance of the consumer banking has been affected, and some banks have developed higher infection rates in their consumer loan portfolios. Overall profitability of the banking industry has, however, continued to remain robust.

Commercial Banking Sector Indicators - 1997 vs 2004 1997 (80% public 2004 (20% public sector owned) sector owned) Asset Quality: NPLs to Total Loans 20.1% 9.0% Return on Assets (after tax) -1.3% (loss) 1.3% ROE after tax -36.2 %(loss) 19.8% Net Interest Income/Gross Income 46.5% 62.5% Cost / Income (efficiency) (lower the percentage the 85.8 51.8 higher the efficiency) Source: Table developed from data found in SBP Banking System Review 2006

2.2.1 The “Privatization For The People” Program

69. The ‘Privatization for the People Program’ was launched in February 2002 to offer shares in public enterprises to the general public. This program’s several objectives were: to create ownership and enthusiasm for privatization among the public; to directly pass on the benefits of the privatization program to large segments of the public; to bring new companies for listing into the stock market thereby broadening the base of the stock market; to offer good investment opportunities to middle class investors and to benefit from the transparent procedures available for privatization through the stock market and create a larger group of stockholders in Pakistan.

70. The Government in 2006 also began floating Global Depositary Receipts (GDRs) in a move to attract foreign portfolio investment and to increase Pakistan’s visibility in the international marketplace. Figure 7 shows that this has led to a significant increase in foreign ownership of equities in Pakistan’s domestic stock market- from less than 3% of aggregate market capitalization in October 2005 to over 6% by February 2007. Primarily using the London

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20 also refers to the same issue when it states “The recent surge in portfolio investment, particularly in the stock market, has both positive and negative implications. On the one hand, these flows helped finance the country’s current account deficit, but on the other hand, there are some concerns in terms of volatility attached with these flows since their abrupt withdrawal can adversely affect the domestic stock prices and the stability of the domestic currency”.

Figure 7: Foreign Stake in Domestic Stock Market (as percent of aggregate market capitalization)

Source: State Bank of Pakistan. 2007.Third Quarter Report FY2007. Karachi

2.2.2 Lessons Learnt from Pakistan’s Experience with Privatization

71. The privatization process has contributed substantially to raising the role and profile of the private sector in economic activity. In structuring privatization deals, however, adequate attention to post-privatization service delivery needs to be ensured to fulfill the efficiency purpose of privatization and create political acceptance of the privatization process. To this end, the privatization policy should focus at the medium and the long term instead of merely targeted to achieving immediate divestment and transfer of ownership to finance the public sector deficits. In this regard, privatization must be undertaken under the ambit of a well defined privatization policy with adequate legal cover. Importantly, the utilization of the proceeds from privatization need to be predetermined and made public so that the political imperatives of politicians and short term ends of policy makers are curbed. Intergenerational accounting and considering privatization proceeds as what they are: one off non-recurring proceeds could lead to greater scrutiny and caution in applying privatization proceeds to overcome immediate budget constraints. Finally, adherence to transparent privatization procedures that ensure accountability at all levels of Government should be ensured and not compromised for the sake of political expediency.

2.3 DEREGULATION AND ECONOMIC LIBERALIZATION

72. Besides privatization, the Government’s investment friendly policies marked by deregulation and liberalization have had a marked impact on investment, with a particularly significant acceleration in foreign direct investment. Amongst the highlights of the lliberal

20 State Bank of Pakistan. 2007. Third Quarter Report for Fiscal Year 2007. Karachi 27 investment policies being pursued by Pakistan include equal treatment to local and foreign investors, opening up of almost all economic sectors to FDI, and allowing foreign equity ownership of up to 100% with no or few Government permissions required. In addition, attractive incentives have been put in place that allow hassle-free remittance of capital, profits, dividends, royalty, technical and franchise fees. Export processing zones and industrial estates providing attractive incentives have been set up with more planned in various parts of the country. Pakistan has also zero rated the import of raw material for export manufacturing. Pakistan currently has bilateral agreements with a number of countries, with specific investment protection agreements with 46 countries and avoidance of double taxation agreements with 52 countries.

73. Tariff reforms Implemented include an across the board significant reduction in tariffs since 1999 with the maximum tariff set at 25% and reduced import duty on 4,000 items. Taxation reforms have broadened the tax base, eliminated multiplicity of taxes, and introduced a universal self assessment system for tax collection that has made the taxation process more efficient21. Highlights of Pakistan’s liberal investment policies are summarized in Table 11.

Table 11: Government’s Incentives for Investment Non -Manufacturing Sectors Policy Parameters Manufacturing Sector Infrastructure & Services including IT & Agriculture Social Telecom Services Not required except for Not required except specific licenses from concerned Govt. Permission specified industries* agencies. Remittance of capital, profits, dividends, Allowed Allowed etc. Upper Limit of foreign 100% 100% 100% 100% equity allowed Minimum Investment No 0.3 0.3 0.15 Amount (M $) Customs duty on 5% 0% 5% 0-5% import of PME Tax relief (IDA, % of 50% 50% PME cost) No restriction for Allowed as per guidelines - Initial lump-sum upto Royalty & Technical payment of royalty & $100,000 - Max Rate 5% of net sales - Initial period 5 Fee technical fee. years * Specified Industries: PME= Plant, Machinery and - Arms and ammunitions Equipment - High Explosives. IDA= Initial Depreciation - Radioactive substances Allowance - Security Printing, Currency and Mint. - No new unit for the manufacturing of alcohol, except, industrial alcohol Source: Board of Investment: http://www.boi.gov.pk

21 In the 2007-08 budget, in an effort to curb imports and raise more revenues to contain the trade and fiscal deficits, the Government once again raised the maximum tariff to 30-35% and imposed higher duties on non-essential imports. It remain to be seen if these were temporary measures and would be withdrawn with the anticipated reduction in trade and fiscal deficits.

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74. With the opening up of the economy, Pakistan has attracted FDI from many countries. Table 12 shows the origins of foreign investment flows into Pakistan. The US, UAE and UK were the most significant sources for investment in FY2007. Among these countries, in FY2008, Norway and Malaysia were the other two major investors. The overall investor country mix consists of both regional and global investors. New major investors include Peoples Republic of China and the UAE. Foreign companies in recent years have generated healthy returns from investments in Pakistan that demonstrates the profitability of FDI in the country (Table 12).

Table 12: Country Wise Foreign Investment Inflows ($ million) Country FY2006 FY2007 FY2008 Direct Portfolio Total Direct Portfolio Total Direct Portfolio Total Australia 31.3 31.3 72.0 -6.4 65.5 69.6 -73.2 -3.6 Germany 28.6 -3.5 25.1 78.9 7.0 85.9 69.6 -0.5 69.1 Hong Kong 24.0 31.2 55.2 32.6 -72.6 -40.0 339.8 -245.5 94.3 Japan 57.0 -8.7 48.2 64.4 3.9 68.4 131.2 9.9 141.1 Kuwait 18.1 2.9 21.0 65.9 17.0 82.9 36.0 28.3 64.3 Luxembourg 23.5 -1.0 22.5 13.0 -0.4 12.6 -0.4 39.3 38.9 Mauritius 87.0 -4.1 83.0 77.6 13.0 90.6 99.6 5.9 105.5 Netherlands 121.1 -0.7 120.4 771.8 6.2 778.0 121.6 24.5 146.1 Norway 252.6 252.6 25.1 0.0 25.1 275.0 0.0 275.0 Saudi 277.8 0.8 278.5 104.9 0.1 105.0 46.2 -1.6 44.6 Arabia Singapore 9.9 5.6 15.5 20.9 118.2 139.1 24.8 19.6 44.4 Switzerland 170.6 11.6 182.2 175.0 -127.4 47.6 169.3 -97.8 71.5 U.A.E 1424.5 63.3 1488.0 662.2 14.9 677.0 588.6 4.3 592.9 U.K 244.0 -19.5 224.5 860.0 960.1 1820.1 460.2 -125.1 335.1 U.S.A 516.7 303.8 820.5 913.3 853.4 1766.8 1309.3 439.2 1748.5 Others 225.7 -30.2 195.5 1202.4 33.3 1235.7 1412.4 -8.0 1404.4 Source: State Bank of Pakistan: http://www.sbp.org.pk

75. The Government is attempting to increase foreign investment particularly in the energy and infrastructure sectors. With the existing electricity and gas shortfalls, the Government is very keen to source foreign investment in setting up power projects all over Pakistan. 27 power projects costing around US $8 billion are in the process of being set up in the country over the next 7-8 years and will require an average of about US $1 billion investment every year. Provincial governments too have become proactive in attracting foreign investors. The Government of Punjab, for example, in collaboration with 60 Korean companies, is working towards the establishment of a Korean industrial estate for high-tech manufacturing in Lahore. A similar industrial estate for Chinese investors is also in the works.

76. Pakistan has provided lucrative business for international investors. Table 13 below provides evidence of the high returns that foreign companies have been able to generate from investment in Pakistan.

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Table 13: Leading Foreign Investor Companies – Average Returns Company Sector 1999 2000 2001 2002 2003 Average

Shell Pakistan Oil and Gas 22% 27% 20% 18% 21% 22%

Hubco Power 24% - 39% 28% 24% 29%

British Oxygen Company Industrial Gas 27% 25% 11% 43% 48% 31%

Glaxo SmithKline Pharmaceutical 19% 22% 8% 15% - 16%

Unilever Consumer Items 52% 106% 45% 148% - 88%

Gillette Pakistan Consumer Goods 33% 33% - 41% - 36%

Colgate Pakistan -do- 18% 21% - 31% 36% 27%

Nestle Milkpak Food 33% 32% 25% 75% - 41%

General Tyre Tyres 21% 29% - 23% 24% 25%

Siemens Engineering Engineering 10% 20% 17% 22% 19% 18% Source: Board of Investment. 2007. Available: http://www.boi.gov.pk

2.4 REGULATORY STRUCTURES: PROGRESS AND ISSUES

77. Over time, Pakistan has substantially improved its legal and regulatory structures to create an enabling business environment for private sector development. Yet, issues remain in terms of the managerial and technical capacity of regulators, their autonomy and independence, and reports of government interventions in regulatory decisions. To enhance private sector participation, it is critical that regulatory agencies are appropriately empowered, have the requisite capacity, and are able to operate independently and with full autonomy to regulate private business and promote investors’ confidence.

78. The major statutes that govern and regulate corporate activity are the Securities and Exchange Ordinance, 1969; Companies Ordinance, 1984 and the Securities and Exchange Commission of Pakistan Act, 1997 and subsequent modifications. The primary regulatory body that governs corporate entities in the private sector is the SECP. (formerly Corporate Law Authority created in 1984). Besides the SECP, other key regulators include the State Bank of Pakistan (SBP) that came into being in 1948 and the Competition Commission of Pakistan (formerly the Monopoly Control Authority formed in 1970). Important sector regulators include: the National Electric Power Regulatory Authority (NEPRA), Oil and Gas Regulatory Authority (OGRA), Pakistan Electronic Media Regulatory Authority (PEMRA), and the Pakistan Telecommunications Authority (PTA). The establishment of regulatory bodies in the new sectors was a result mainly of the large scale privatization of public sector entities operating in these sectors.

79. Securities and Exchange Commission of Pakistan (SECP): SECP is the main regulatory body charged with the responsibility to develop and foster an efficient corporate sector and capital markets within an effective governance and regulatory framework. The SECP regulates the corporate sector based on a comprehensive set of statutes, rules, regulations, guidelines and orders. The Securities and Exchange Commission of Pakistan Act was promulgated in December 1997 and the SECP came into being on 1 January 1999 after the

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Corporate Law Authority was restructured under the ADB-assisted Capital Market Development Plan (CMDP) approved in 2007.

80. The authority of the SECP was extensively widened since its creation to include the regulation of the insurance sector, non-banking financial companies and pension funds. For non-banking financial companies alone, the SECP licenses, regulates and governs investment financial services providers, leasing companies, housing finance services, venture capital investment, discounting services, investment advisory services, real estate investment trusts and asset management services. But, SECP faces issues of capacity and autonomy in governance. On capacity, the SECP has recently experienced an exodus of experienced personnel due to its inability to retain quality manpower. The capacity and capability of any regulator is as good as the quality of its manpower and it is essential that a regulator like the SECP maintain its systemic memory by implementing human resource policies that enhance retention.

81. Besides regulating the banking sector, under the ADB-assisted Accelerating Economic Transformation Program in 2008, the SBP has been made responsible for regulating and supervising the framework for consolidated supervision of financial conglomerate, provides it with greater regulatory powers over parties who control banks and banking groups, and gives it the power to license, regulated, and supervise all deposit-taking institutions.

82. On autonomy in governance, the SECP Act vested executive authority in five commissioners appointed by the President of Pakistan and having security of tenure once appointed. Policy oversight was the function of a nine-member policy board that was to comprise of five eminent professionals: the SECP chairman and three federal government secretaries (ex officio members) and the Deputy Governor of the SBP. However, under the Finance Bill of 2007, the policy board was expanded to 10 members with the Prime Minister or his nominee as Chairman of the Board who is empowered with a casting vote in case of a tie between board members. The impact of this change on the performance and autonomy of the SECP is being currently debated.

83. State Bank of Pakistan (SBP): The SBP is Pakistan’s central bank and regulator of the banking sector. Under the State Bank of Pakistan Order 1948, SBP was charged with the duty to "regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in Pakistan and generally to operate the currency and credit system of the country to its advantage". Its role was expanded under the State Bank of Pakistan Act 1956 to "regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources". In February 1994, the State Bank was finally granted autonomy, which was further enhanced in 1997. The SBP has authority to regulate the banking sector, implement monetary policy and control government borrowing.

84. However, despite being a financial sector regulator, SBP continues to hold a significant amount of equity in a number of financial institutions generating a potential conflict of interest situation. While the SBP has so far managed this dual role quite professionally, the privatization program has successfully reduced its majority shareholding concentrations in financial institutions and its minority holdings are also being reduced through various domestic and offshore capital market instruments.

85. Competition Commission of Pakistan: A Monopoly Control Authority (MCA) was established in August 1971 under section 8 of the Monopolies and Restrictive Trade Practices 31

Ordinance 1970 (MRTPO) to protect against undue concentration of economic power, growth of unreasonable monopoly power and unreasonably restrictive trade practices. The MRTPO, however, had major limitations in terms of scope and coverage. A Competition Ordinance (CO) was finally promulgated in 2007 to bridge the gaps in the existing MRTPO, and under this ordinance, the MCA was transformed into the Competition Commission of Pakistan (CCP). The new law focuses on fostering greater competition, reducing barriers to entry, curbing abuse of market power and providing discretionary power to the CCP to be able to determine optimal market concentration. In light of the powers granted to it under the CO of 2007, it is important that the CCP is provided necessary independence and autonomy for the effective discharge of its functions, and develops the requisite capacity to promote a competitive and efficient economy.

86. National Electric Power Regulatory Authority (NEPRA): NEPRA was formed in 1997 to introduce transparent and judicious regulation in the power sector based on sound commercial principles. NEPRA's main responsibilities are to issue licences for generation, transmission and distribution of electric power; establish and enforce standards to ensure quality and safety of operation and supply of electric power to consumers; approve investment and power acquisition programs of the utility companies; and determine tariffs for generation, transmission and distribution of electric power. NEPRA regulates the power sector to promote a competitive structure for the industry and ensure the co-ordinated, reliable and adequate supply of electric power. In light of the existing electricity crisis in Pakistan, NEPRA’s role as a regulator has come under some critique22. It is essential that NEPRA be further strengthened and an efficient regulatory, governance, tariff and licensing regime evolved to meet the existing and emerging energy sector challenges.

2.5 GOVERNMENT STRATEGY FOR PRIVATE SECTOR DEVELOPMENT

87. Building on public policy and regulatory improvements introduced in recent year, the Medium Term Development Framework (MTDF:2005-2010) of the Government places a special emphasis on private sector development as a key element of the strategy to achieve sustained growth. Under the MTDF, the Government is supporting private sector development through:

(i) Strengthening the privatization policy and improving the business climate to catalyze the private sector; (ii) Upgrading of education and skills and creating necessary public institutional arrangements including improvement of information and communication technology (ICT) infrastructure to strengthen the knowledge base and competitiveness of the economy; (iii) Strengthening skills and vocational training for improving the quality of workforce in the private sector for higher productivity; (iv) Improving quality, productivity, and standards to enhance conformity of Pakistani products with WTO requirements through restructuring quality standards institutions, defining clear performance standards, and strengthening the environment for intellectual property rights protection; (v) Fostering public-private partnerships through improving the legal and regulatory environment for PPPs and addressing institutional and capacity issues; (vi) Vitalizing Pakistan’s capital markets through developing bond markets, encouraging institutional investment, and strengthening corporate governance.

22 ADB. 2007. Constraints to Private Sector Investment in Infrastructure. Manila

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88. These components taken together constitute the way forward for the Government’s strategy on private sector development. Side-by-side, the Vision 2030 approved in 2007 incorporates private sector development as a “key element” of the Government’s long-term thinking on sustainable development in the country. The Vision takes note of structural factors impeding the development of the private sector and argues the need for streamlining public regulatory and administrative procedures to reduce the cost of doing business in the country. Like the MTDF, the Vision 2030 is strongly supportive of public-private partnerships and recognizes the need to “facilitate provision of resources, technical expertise, outreach, and financial mechanisms’ to develop an enabling environment for PPPs in the country. 33

SECTION III

KEY CHALLENGES AND THE WAY FORWARD FOR PRIVATE SECTOR DEVELOPMENT IN PAKISTAN

89. Pakistan’s private sector has developed and matured significantly on the back of the overall improved macroeconomic environment and strengthened business conditions marked by privatization and liberalization of the economy. Major challenges, however, continue to confront the private sector. The macroeconomic outlook faces renewed problems arising from rising deficits and inflation and a major financing gap that threatens the fiscal space for public investment. The business environment is still saddled with governance and institutional bottlenecks and rigidities in factor markets that raise the cost of doing business and impact on Pakistan’s international competitiveness. The private sector itself faces major tasks of introducing improved business operational procedures, strengthening corporate governance and accountability to shareholders, diversifying into non-traditional sectors to take advantage of international markets conditions, and adopting modern technology and raising the quality of human resources for higher productivity and value added. This section attempts to relate these challenges to the prospects for private sector development in Pakistan and identifies key areas for improvement in the business environment to catalyze higher private sector participation in economic development.

3.1 MAJOR MACROECONOMIC AND INFRASTRUCTURE CHALLENGES

90. The implementation of economic reform program in recent years and the growth spurt this released placed Pakistan amongst the fastest growing Asian economies with the growth rate averaging around 7.5% between FY2004-FY2007 (figure 8). Growth subsequently came down but still remained resilient at 5.8% in FY2008. Pakistan’s story in this regard demonstrates the impact of macroeconomic discipline and commitment to reform in turning the economy and generating strong private sector led drivers for high growth.

91. During the latter half of the nineties, Pakistan had developed numerous economic problems. The per capita GDP growth rate averaged less than 1% per annum. Foreign exchange reserves at one point covered only 2 weeks of imports and public debt hovered at over 90% of GDP. The impact of the macroeconomic situation was far reaching, restricted the Government’s fiscal space and led to deteriorating physical and social services infrastructure. Economic reform had become inevitable in these circumstances. Reforms that began in the late 1990s accelerated the process of change and pushed forward a clear agenda of macroeconomic stabilization based on fiscal, monetary and structural reform. These reforms resulted in greater fiscal discipline, increased revenue flows, stabilized the exchange rate, curbed inflation, reduced transfers to hemorrhaging public sector entities, strengthened regulatory structures and systems, promoted good governance, and accelerated the pace of deregulation and privatization. Macroeconomic stability also generated fiscal space for the government to increase investments in the social and pro-poor sectors and enhance spending for infrastructure development. Embedded within this strategy was the core vision that the primary agent and driver of growth was the private sector that had to be supported through the three key policy pillars of privatization, liberalization and good governance.

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Figure 8: GDP Growth (%) 10.0 9.0 9.0 8.0 7.5 6.8 7.0 5.8 5.8 6.0 5.0 4.7 4.0 3.1 3.0 2.0 2.0 1.0 0.0 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

Source: Ministry of Finance. 2008. Pakistan Economic Survey 2007-08. Islamabad.

92. Rising Macroeconomic Imbalances: The economy, however, came full circle in FY2008. The biggest challenge to macroeconomic stability at present is the reemergence of the twin deficits –fiscal and external over the last two years. After averaging 3.1% between FY2003 and FY2005, the fiscal deficit increased to 4.3% in FY2006 and hovered at around the same level in FY2007. Due to a continued expansionary fiscal policy on the back of rising current expenditures but stagnant tax to GDP ratios fiscal deficit jumped further up to 7.4% of GDP in FY2008; thus significantly exceeding the Government’s fiscal deficit target of 4.0% of GDP for the year. A sharp deterioration in the fiscal account significantly undermined the hard won fiscal space for continuing social sector investment and infrastructure development spending at the levels required. Fiscal profligacy in the absence of commensurate increase in revenues indicates the recurrence of a higher debt burden which in turn will constrict fiscal space even further because of higher debt service payments. Greater government borrowings to finance the deficit, which have witnessed a record increase of Rs.584 billion during FY2008, significantly crowded out credit to the private sector that intern had negative impact on the private sector investment. A key challenge in maintaining higher public spending is the restructuring of the taxation system to increase its scope to cover more of the hitherto untaxed informal economy in Pakistan which by some estimates exceeds the formal economy by a factor of 2.

93. The external current account deficit likewise has rapidly grown over the last two years, reaching 4.9% of GDP in FY2007 compared to 3.9% of GDP in the preceding fiscal year. Continued high oil and food prices during have translated into large import payments, and with exports insufficient to fund imports, resulted in a further deterioration in the current account deficit which reached at 8.4% in FY2008. The burgeoning deficits on the income and services accounts have put added pressure on the external account. In the absence of a significant and sustained increase in exports, a sharp deterioration in the balance of payments situation has imposed a major constraint on Pakistan’s future growth prospects. As a result, GDP target for FY2009 has been lowered to 3.5%. It is thus critical that a conducive business environment is provided to the private sector to increase investment, production and, exports, to address the large imbalance in the external account. It is essential in this regard that the private sector itself becomes sufficiently competitive in international markets to generate exports at a level that ensures that the balance of payment constraint does not limit the economy to a sub-optimal low level growth equilibrium.

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94. The continued tightening of monetary policy by the SBP in response to the rising inflationary pressure has resulted in repeated upward adjustment of interest rates over the last couple of years. The discount rate increased from 7.5% in FY2005 to 9.5% in December 2007 and further to 13.0% by July 2008 and 15% by November 2008. While important from the perspective of maintaining macroeconomic stability in an environment of high inflation, a tight monetary policy could restrict access to credit for the private sector and raise the cost of borrowing for investment, particularly when Government borrowings from the banking system to finance the fiscal deficit are significant. Nevertheless, the real interest rate in Pakistan at 3.9% is still low at this point. Thus, an argument could be made that monetary tightening is currently not constraining private investment in a major way. Still, there will be a limit to which interest rates could be raised before a trade-off with growth and investment sets in. Inflation, therefore, needs to be contained through policy and administrative fiscal restraint measures. To obviate the need for frequent upward adjustments in interest rates that could prejudice private sector economic activity, investment, and growth, excessive Government borrowing from the State Bank that is monetizing the fiscal deficit and fueling inflation would need to be controlled. The spike in food prices, the major contributor to headline inflation, will also need to be arrested through appropriate supply side responses. Continued efforts at substitution of energy resources will be critical, particularly through exploiting the hydropower potential of the country, to curb the sever impact of oil prices in the medium term.

95. Low national savings and investment rates remain a major constraint to growth. After a significant improvement in investment from around 22.1% of GDP in FY2006 to 23% of GDP in FY2007, and in national savings from 17.2% of GDP to 18% of GDP in the same period, both investment and saving rates declined to 21.6% and 13.9% respectively in FY2008. At this level, Pakistan’s savings and investment rates remain far too low compared to other faster growing countries such as China and India. Figure 9 shows, that Pakistan’s saving rate in 2005 was about half of India’s and only about a third of that of the Peoples Republic of China. Unless higher domestic savings are mobilized, the dependency on external inflows to finance required investment levels will increase, which could adversely impact economic stability given the volatility attached to such inflows.

Figure 9: Domestic Saving Rates in 2005

Domestic Saving Rates

50 45 40 35 30 25 20

Saving Rates 15 10 5 0 China India Pakistan Country

Source: ADB. 2006. Key Indicators 2006: Measuring Policy Effectiveness in health and Education. Manila.

96. Slow Progress towards Structural Transformation: Structural transformation of the economy and a shift towards higher value adding sectors is critical to sustain Pakistan’s growth momentum - in line with the experience of other faster growing developing economies in Asia.

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Starting from a largely agrarian base, Pakistan’s structural transformation requires an increasing share of the industrial and manufacturing sector in value added that creates larger employment opportunities and generates higher value exports for growth. To the contrary, Pakistan, from being a dominantly agricultural economy in terms of contribution to GDP, has become a largely services sector economy with services contributing more than half of the total GDP in FY2007 (Table 8 of Section 1). The share of the manufacturing sector has grown more slowly and reached only 19% of GDP in FY2007 compared to the Peoples Republic of China (35%), the Republic of Korea (24.7%), Indonesia (28%), and Malaysia (29.8%). The question for Pakistan is whether the present pattern of growth is sustainable and if the services sectors can continue to grow without growth and transformation within the industrial and manufacturing sectors, given that the demand for services stems to a great extent from these sectors. The answer for the most part is that sustaining growth requires faster industrialization at the stage where Pakistan is currently at in turn of growth.

97. Pakistan’s industrial and exports base continues to be narrow with the textile industry being the single most important industrial sector and the primary generator of export earnings. There is an urgent need to strengthen and diversify the manufacturing export base, both in terms of products and destination of imports, in view of the current concentration of exports in a small number of sectors, principally textiles and rice, leather and petroleum products and three major destinations: the US, EU, and the UAE. The textile sector, along with the sugar industry, is based directly on agriculture sectors inputs. But little has been achieved in either improving agriculture productivity or broadening the scope of the industrial sector. It is due to a lack of a cohesive vision that takes a holistic view of the various sectors within an integrated framework that Pakistan’s agriculture and manufacturing sectors continue to under-perform.

98. With no major investment activities planned, and most manufacturing units already running near full capacities, the growth rate in the manufacturing sector has slowed down from 14.0% in FY2004 to 8.2% in FY2007 and further to 5.4% in FY2008. Future growth from this sector will only come about if the current narrow manufacturing base is expanded by adding non traditional sectors. It is difficult to conceive a continuing process of structural transformation without accelerating industrial growth and a deepening and widening of Pakistan’s industrial base. It is essential that the Pakistani public and private sectors identify either traditional industrial transformational sector(s) like automobile and consumer electronics or non traditional ones like aviation, alternate energy and defense to develop core competencies and efficiencies that generates change up and down the value chains and results in greater diversity and specialization.

99. Services sector growth, while impressive, needs to be sustained by developing a more conductive policy environment that helps cover the existing gaps. For example in the financial services industry, there is still a dearth of financial institutions that specialize in project finance and long term credit products, venture finance and small and medium enterprises (SME) lending. There is also a need for more microfinance institutions given the still very low convergence of poor households by these institutions. Capital markets need to generate stronger corporate debt markets and support the creation of more institutional investors like mutual funds and pension funds that provide alternate avenues for savings and investment to commercial banks. The information technology sector has big potential and can become a more significant contributor to growth as witnessed in India and Africa where telecommunications and financial sectors have converged to create virtual financial institutions and markets using cellular telecommunications systems.

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100. Crippling Energy Deficit: A major challenge to growth, industrialization and private sector development in Pakistan is the emerging energy crisis manifested in frequent load shedding and unreliability of power supply that lead to increased costs of production and decreased factor productivity, and results in loss of international competitiveness. Electricity demand is outstripping supply by a wide margin, and by 2010, demand is expected to exceed supply by approximately 5,500 MW (Figure 10).

Figure 10: Electricity Demand and Supply Curve 20584 20500 Firm Supply (MW) 19080 19500 Demand (MW)

18500 17689

17500 16548

16500 15483 15082 Megawatts 15500 15046 14336 14500 15072 15091 15055 15055 15055 14642 13500 13831 13071 12500 2003 2004 2005 2006 2007 2008 2009 2010 Year

Source: Private Power Infrastructure Board: http://www.ppib.gov.pk

101. Repeated business surveys have identified insufficient power and energy as a binding constraint to growth and development of the industrial sector. For example, survey23 of 650 small and medium enterprises (SMEs) in the manufacturing sector found that almost 80% of the SMEs did not intend to make new investments over the next few years mainly because of expensive and unreliable electricity. There is an urgent need to increase electricity generation, improve the quality of electricity distribution system, and find a suitable set of alternatives to the fast depleting national gas fields. Alternate sources of energy like renewables offer potential for Pakistan which besides hydel include bio diesels, wind turbines, solar thermal and solar photovoltaic. Coal is abundant in Pakistan but in most cases is of poor quality. Still, the Government’s 2030 Energy Security Action Plan has identified coal as a major source of energy. Given its complexity and checkered history of piece meal planning approaches that failed to deliver, it is now essential to prepare and adopt an integrated vision and implementation strategy for the comprehensive development of the energy sector in Pakistan.

102. The private sector in Pakistan has been engaged in power generation since the 1990s with the advent of the independent power producers (IPPs). The emphasis of the Government is on expanding the role of the private sector in energy and other infrastructure development

23 Undertaken by the Lahore University of Management Sciences in 2003 and reported in Haq, M. 2005. Entrepreneurship, Private Investment, Economic Growth. The Lahore Journal of Economics, Special Edition, September 2005.

38 recognizing that public sector development resources will be insufficient to meet the emerging infrastructure requirements generated by economic growth, urbanization, and an expanding population base. This is not an easy task as the private sector has seldom been a major player in emerging economies in the development of infrastructure given long project gestation periods, uncertain political horizons, and lagged returns. Still, given Pakistan’s early success in attracting the private sector in the power sector, it is conceivable that a mix of privatization, greenfield projects and public-private partnerships could generate greater opportunities and interest the private sector in investing in infrastructure development in the country. Even in the power sector, however, the breach of power purchase agreements by the Government in the case of the IPPs in the late 1990s remained a barrier to entry for new private sector investors but now new power producers in the private sector are again becoming active and investing in various projects in the country. Consistency of policy and macroeconomic and political stability, the ability of the Government to create appropriate pricing, regulatory and contractual structures, and the availability of long term finance are some of the most critical elements for building a larger and more vibrant roles of the private sector in infrastructure development in Pakistan.

3.2 GOVERNANCE AND INSTITUTIONAL BOTTLENECKS

103. Both domestic and foreign investors both look to a country’s governance indicators in terms of political stability, law and order, and transaction costs of doing business when making investments decisions. Foreign investors especially rate governance very high within their decision framework regarding offshore investment locations. Pakistan’s governance indicators are comparatively poor relatively to many other countries at similar levels of development which seems as distinctive for new potential investors and drags Pakistan down on the competitiveness ladder relative to many other countries in the region. Figure 11 illustrates Pakistan’s rankings24 across six dimensions of governance over the1998-2006 period. Rankings for voice and accountability and political stability deteriorated over this period, remained the same for control of corruption (although with deterioration between 2002 and 2006), and improved for government effectiveness and regulatory quality. The latter improvement was expected under the Government’s economic structural reform program focused on strengthening the enabling environment including regulatory structures for private sector development. But even for those governance indicators in which there was improvement, Pakistan’s comparative percentile rankings remain low, threatening the economy’s international competitiveness and its standing as an investment destination relative to other countries in the region. Governance reforms in Pakistan, therefore, have to continue and expedited for the country to improve its governance rankings and, in doing so, ameliorate perceptions of institutional failure and instability that have come to the fore particularly over the past year.

24 Taken from the Worldwide Governance Indicators (WGI). The Worldwide Governance Indicators (WGI) reports aggregate and individual governance indicators for 212 countries and territories over the period 1996–2006, for six dimensions of governance, namely; i) voice and accountability, ii) political stability and absence of violence, iii) government effectiveness, iv) rule of law, v) regulatory quality and vi) control of corruption. The aggregate indicators combine the views of a large number of enterprise, citizen and expert survey respondents in industrial and developing countries. The individual data sources underlying the aggregate indicators are drawn from a diverse variety of survey institutes, think tanks, and non-governmental organizations. 39

Figure 11: Pakistan’s Governance Rankings

90th-100th Percentile 50th-75th Percentile 10th-25th Percentile 75th-90th Percentile 25th-50th Percentile 0th-10th Percentile Source: Kaufmann D., A. Kraay, and M. Mastruzzi. 2007. Governance Matters VI: Governance Indicators for 1996-2006. World Bank: Washington D.C

3.3 CONSTRAINTS TO DOING BUSINESS IN PAKISTAN

104. Pakistan’s reform initiatives have resulted in improvements in the business environment and a reduction in the cost of doing business. The 2007 Doing Business in South Asia report25 ranks Pakistan 74 in a list of 175 countries and second in South Asia in terms of the private sector’s ease of doing business in the country. Pakistan’s performance on the doing business survey is summarized in Figure 12. The figure shows the strong and weak aspects of Pakistan’s business environment. Pakistan ranks above the global average in starting and closing a business, registering property, obtaining credit, and protecting investors. Areas where Pakistan overall ranks below the global average include dealing with licenses, employing workers, paying taxes, trading across borders and enforcing contracts. Critical issues in these weaker areas are examined below.

25 World Bank. 2007. Doing Business in South Asia 2007. Washington D.C

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Figure 12: Pakistan’s Performance on the Doing Business Survey

Source: World Bank. 2007. Doing Business in South Asia 2007. Washington D.C.

105. Enforcing Contracts: Pakistan’s worst performance on the doing business indicators is on enforcing contracts. Ranked way down at 163rd in the global comparison, this is the Achilles’ heel of Pakistan’s business community. It takes as much as 880 days to enforce a commercial contract in Pakistan, requires 5 procedures, and costs an average of 23% of a claim’s value. It is critical, therefore, to develop effective and efficient contract enforcement mechanisms to reduce delays and bring down the cost of doing business. Improved contract enforcement through emphasizing tax and labor market reforms, strengthening judicial and adjudication systems, and streamlining customs, licensing, and other regulatory procedures will promote formalization of the economy, generate greater public sector revenues, and result in higher private sector investment. Reforms are underway to improve contract enforcement include setting up of specialized administrative and judicial tribunals to resolve tax, banking, customs, labor disputes on a fast track basis, and establishing alternate dispute resolution mechanisms. But, these and other related reforms have to be pursued with commitment over the long-term to lead to result in strengthened property rights protection and greater private sector confidence for higher investment.

106. Dealing with Licenses: Obtaining licenses in Pakistan is complicated, requiring 12 procedures and costing almost 10 times the per-capita income (double the South Asian average), which relegates Pakistan to the 89th position globally on this indicator. The cost of obtaining licenses differs from province to province, mainly because of the differential in the cost of utility connections. Karachi, Pakistan’s main commercial city, is among the most expensive to obtain a business license as a result of the high cost of obtaining water, sewerage and electricity connections in the city. Pakistan’s poor rating on license thus also shows the lagging state of its basic infrastructure that translates directly into relatively high costs of doing business. 41

107. Employing Workers: Pakistan’s rigid labor market conditions are manifested in its low rank on the doing business indicator for employing workers. Pakistan is ranked at the 126th position globally on this indicator. Pakistan’s labor code enforces strict hiring conditions through rules governing temporary contracts and minimum wage. Social security payments or payroll taxes associated with hiring a new worker amount to 12% of the salary which is relatively high in the regional context. Firing conditions are relatively easier, but an employer must still pay the equivalent of 90 weeks of salary in severance, penalties and notice to dismiss a worker which is again comparatively high in the regional and global context. Such labor market rigidities have a negative impact on foreign direct investment flows as capital and investment move to countries with fewer or no labor market rigidities. For, example, countries such as China, New Zealand, Malaysia and Singapore put no limit on term contracts in labor markets. Recognizing the need to reform the labor market, the Government is taking steps to streamline and modernize labor codes, increase flexibility in hiring and firing, and lower costs of compliance.

108. Paying Taxes: Despite a relatively low tax rate for commercial profit, Pakistan ranks at a low 140th position on paying taxes, with tax administration remaining a key area of weakness notwithstanding some recent improvements. A standard business establishment has to make as many as 47 tax payments to various government agencies, and spends annually an average of 560 hours to file taxes. Tax reform is essential to broaden the tax base, further reduce average tax rates, and rationalize the number of taxes as well as the involved procedures. Reforms currently underway include setting up of large and medium taxpayers units in major cities, introducing e-filing of taxes, improving the system tax refunds, and establishing an easier codified taxation system that reduces individual discretion of the tax authorities. With this progress, Pakistan’s current ranking is an improvement over its 143rd rank on this indicator in 2006.

109. Trading Across Borders: Custom reforms in Pakistan have reduced the time it takes to export from 33 to 24 days and import from 39 to 19 days. However, Pakistan still ranks at a low 91st and 51st on these two indicators respectively. 8 documents are required for export purposes and 12 for import which is high in the regional context. Import and export costs have to be brought down through streamlining documentation requirements and improving processes for clearance. At the same time, modernization of ports and transportation systems is essential to exploit Pakistan’s strategic regional location to expand regional and global trade.

110. Intra-country Differences in the Business Environment: There is considerable variation in the performance of Pakistan’s major cities on the doing business indicators. For example, business start up costs are 25% higher in Karachi compared to other cities such as Faisalabad, Lahore, Sialkot and Peshawar that have eliminated stamp duty and reduced start up costs. In an investment climate survey, with respondents from the national business community, Karachi ranked second in terms of its investment friendliness, with Lahore first ranked as the choicest place for investment (Figure 13). The survey confirmed significant disparities between larger and smaller cities in terms of investment climate. For example, lack of skilled labor in the cities of Hyderabad and Sukkur raise business costs relative to Karachi. In addition, the law and order situation in smaller cities is of concern: businessmen cited the poor law and order as the foremost barrier to investment in the cities located in interior Sindh.

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Figure 13: Ranking of Investment Climate by City (perceptions of firms outside the city)

Percent 1 Best Better No Better 0.5 Worst

0

- 0.5

Quetta Peshawar Islamabad Sialkot Karachi - 1 Sukkur Hyderabad Gujranwala Faisalabad Lahore

Source: Investment Climate Assessment, Small and Medium Enterprise Development Authority and the World Bank. 2001.

3.4 PAKISTAN’S LAGGING COMPETITIVENESS

111. Competitiveness is key for private sector development. A State of Pakistan’s Competitiveness 2007 Report26 compares Pakistan’s rankings on the global competitiveness index (GCI)27 with a selected group of countries in the region (Table 14).

Table 14: State of Pakistan’s Competitiveness 2007

Source: Competitiveness Support Fund. 2007. The State of Pakistan’s Competitiveness 2007. Islamabad.

26 Competitiveness Support Fund. 2007. State of Pakistan’s Competitiveness. Islamabad. 27 World Economic Forum. 2007. Global Competitiveness Report. 43

112. It is apparent for the table that, Pakistan’s very low rank on health and primary education as well as higher education and training come out as among the most critical holding back Pakistan’s competitiveness. Interviews with members of the business community undertaken as part of the private sector assessment confirmed that the low quality of human resource skills available had increasingly become their main concern. (See Section VIII). Pakistan’s ranking is comparatively better for infrastructure, business sophistication, innovation and market efficiency.

113. But, it is apparent from Table 14 that each country included in the comparison has its highs and lows on the competitiveness rankings, with the exception of Malaysia which seems to rank high on all indicators. Bangladesh, for example, faces challenges on institutions, infrastructure and health and primary education. The Peoples Republic of China’s major strength is its macro economy, with a strong showing on infrastructure and health and primary education. India’s strengths are its institutions and infrastructure. Sri Lanka scores very high on primary education and health care. A brief overview of Pakistan’s ranking on selected GCI indicators and sub-indicators follows.

114. Institutions: Within institutions, Pakistan ranks the worst on the security indicator among all the sub-indicators for institutions (Figure 14a). This needs no explanation - the law and order situation has to improve to enhance the country’s competitiveness. As is evident from the figure, the ranking for property rights protection, private sector accountability, and corporate ethics also deteriorated between 2005 and 2006.

115. Infrastructure: Pakistan’s infrastructure ratings are mixed (Figure 14b). It ranks low on the quality of electricity supply and telephone lines (although mobile phones have recently led to a substantial improvement in the country’s tele-density). Pakistan ranks relatively better on the quality of transport and railway infrastructure despite some slippage in 2006 in the former. Pakistan’s overall infrastructure rank improved in 2006 over the rank in 2005.

116. Health and Primary Education: Pakistan’s dismal rankings on key social sector indicators including primary school enrolments, infant mortality, and malaria prevalence are confirmed in 16c. Rankings on many social indicators slipped further in 2006. Overall, Pakistan’s ranking on heath and primary education was the worst among all the GCI indicators and brings out the challenge of development of human resources in any strategy to enhance Pakistan’s international competitiveness.

117. Higher Education and Training: Pakistan ranks low and generally behind its comparative group on higher education and training. Despite some improvements in the quality of the educational system (ranked 74th), staff training and quality of management schools (ranked 71st), Pakistan continues to lag on enrolment for secondary and tertiary education.

118. Market Efficiency: Figure 14d shows that while Pakistan’s market efficiency rankings in 2005 were relatively high, there was a marked deterioration in 2006. Pakistan’s rankings on the all three sub-indicators: sophistication of financial markets; flexibility of labor markets; and distortions in good markets worsened between 2005 and 2006. This clearly indicates the need to deepen structural reforms to improve functioning of factor markets for greater efficiency and competitiveness.

119. Technological Readiness: Pakistan at the 77th position is ranked low on technological readiness (Figure 14e). The low technology ranking is also linked to Pakistan’s poor performance on the education and human resource development indicators mentioned before.

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Between 2005 and 2006, there was a marked deterioration of Pakistan’s ranking on firm-level technology adoption and technology transfer through FDI –most of the FDI. This is because in Pakistan in recent years has been centered in the services industry and has bypassed the manufacturing sector where the gains from technology improvements facilitated by FDI would have been the highest.

120. Business Sophistication: Pakistan scores well at 47th place with a relatively high rank in value chain presence, nature of competitive advantage, production process sophistication, local supplier quality and local supplier quantity (Figure 14f).

121. Innovation: Pakistan’s relatively good rank of 60 in the GCI is driven by improvements indicators measuring capacity for innovation, university/Industry research collaboration, and company spending on R&D. A larger improvement in Pakistan’s rank on innovation is, however, held back because of lack of availability of scientists and engineers (linked again to the issue of poor quality of human resources) and inadequate intellectual property protection. Given the poor quality of human resources, the country’s comparatively high rank on innovation comes as somewhat of a surprise. In all probability, this rank reflects the fact that the private sector entities selected for purposes of data collection comprised the top 120-125 corporate and multinationals operating in the country. This group could naturally be expected to have attained a higher degree of technological innovation than, for example, firms operating in the SME sector. Thus with a more representative sample, it is likely that Pakistan would have scored lower on the innovation indicator.

122. Implications of the GCI Results on the Role of Public and Private Sectors: The GCI findings confirm the many challenges confronted by Pakistan’s public and private sectors to achieve higher international competitiveness. Keeping the results of the competitiveness survey in view, the focus of the public sector at this point has to be on developing the necessary institutional frameworks, maintaining a stable macroeconomic framework, improving infrastructure, especially in the energy sector, and improving the quality and outreach of education and healthcare delivery mechanisms. The private sector has to also contribute in all these areas, particularly in strengthening private provision of public goods including infrastructure and social services to bridge the existing deficits that cannot be met by the public sector alone. In addition, the private sector has to lead in improving technological readiness in the manufacturing and services sector, investing more resources in research and development, and adopting international standards of corporate management and sophisticated business practices for greater efficiency and higher competitiveness.

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Figure 14a: GCI Rank on Institutions

Figure 14b: GCI Rankings on Infrastructure

Figure 14c: GCI Rankings on Health and Primary Education

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Figure 14d: GCI Rankings on Market Efficiency

Figure 14e: GCI Rankings on Technological Readiness

Figure 14f: GCI Rankings on Business Sophistication

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Figure 14g: GCI Rankings on Innovation

Figure 14h: GCI Rankings on Macroeconomy

Figure 14i: GCI Rankings on Higher Education and Training

Source: Competitiveness Support Fund. 2007. The State of Pakistan’s Competitiveness 2007. Islamabad

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3.5 SUMMARIZING THE WAY FORWARD FOR PRIVATE SECTOR DEVELOPMENT:

123. The World Wide Governance Indicators, the Doing Business in Pakistan report, and the Global Competitiveness Index (GCI) provide valuable insights into the governance, structural, and private sector specific factors that impedes Pakistan’s international competitiveness, raises the cost of doing business, and hampers the general business environment in the country. The following three factors come out as the critical ones from the point of view of developing the private sector in Pakistan.

124. Institutions and Governance The rankings have identified a critical need for strengthening contract enforcement mechanisms, improving property rights protection, and streamlining regulatory systems to improve the business environment for the private sector. The need for labor market reforms, strengthening the taxation system and improving licensing and customs procedures was also highlighted. Last but not the least, the analysis highlighted political stability and improvement in the law and order situation, and control of corruption as key elements of the strategy to strengthen private sector development in the country.

125. Infrastructure Development The analysis noted Pakistan’s very low rank on electricity supply. This indeed is becoming a binding constraint to Pakistan’s industrial development, particularly in view of the current electricity crisis, and needs to be overcome on an emergency basis. Although Pakistan seems to have fared better on transport systems, still there is a clear need for substantial improvements with respect to road and rail networks, ports and airports.

126. Improving the Quality of the Workforce: Among the most complex and structural challenges in the development of the private sector is developing educated, skilled, and in- demand human resources. Pakistan’s social sector delivery service mechanisms are dismal and rank amongst the lowest in the world. Technical education and vocational training systems remain supply driven and are not effectively connected to market demand. The result is a lack of quality manpower in all sectors that reduces total factor productivity of the economy. Development of human resources though focusing on primary, secondary, tertiary education and health sciences, and starting vocational and technical training system to better respond to the market demand for labor is thus a must for Pakistan to strengthen its international competitiveness. 49

SECTION IV

THE MISSING LINKS

127. This section identifies two-admittedly disparate areas that have been so far under emphasized but which have a great impact with respect to strengthening private sector development and sustaining future economic growth. The first area is that of the informal sector and SMEs. While generally looked at as separate, the two have a complex relationship whose dynamics need to be clearly understood. These sectors remain critical from the perspective of employment creation. The second area is that of climate change. While at first sight it might seem out of place to highlight in the private sector assessment an issue which is understood mainly as an environmental concern, the fact of the matter is that climate change patterns have an intrinsic link with challenges and opportunities for the private sector such as with respect to the performance of the agriculture sector (largely private sector driven), or introduction of clean renewable energies and modernizing public transportation systems, in both of which the private sector can have a key role. A related area of private sector involvement is the linkage between capital markets and climate change that is permeating through increased capital market funds available for investment in clean technologies.

4.1 THE SME and INFORMAL SECTORS:

128. The informal sector in Pakistan, despite being a major employer and contributor to economic activity in Pakistan remains virtually uncharted. The nature, structure and issues that impact the informal sector are neither properly documented nor researched. The Government does not have a vision or strategy for the informal sector, which is a significant disconnect, given the sector’s importance for labor adsorption and the growth of the private sector.

129. Pakistan does not have quantitative data on the contribution of the informal sector to GDP. Employment data for the informal sector is available in the Labor Force Survey (LFS). The LFS includes all household enterprises owned and operated by own-account workers in the informal sector. Excluded are all the informal enterprises engaged in agricultural activities or wholly engaged in non-market production. Consisting of primarily self–employed entrepreneurs in a variety of sectors, the informal sector remains a main source of job creation and employment in the country.

4.1.1 Employment Trends in the Informal Sector

130. According to the LFS, the informal sector during FY2006 accounted for 72.9% of the employment outside the agriculture sector, somewhat higher (75%) in rural areas than that of urban areas (71%). Table 15 captures the employment statistics in the informal sector. The informal sector's share in overall employment in the non-agriculture sector has been rising consistently over the years. It surged by five percentage points from 65% in FY2002 to 70% in FY2004 and to 73% in FY2006. In terms of gender, the concentration of male workers in the informal sector is higher was both the rural and urban areas. Table 16 shows that the largest informal sector employer was wholesale and retail trade with 34.5% of total employment in the sector in FY2006. This was followed by manufacturing sector at 21.3%.

131. Formal sector activities, due to logistics and facilities, are more concentrated in urban areas (29% of total workforce in the formal sector) as compared to rural areas (25%).

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Table 15: Formal and Informal Sectors- Distribution of Non- Agriculture Workers (%)

Source: Federal Bureau of Statistics. 2006. Pakistan Labor Force Survey 2005-06. Islamabad

132. Location, age and education have a major impact on employment patterns in the informal sector. According to a study, there is a concentration of very young and very old workers in the informal sector (82.5% of very young and 80.6 % of very old workers are employed in the informal sector), but this sector is not too attractive for those aged between 30- 39 years28. This study also notes that the informal sector has the maximum concentration of illiterate workers and a minimum representation of workers with secondary or tertiary level of education; approximately, 45% workers of the informal sector had never received any formal education.

Table 16: Informal Sectors Workers- Distribution by Major Industry Divisions

Source: Federal Bureau of Statistics. 2006. Pakistan Labor Force Survey 2005-06. Islamabad

28 Gennari, P. 2004. The Estimation of Employment and Value Added of Informal Sector in Pakistan" Bangkok. (UNESCAP) 51

4.1.2 Estimation of the Informal Sector's Contribution to GDP

133. The same study estimates29 the contribution of the informal sector to be 21.2% to GDP based on 2000 numbers (Table 17). The contribution of informal sector to GDP is substantial in the construction and wholesale and retail trade. The sector's contribution to transport and communications (24.6%) and to social, community and personal services (28.3%) is also large. In manufacturing, the value added produced in the informal sector is estimated at just over 15% of total output.

Table 17: Pakistan. Revised GDP and Annual Value added of the Informal Sector (1999- 2000)

Source: Gennari, P. 2004. The Estimation of Employment and Value Added of Informal Sector in Pakistan" Bangkok. (UNESCAP)

4.2 THE FUTURE OF THE INFORMAL SECTOR IN PAKISTAN

134. Pakistan’s Poverty Reduction Strategy Paper (PRSP)30 projects that high economic growth will promote employment in the formal sector and would lead to reduced reliance on the informal sector as the key provider of jobs in the economy. In a study31, however, the Swedish International Development Cooperation Agency (SIDA) contested the view that the informal economy is somehow transitory and that rapid economic growth would replace the informal sector with the formal sector as the key employer. The study notes that “the informal economy can no longer be considered as a temporary phenomenon. Furthermore, the informal economy has been observed to have more of a fixed character in countries where incomes and assets are not equitably distributed. It seems that if economic growth is not accompanied by improvements in employment levels and income distribution, the informal economy does not shrink”.

135. If this latter perspective holds true, and certainly some of the conditions mentioned in the SIDA report such as inequity in incomes and assets do appear to exist in Pakistan, it would be wrong to assume that the informal sector would shrink in importance with economic growth. It would be more appropriate to plan how the efficiency and productivity of the informal sector could be enhanced so that its capacity to generate better quality employment opportunities is enhanced. In this regard, the obstacles faced by the informal sector would need to be

29 Gennar.P. 2004. The Estimation Of Employment And Value Added of Informal Sector In Pakistan. Bangkok. 30 Ministry of Finance. 2003. Poverty Reduction Strategy Paper-I. Islamabad 31 Becker F. K.. 2004. Fact Finding Study on Informal Economy. SIDA

52 addressed. Included in the list of obstacles are infrastructure bottlenecks such as lack of power and electricity and insufficient access to transport; institutional factors such as poor skills base and lack of access to education and training opportunities for the labor force and inadequate property rights protection; and economic issues including limited access to technology and lack of access to credit (see Box 5).

Box 4: Key Issues in Development of the Informal Economy

– Infrastructure issues – Poor infrastructure such as transport, storage facilities, water, and electricity. – Lack of working premises. – Poorly developed physical markets. – Institutional issues – No access to formal training and, as a result, lack of skills in particular as regards basic economic skills and managerial expertise. – Lack of formal schooling sometimes even resulting in illiteracy. – Limited access to land and property rights. – Limited access to formal finance and banking institutions. – Reliance on self-supporting and informal institutional arrangements. – Too restrictive or cumbersome taxation systems and labor laws. – Excessive government regulations in areas such as business startup, in particular as regards cumbersome, time demanding and costly procedures for business registration. – Limited access to employers´ organizations, i.e. limited possibilities to exercise influence. – Lack of access to official social security schemes. – Lack of information on prices, viability of products, etc. – Fewer market opportunities due for instance to non-compliance to international standards. – Economic issues – Excessive registration and transaction costs of starting or operating businesses. – Limited access to technology. – Lack of opportunities for bulk purchase of inputs. – Lack of working capital: credit has to be obtained from informal sources such as friends or relatives or non-banking financial agencies with unfavorable terms. – Insufficient funds do not allow for further investments. Source: Becker. K. 2004. Fact Finding Study on Informal Economy. Stockholm

136. Given its importance for employment creation and its significant contribution to GDP, Pakistan’s private sector development strategy needs to recognize the criticality of the (presently) non-transitory nature of the informal sector and the need to promote enabling conditions under which the sector continues to effectively contribute to the national economy and employment.

4.3 SMALL AND MEDIUM ENTERPRISE SECTOR

137. The bulk of Pakistan’s informal sector comprises of individual agents and small and micro enterprises. Pakistan’s small and micro-enterprise sector is a primary generator of jobs. Over 99% of enterprises with a work force of less then 50 people32are based in the informal

32 Source: Federal Bureau of Statistics. 2005. Economic Census 2005. Islamabad

53 sector. The country, however, lacks a medium-sized enterprise sector as most small enterprises are unable to scale up operations and graduate to the “medium sized” category of enterprises.

138. In the above context, a key reason for the ‘M’ in the SME sector having not developed is that Pakistan’s financial sector lacks specialized financial institutions to nurture growth of small enterprises to medium sized enterprises. The lack of dedicated SME sector financial institutions is attributable to the lack of orientation and capacity to undertake cash flow based lending, with almost all lending being asset based. In addition, the human resources required to undertake SME financing on a large scale are not in place. The inefficient, unduly complex, and archaic land registration and transfer system removes land from the list of acceptable collateral and creates additional complication for SMEs seeking formal sector finance. The result is that despite a number of initiatives over the past decade, credit disbursed to the SME sector in FY2007 for various sectors had fallen to a pitiful Rs.26.5 billion from Rs.43.2 billion in FY2006 (Table 18). SME credit extension remains inadequate due to structural weakness, including lack of information and documentation, reluctance to disclose financial data, asset based lending, lack of information and awareness pertaining to SME lending products at the level of the consumer, complex lending processes, and dependence on collateral based lending. In the total private sector credit disbursement of Rs. 1,669.733 billion in FY2007, the share of the SME sector was a shocking 1.7%. Pakistan has only one dedicated financial institution for the SME sector-the SME Bank Limited. The SME Bank’s share in SME financing is only about 5%. While the SBP has been pushing for an expansion of credit to the SME sector and has had some success in this regard much more needs to be done. While the number of SME borrowers has increased from 67,000 in 2002 to 168,000 in 2006, the quantum in light of the size of the SME sector is still very low34.

139. The SME Bank is now slated for privatization. The privatization of the SME Bank has been supported by ADB under the SME Sector Development Program approved in 2005. The Privatization Commission (PC) constituted a transaction committee and initiated the transaction on 12 February 2007. A fundamental structural flaw in ensuring that the SME Bank continues to dedicate its support for the SME sector is that the bank has been granted a commercial banking license providing it with a strong motivation to enter into mainstream commercial banking which could impact its role as a dedicated financial services provider for the SME sector. Privatization in these circumstances could lead to the SME Bank being taken over by another commercial bank with the attraction of the commercial banking license, since risks with SME sector remain very high and are a major deterrent for financing in the sector whereas commercial banking is a well established highly profitable business. This, if happens, could lead to a further contraction in available credit to the SME sector.

140. In support of SME development, various labor laws have been revised through an extensive consultative process with stakeholders. As a result, new policy directions in the form of a Labor Protection Policy and a Labor Inspection Policy have been released with necessary amendments incorporated in the Factories Act of 1934. These policies balance worker’s welfare in the SME Sector with the need to rationalize the cost of doing business for SME enterprises. A Small and Medium Enterprise Development Authority is facilitating development of SME clusters by establishing Common Facility Centre in all provinces with focus on process-technology related services. For example the first CFC Sanitary-ware Development Centre is being set up in Gujranwala. However, given the overwhelming importance of the SME sector in generating

33 State Bank of Pakistan. 2007. SBP Annual Report 2006-07, Vol I. Karachi 34 State Bank of Pakistan. 2007. SBP Banking Sector Review 2006. Karachi

54 employment opportunities and contribution in value added, there is a need for continued emphasis on improving access to finance for SMEs, provision of business development services, to facilitate SMEs growth, and strengthening the overall enabling environment within which SMEs are facilitated to achieve their full growth and employment potential.

Table 18: Credit to SMEs (Rs. million)

Source: State Bank of Pakistan. 2007. Financial Stability Review. Karachi

4.4 CLIMATE CHANGE AND IMPACT ON THE ECONOMY AND THE PRIVATE SECTOR

141. Climate has a major impact on Pakistan’s economy with agriculture being a primary productive sector and the largest employer, and with a manufacturing sector dominated by the textile sector that has strong backward linkages with the agriculture sector. Despite being private sector driven, the agriculture sector in Pakistan is inefficient and has suffered in recent years due to droughts and environmental factors like water logging and salinity. A review of total factor productivity in the 1993 – 2003 period suggests that no growth took place35 in the agriculture sector with the major reasons being deterioration of the natural resource base, drought, reduced effectiveness of agricultural extension and outreach services and long term deterioration of water and soil quality. The impact of climate change, by making weather patterns erratic and reducing reliability of availability of water, would further reduce agricultural productivity and lead to food and raw material shortages, and result in major livelihood and jobs in the agriculture sector.

142. The adverse impacts of climate change are now well established. Table 19 summarizes key vulnerable sectors that could be affected by climate change. Pakistan, lying in the Arid and semi Arid Asian zone, would be affected because of the impact of climate change on food security and water resources followed by human health, impact on settlements and losses in biodiversity.

35 World Bank. 2006. Pakistan – Growth and Export Competitiveness. Islamabad 55

Table 19: Impact of Climate Change

Source: Intergovernmental Panel on Climate Change. 2001. Climate Change 2001: Impacts, Adaptation, and Vulnerability. Geneva.

143. In view of the above, Pakistan needs to mount a serious response to the challenge of climate change. To do this, it is essential to understand and analyze the vulnerabilities of Pakistan’s economy, especially in as much as these relate to the agriculture and industry sectors. Based on such analysis, measures need to be developed in close partnership with the private sector to evolve climate change coping strategies and generate innovative solutions to the challenge. Fiscal measures as well as investment initiatives to direct and stimulate private sector investment in appropriate clean energy technologies are essential. The potential impact of climate change must also be factored into medium and long term infrastructure development projects. This is especially important for infrastructural development projects that have long gestation periods such as dams, integrated water management systems, coastal developments and ports to name a few.

144. Europe has taken the lead to develop market based mechanisms in the private sector to work towards addressing the climate change challenge. The weekly “Economist” magazine maintains that Europe was home to the majority of carbon emission trading valued at a total of €40 billion36. Banks such as HSBC and ABN AMRO are actively financing investments in green technologies. The United States too is catching up with the Citibank having promised $50 billion in investment over the next 10 years to fight climate change. The Financial Times notes that individuals are also increasingly investing through mutual funds in renewable energy technologies including wind and social power37. Again most “retail” investments of this sort are happening in Europe. Notwithstanding the recent international financial melt-down, these developments in the international financial markets can over time have a significant demonstration effect on domestic capital markets in emerging and developing economies including Pakistan to raise private sector investment for climate change initiatives. Deepening of financial markets, development of the mutual funds industry, and mobilizing greater domestic savings are critical in galvanizing private sector investment in climate change in less developed countries.

36 The Economist. 15-21 March, 2008. The Greening of Wall Street.(www.economist.com) 37 The Financial Times. 24 March 2008. Investment is Key in Climate Change Battle. (www.ft.com)

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SECTION V

THE ROLE OF THE PRIVATE SECTOR IN INFRASTRUCTURE DEVELOPMENT

145. Pakistan's physical infrastructure is inadequate in comparison with world standards and has been identified as one of the critical reasons holding back more rapid economic growth in the country. The infrastructure sector in the country consists of power, telecommunications, roads, ports, railway, air transport, urban infrastructure, information technology cyber parks, and industrial estates. The public sector has been the main provider of basic infrastructure in Pakistan. However, given the major unmet needs and limited fiscal space, the Government’s capacity to address the infrastructure deficit is severely constrained. To augment limited public resources for infrastructure, private sector participation in infrastructure development has to be encouraged by creating the necessary enabling environment for increased private sector involvement. Supporting private sector participation in infrastructure development, therefore has to be a key element of ADB`s new Country Partnership Strategy (CPS) for Pakistan.

146. Table 20 compares Pakistan’s infrastructure indicators with those of South Asia, low income countries as a whole, and the OECD countries. While Pakistan holds up generally well on infrastructure sector performance compared to other South Asian and low income countries, it is clearly way below the averages for the OECD countries. Pakistan’s electricity and power infrastructure has already come under major strain, and there is a danger that the infrastructure sector in its totality will become a major bottleneck for continued growth and development unless a well designed long term strategy to enhance infrastructure investment and expand private sector participation in infrastructure development is evolved and implemented.

Table 20: Comparative Infrastructure Indicators for Pakistan South Asia Low Income OECD Indicators Pakistan Average Countries Average GNI per capita, Atlas method (current 600 806 411 33,470 US$) Access to electricity (% of population) 53 33 25 Electric power consumption (kwh per 363 241 401 8769 capita) Improved water source (% of population 90 72 64 99 with access Improved sanitation facilities (% of 54 48 38 population with access) Total telephone subscribers per 100 8 11 8 inhabitants

Source: Private Participation in Infrastructure Database. 2007. Available: http://www.ppi.worldbank.org

5.1 PRIVATE SECTOR INVESTMENT IN INFRASTRUCTURE:

147. The potential of the private sector to meet Pakistan’s pressing infrastructure needs is largely untapped. Thus far, Government initiatives to promote the private sector’s role have only succeeded to a certain extent with private sector investment having come in the power and cellular telecommunications sectors. The private sector is now also setting up an oil terminal at the Karachi Port. There is also a proposal to set up an urban mass transit system in Karachi by the private sector. But attempts to privatize the road infrastructure, for example, have met with little success. As another example, other than a public-private desalination project in Karachi, 57 the private sector has not financed any water supply and sanitation projects or projects targeted at solid waste management.

148. Available data (see Table 21) indicates that Pakistan had total private sector investment in infrastructure of US$17.206 billion during 1990 – 2006, with a major concentration (96%) in the energy and telecom sectors. There was very little private investment in transport and no investment in water and sewerage sectors. A large proportion of private sector infrastructure investment was in greenfield projects38. This has come about due to a slower than expected privatization of public sector infrastructure assets, lack of appropriate public sector assets to divest, and dearth of attractive sectoral policies. Greenfield projects in the energy and telecom sectors reflect investors’ desires to enter sectors where pricing, cost, and governance structures are well defined.

Table 21: Sectors for Private Sector Investment in Pakistan (1999 – 2006) Greenfield Sector Concession Divestiture project Total Energy 0 740 5,997 6,738 Telecom 0 4,047 5,678 9,725 Transport 283 0 460 743 Water and 0 0 0 0 sewerage Total 283 4,787 12,136 17,206 Source: Private Participation in Infrastructure Database. 2007. Available: http://www.ppi.worldbank.org

149. Despite the laggard interest of the private sector so far, the Government remains keen to tap private sector participation and investment in the infrastructure sector. The MTDF for 2005- 2010 has earmarked $16 billion for public sector investment in the infrastructure sector. Pakistan’s total requirements for infrastructure development over the next five years are in the range of $ 40 billion, but are much higher at about $65 billion if the planned large water storage dams are also included. The funding gap between the total requirements and the available Governments’ public sector resource is expected to be filled by the private sector. Such a strategy, however, seems very ambitious given the existing constraints to private sector participation in infrastructure development. Box 5 provides an international perspective on experiences with private sector participation in infrastructure development. This basically confirms that most private investment has concentrated in the power and energy sectors and that a number of challenges are faced by the private sector in the other infrastructure sectors. With respect to the latter, Box 6 highlights a number of a number of controversial infrastructure deals involving the private sector.

5.2 CONSTRAINTS IN PAKISTAN TO PRIVATE SECTOR INVESTMENT IN INFRASTRUCTURE

150. Private sector domestic investment and FDI inflows in infrastructure development in Pakistan are still very low despite a record overall increase of both domestic and incoming foreign investment in recent years. Besides the generic constraint to investment arising from the security situation in Pakistan and political events particularly in 2007 and 2008, two key factors hampering investment and infrastructure include underdeveloped financial markets and instruments and structural and policy constraints.

38 Greenfield projects are new factories, power plants, airports which are built from scratch on Greenfield land

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Box 5: The Global Perspective on Private Sector Participation in Infrastructure – Lessons & Policy Implications

Beginning with limited private participation in the infrastructure sector globally in the 1980s, private investment reached a high of US$ 110 billion in 1997-981 (Figure 43). This increasing trend was reversed after the East Asian currency crisis and private investment declined until 2004, after which it picked up again in 2004 and 2005. Like the case with Pakistan, the largest concentration of private sector investment globally in infrastructure is in the telecoms and energy sectors.

Figure : Substantial New Growth in Investment

Source: Private Participation in Infrastructure Database. 2007. Available: http://www.ppi.worldbank.org

The current international trend of private sector investment in infrastructure is based upon a greater emphasis on risk mitigation strategies concentrating in a few sectors like telecom, energy and transport where the regulatory and pricing structures are easier to design, model and enforce. The larger share of investment going to telecommunications suggests that sponsors are giving priority to sectors where consumer prices tend to be set at levels fully covering costs and where undue political intervention is relatively less frequent. Second, the focus on greenfield projects suggests that sponsors are seeking protection from political and regulatory risks. Indeed, in energy and water, greenfield projects primarily involve bulk facilities (power plants, water treatment plants) and include off-take agreements with a public party, shielding private operators from the politically sensitive consumer market. Also, the major modality for participation in infrastructure development are management and lease contracts, which require no private investment to reduce private sector risks.

Governments in developing countries since the late 1980s have sought private sector investment in infrastructure to generate fiscal space, tap offshore capital resources, inject new technology, develop domestic capital markets and generate greater efficiencies in the delivery of services. The tools for attracting private investment have ranged from privatization to greenfield projects to concessions. The unrealistic hype generated by some governments regarding the capacities and capabilities of the private sector were punctured in the late 1990s by a few well-publicized private sector failures (see Box 6). These were generally caused by poor initial privatization design, short term political and economic policies particularly those geared towards meeting immediate budgetary concerns, and regulatory failures and inability of investors to model unforeseen force majeure events into their business models. In some cases, the presence of foreign investment, especially in essential services sectors also generated political and social fallout that resulted in higher political risk ratings and the return requirements led to resentment and political turmoil. The sectors where the highest frequency of failure occurred were in water concessions and energy (Independent Power Producers). Analysis of private sector failures in infrastructure delivery is essential for identifying the root causes of failure, so that transaction designs can be improved and made more robust to mitigate most generic flaws.

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Box 6: High-Profile Controversies Involving Private Infrastructure

East Asia • Takeover of Bangkok Second Stage Expressway (1993) • Cancellation of Dabhol power plant (1994) • Renegotiation of Independent Power Producer (IPP) contracts in Indonesia, Pakistan and the Philippines (1998) • Abandonment of Manila water concession (2001) • Abandonment of Manila airport concession (2004)

Latin America • Mexican toll road bankruptcies (1995) • Cancellation of Tucuman water concession (1996) • Cancellation of Cochamba water concession (2000) • Cancellation of Arequipa electricity concession (2002) • Argentina’s economic crisis and devaluation threatens to bankrupt private utilities (2002)

Industrialized Countries • California’s electricity crisis (2000) • Railtrack bankruptcy (2001)

Source: Gomez, A.Jose, Dominique Lorraine and Meg Osius. 2004. The Future of Private Infrastructure. Cambridge Massacheutts: Taubman Center for State and Local Government Kennedy School of Government, Harvard University.

5.2.1 Undeveloped Financial Markets and Instruments

151. The bulk of private sector financing for infrastructure development in Pakistan, concentrated in the telecommunication and financial sectors, has been generated offshore and entered Pakistan as FDI. In order to encourage private sector financing in other infrastructure sectors like road networks and transportation and water and sanitation, it will be essential to tap domestic financial markets given that foreign capital would be less likely to flow in these “riskier” sectors. However a major constraint to generating domestic sources is the absence of a secondary market in debt securities and the Government’ pre-emption of funds of large public sector savings institutions like the State Life Insurance Company and provident and pension funds – some of the potential major providers of long-term investment funds. The absence of an active market in long-term debt securities is a major reason for the dearth of local financing in the amount and tenor required to finance infrastructure.

152. Considering the large investment requirements for infrastructure development, direct financing from financial institutions would be insufficient given the balance sheet and credit exposure limitations of these institutions. The alternative would be to raise funds directly from the public. To do this would require, in conjunction with ongoing capital market reforms, raising institutional capabilities and developing financing instruments that more appropriately meet the long-term financing requirements of infrastructure projects so that resources can be mobilized on a sustained basis. Over time, financial institutions should develop the requisite skills for formulating, developing, appraising, supervising, and providing advice to infrastructure projects in the different sub sectors. The ultimate objective is to develop a mechanism where private financing would be available without the need for multilateral or Government support. Over the long-term, only an efficient and properly functioning banking sector and capital market can sustain large-scale infrastructure financing in the country. At present, the capacity of Pakistan’s

60 capital market remains limited relative to requirements and lacks the needed depth of instruments and maturity profile to meet the complex financing requirements of infrastructure projects, which typically have very long gestation periods. While some progress in developing a corporate bond market was made during the period 2000 – 2003 using typically term finance certificates (corporate debt paper issued in Pakistan with maturity generally not exceeding five years), the stock market boom and low interest rates effectively stopped further growth and development of the market for longer term maturity bonds. In addition, markets or instruments do not exist at present for zero coupon municipal bonds in Pakistan due in part to the legal constraint on local and provincial government to directly issue debt.

5.2.2 Structural and Policy Constraints:

153. Public and Political Support: It will be important to develop political consensus and public support for private sector participation in infrastructure especially for privatizations and concessions. To this end, privatization of essential services should not be treated as an end in itself–rather the focus should be on ensuring clear improvement in service delivery, higher coverage, and rationalized pricing. Removing of massive subsidies and price distortions would require effective publicity campaigns to generate support. Transparent renegotiation systems, fair arbitration and buy-back options would be required to deal with contingent possibilities. Regulatory discretion needs to be designed and used within well designed structures and systems where public consensus and support are maintained.

154. Development of Appropriate Divestment and Regulatory Structures: Appropriate divestment structures – privatizations, concessions, and lease and management contracts need to be coupled with adequate regulatory capacity. Optimal durations of concessions and lease and management contracts need to be determined for each sector or category of divestment. Contract structures, especially in long term contracts of 10 years or more, should cater to the potential origination of disputes due to contingencies or events not earlier envisaged. The degree of regulation, discretionary regulatory power and capacities of the regulator to regulate needs to be based on individual sectoral requirements. In natural monopolies where market power is evident, stronger regulatory powers and capacities need to be developed while in those sectors where monopoly power is weak or there is sufficient competition, regulation needs to be rationalized.

155. Identification of Public and Private Sector Roles and Concentrations: Not all infrastructure sectors are suitable for private management or ownership. Nuclear power plants and urban water distribution systems39, for example, are not particularly attractive privatization or pure private sector candidates. PPPs can, however, be undertaken where complementarities between private and public sectors are enhanced. For example, bulk water supply by the private sector with public sector distribution and private sector collection could be a model in municipal water supply that creates complementarities.

39 Price of water generally covers a smaller share of costs than prices of other utilities thus requiring government subsidies or higher tariffs which generates political controversy and interference. Also, being capital intensive, it is not amenable to short term contracts but long term contracts can lead to serious disputes. 61

5.3 PUBLIC PRIVATE PARTNERSHIPS (PPP) FOR INFRASTRUCTURE DEVELOPMENT40

156. Through an ADB supported initiative,41 the Government is aiming to establish an enabling framework and environment for promoting public-private partnerships for infrastructure development. This includes developing a Public-Private Partnership (PPP) policy framework, developing institutional capacity to close PPP deals, and providing long term infrastructure financing. The Government’s focal point for developing this policy framework and institutional capacity is the Infrastructure Project Development Facility (IPDF), whereas the long term financing will be channeled through an Infrastructure Project Financing Facility (IPFF). Key constraints to developing viable PPPs for infrastructure development are broadly similar to the ones that impede pure private sector investment in infrastructure projects. Some of the key constraints include the following.

5.3.1 Constraints for PPPs

157. Lack of Explicit PPP Policy: Pakistan until recently did not have any policy framework for promoting PPPs in infrastructure development. The IPDF in September 2007 formulated a PPP policy document. This document, however, remains a draft and legal and policy support at the federal, provincial and local government levels to encourage PPP initiatives remains unclear. The PPP policy needs to, therefore, be applied at the earliest to provide clarity on the Government’s strategic approach to public-private partnership.

158. Lack of Capacity and Structural Issues: Due to lack of experience, the capacity in the public sector for promoting and developing PPPs for infrastructure development is limited, particularly in terms of disaggregating and allocating risks and effectively managing the competing interests of the private sector focused on project revenues and the public’s sector emphasis on asset creation. The lack of the public sector’s institutional capability to prepare viable PPPs means that priority areas for private sector participation are not properly identified and feasible projects not developed for bidding. The lack of financial engineering expertise brought about by a lack of appropriate financial instruments, financial institutions and immature domestic debt markets generates difficulties in packaging projects that could be successfully offered for financing.

159. These constraints generate major challenges for the implementation of PPP centric infrastructure development envisioned by the Government. In addition, PPP projects in many sectors, especially in hydel power generation, water supply, sanitation, solid waste management and urban transportation fall under provincial and/or local government jurisdictions. Capacity levels at lower levels of government are generally even more inadequate to deal with the private sector and address challenges posed by PPPs as there is a complete lack of appropriate institutional structures and processes, systems and procedures, and capable dedicated staff.

160. Ineffective Public Procurement Mechanisms: The current public procurement laws as well as public procurement approval processes are cumbersome and outdated. It is unclear the

40 Public Private Partnership (PPP) is a partnership between the public and private sector for the purpose of delivering a project or service traditionally provided by the public sector. Public Private Partnership recognizes that both the public sector and the private sector have certain advantages relative to the other in the performance of specific tasks. By allowing each sector to do what it does best, public services and infrastructure can be provided in the most economically efficient manner. 41 ADB. 2006. Report and Recommendations of the President to the Board of Directors for a loan to Islamic Republic of Pakistan on Enhancing Private Participation in Infrastructure. Manila.

62 extent to which PPP projects need to follow these laws and procedures. The Government’s project approval system through the PC-Is at this point does not require PPP option analysis for projects. There is, therefore, no compulsion to seriously consider private sector participation in projects to be extended under the public sector development program.

161. Financing Constraints: Financing is a major concern for PPP projects in the absence of long-term financing requirements. Financial institutions in most cases lack the skills for appraising PPP infrastructure projects from a risk and viability perspective in the various sub- sectors.

5.3.2 Issues, Challenges, and Way Forward on Private Sector Participation in Key Infrastructure Sectors in Pakistan

162. Power Sector: In 1993/94, the Government decided to allow private sector participation in power generation with a package of incentives and guaranteed returns on investment. Today, there are 14 independent power producers (IPPs) in Pakistan. Their total installed capacity at 5,859 MW is about 30% of the total installed electricity generation capacity in Pakistan (Table 22). In addition to the IPPs, one hydel power plant has also been commissioned by the private sector. A Private Power and Infrastructure Board (PPIB) was set up in 1994 to implement the Government’s power policy of 1994 for the private sector and act as a single window facility for investors. Though the power policy enabled quick setting up of private power plants, procedural drawbacks including the absence of international competitive bidding procedures, unstaggered timing of the plants’ commissioning, poor planning of the location of the power plants, inappropriate choice of fuel, and guaranteed high power prices to IPPs, presented a number of fiscal, financial, and transparency related issues in the evaluation of the IPP projects. The payments to the IPPs subsequently had a large adverse impact on the budget. The tariff issues with the IPPs have been since amicably resolved.

Table 22: Total Installed Generation Capacity (MW)

Source: Ministry of Finance. 2007. Pakistan Economic Survey 2006-07. Islamabad

163. A National Electrical Power Regulatory Authority (NEPRA) was established in 1997 to regulate the power sector and issue licenses, enforce standards, approve investment and power acquisition programs of utility companies and determine tariffs for generation, transmission and distribution of electric power. However, NEPRA’s independence has remained undermined due to inadequacies in the NEPRA Act and the lack of rule based regulatory oversight. At the same 63 time, private sector participation remained limited mainly to power generation whereas the present policy allows private sector participation in distribution as well (but not in transmission). So far, the Karachi Electric Supply Company is the only one that has been privatized and, is, therefore, the only distribution company in the private sector. Attempts to privatize the Faisalabad and Peshawar Electric Supply Companies have so far not been successful due to bottlenecks created by the existing regulatory structures and the economic viability of these companies under the existing tariff regimes. Appendix 4 lists the generic constraints to private sector investment in the energy sector. However, the process of restructuring of distribution companies is underway with the process of rationalization, unbundling and corporatization, which will facilitate the ultimate privatization of these companies.

164. Pakistan water sector strategy identifies a major role for the private sector in hydel projects that provide both water resources as well as energy but states that the environment is not conducive to private sector investment. 42 Table 23 details the major identified potential private sector hydropower projects identified by the Government. These projects have, however, so far not elicited much interest from the private sector given the absence of an enabling regulatory and legal environment and tariff policy. The NEPRA Act, for example, is not even applicable to the Azad Jammu and Kashmir (AJK) and the Federally Administered Northern Areas (FANA), which are rich in hydel potential and offer the greatest possibilities for private sector involvement in energy sector.

Table 23: Potential Private Sector Hydropower Projects (Rs. million)

Source: Ministry of Finance. 2007. Pakistan Economic Survey2006-07. Islamabad

165. To plug the increasing gap between the supply and demand of electric power, the Government is increasingly looking into alternative energy possibilities and an Alternative Energy Development Board (AEDB) was established in 2006 in the office of the Prime Minister. The AEDB has issued letters of interest (LOIs) to eighty two national and international companies for proposals to generate 700 MW of power through wind energy by 2010 and 9700 MW by year 2030. However, implementation remains weak and slow.

42Ministry of Water and Power. 2002. Pakistan Water Sector Strategy. Islamabad. (Funded by the ADB under TA 3130-PAK: Water Resources Strategy Study)

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166. The overall business environment for PPPs in the power sector needs to be substantially strengthened. There is confusion about the roles of the PPIB, therefore, AEDB and IPDF and possible duplication in their activities. Since the Government is the guarantor, it is directly involved in the preparation of project documents, which further complicates the situation. Several agencies have jurisdiction over projects simultaneously, which adds to the complexity of implementing projects.

167. The diminishing reserves of gas have caused the Government to be more cautious in committing gas supply for life cycles of power projects. This has severely impacted development of gas-based thermal projects in the private sector. Investors under the existing policy environment also have to bear cost escalation risks for civil construction in hydel projects. Tariff issues spill over to the wind energy sector too, where the tariffs remain unsettled and tax breaks undefined, leading to the projects' quoted costs being revised lower by the regulator. This results in distorted tariff determination which in turn leads to a lack of interest and investment in the sector. The exclusive franchise rights to state-owned distribution companies (DISCOs) inhibit private investment in the distribution sub-sector. The current legal constraints also restrict the development of small scale or grid-isolated distribution networks from meeting local distribution needs.43

168. Gas: In view of high petroleum prices, gas has gained critical importance as a low-cost fuel in Pakistan. Natural gas is used in general industry to prepare consumer items, to produce cement and also to generate electricity. Compressed natural gas (CNG) is a popular choice as fuel for cars. The private sector is taking advantage of the low price of CNG to convert vehicles from petrol to gas. In the last year alone there has been a 35 percent increase in the number of vehicles running on CNG in the country. Pakistan has become the largest user of CNG in Asia and third largest user in the world after Argentina and Brazil. There are many private companies involved in gas exploration and production activities. There are two public sector companies involved in gas exploration namely the Oil and Gas Development Company Limited (OGDCL) and the Pakistan Petroleum Limited (PPL). The Government is providing incentives to the private sector for import of liquefied natural gas (LNG). For this purpose, it developed the first ever LNG policy in FY2006. There are plans to develop an offshore LNG terminal at Port Qasim to boost import and availability of LNG in the country.

169. Telecommunications: Private sector participation in development of the telecommunications sector in Pakistan is a success story. The telecom sector is now almost entirely in private sector hands and continues to witness very high growth rates. The tele- density in the country has reached an all time high of 40.2 percent (end of April 2007) compared to only 2.8 percent at the end of 2000 (Table 24 and Figure 15). This has made Pakistan a lead performer in the sector in the subregion. Revenues of telecom companies that had already reached Rs.193 billion in FY2006, and crossed Rs.240 billion in FY2007.

170. The telecom sector’s success is based on the Government’s policy of liberalizing and privatizing the sector and the setting up of a strong regulator, the Pakistan Telecommunication Authority (PTA), based on international best practice. The fact that the telecom sector allows pricing that fully covers costs, generates generally low political pressures and has well mapped risks and risk mitigation strategies, makes it a sector of choice for private sector infrastructure investment. Pakistan Telecommunications Limited (PTCL) is still the market leader with a share of 98 percent of fixed line subscribers. PTCL was privatized on 12 March 2006 with the

43 ADB. 2005. Constraints to Private Sector Investment in Infrastructure. Manila. (produced under ADB funded technical assistance Loan 2178) 65

Emirates Telecommunications Company Etisalat purchasing a 26% stake of PTCL for $2.5 billion.

Table 24: Pakistan’s Teledensity in Comparison with other Regional Countries (%) FY2003 FY2004 FY2005 FY2006 FY2007* Pakistan 4.3 6.3 11.9 26.2 40.2 Sri Lanka 12.2 16.6 23.4 29.0 37.0 India 7.1 8.9 11.5 12.8 15.4 Bangladesh 1.6 2.0 4.5 9.0 15.0 Nepal 1.8 2.0 3.0 3.5 6.5 Teledensity includes fixed, WLL and mobile *As of 30th April 2007 Source: Ministry of Finance. 2007. Pakistan Economic Survey 2006-07. Islamabad.

Figure 15: Teledensity of Pakistan (%)

Teledensity of Pakistan

40

35

30

25 Fixed

% 20 Cellular WLL 15

10

5

0 2001-02 2002-03 2003-04 2004-05 2005-06 Mar-07

Source: Ministry of Finance. 2007. Pakistan Economic Survey 2006-07. Islamabad

171. The cellular mobile industry is completely private and has grown tremendously in recent years. The number of mobile users has risen from 12.7 million in 2005 to 68.5 million by August 2007.44 Mobile phone coverage now extends to one third (35%) of the country’s total population. As shown in Figure 15, the cellular component of teledensity has increased dramatically from 1.16 percent to a substantial 35.79 percent between 2001 and 2007. Wireless Local Loop (WLL) phones have also begun to penetrate the local market. There is intense competition amongst the cellular operators to provide competitive services. The result is lower tariffs, expanded networks, customized services and high tech services.

172. Roads: Despite large public sector investments in the road sector led by the National Highway Authority (NHA) at the federal level, the present road network is under rising pressure because of higher traffic flows that are outpacing increases in capacity. At the same time, railways continues to be a dilapidated sector that leads to 95% of the domestic freight sector

44 Pakistan Telecommunication Authority. 2007. Annual Report 2007. Islamabad

66 being carried by roads.45 However, there is little or no private sector investment in the roads sector. Keeping in view the large unmet requirements of the road sector, the NHA has on offer build-operate-transfer projects for national highways since 1997. The NHA issued a policy framework in 1999 and incentives to attract private sector participation on national highway projects but these efforts have not borne fruit. Of the two projects awarded to the private sector by the NHA, one contract was cancelled and is now under litigation while the other project developer was unable to mobilize the finances required for constructing the road project.

173. NHA has a further six BOT projects in the pipeline with a total estimated cost of $ 150 million. The Provincial Government in Punjab has also taken several steps to increase private sector participation in the roads sector, including the establishment of a dedicated private sector cell in the Communications and Works Department as well as establishing a Punjab Road Infrastructure Company where toll revenues are deposited to be used for pre-feasibility studies for road infrastructure. The Sindh Government is also considering the construction of its provincial roads by the private sector but not much work has so far been carried out. With the limited success so far, an in-depth analysis should assess the impediments to the implementation of the current policy, incentives, and the legal framework to attract private sector development for roads development. The capacity of the concerned agencies to conduct pre- feasibility studies and prepare road projects for tendering, the issues of land acquisition, and the lack of setting of the toll fee at reasonable levels, are amongst the main concerns that would need to be addressed from the perspective of the private sector to encourage greater investment into the sector.

174. There is no PPP Policy framework for the roads sector despite recognition for its need in the MTDF (2005-2010). "PPP Option Analysis" is not considered a legal requirement at the feasibility stage of projects and there is ambiguity in the definition of legal boundaries of the respective mandates of the federal and provincial road agencies in concluding PPP deals in the sector. Lack of legal power to assign toll receivables, and guarantee against opening alternate routes increases risk and impedes private sector investment in financing highway projects. Appendix 5 details a list of constraints of private sector investment in roads and railways.

175. National Trade Corridor: The "National Trade Corridor" (NTC) is a flagship initiative of the Government aimed at revamping the whole transport sector including ports, roads, railways and aviation. Its underlying objective is to “decrease the cost of doing business through improvements in the trade logistics46". The NTC emphasizes enhanced private sector participation in transport and use of modern technology to increase sector efficiency and improve asset management with consolidation, up gradation, and maintenance of the existing system. An efficient and well integrated transport system will develop a competitive economy and create vast opportunities to reduce poverty. It will also ensure safe mobility and augment regional connectivity. The NTC is contemplated as a stepping stone towards establishing an energy and industry corridors in future. Progress is being made in implementing the NTC but major constraints remain in attracting greater private sector participation in the various infrastructure sectors that comprise the integrated vision of the NTC.

176. Urban Mass Transit Systems: After decades of neglect, urban mass transit systems are again receiving attention, particularly in the major cities of Karachi and Lahore. However, private sector participation has so far not been meaningfully solicited in developing urban mass transit systems. Past attempts like the Punjab Urban Mass Transit Program in 1998, and the

45 World Bank. 2007. Transport Competitiveness in Pakistan. Islamabad 46 Ministry of Finance. 2007. Pakistan Economic Survey 2006-07. Islamabad 67 revival of the Karachi Circular Railways Project made little progress and never achieved their designed level of capacity or invited any significant degree of private sector participation. A Lahore Mass Transit System is being planned with very strong support from the Punjab Government. Technical assistance from ADB will help prepare the project. The Government of Punjab is keen to attract private sector participation in the project and anticipates that about half of the investment required from the project will come from the private sector.

177. Railways: There has been almost no private sector activity in the railways sector. Plans to privatize railways and allow the private sector access to the sector in the freight, freight handling, and transportation areas have not been implemented. The railways sector continues to languish and lose ground to road transportation despite Pakistan’s geographical and locational advantages for developing an efficient and profitable rail network. Consequently, Pakistan Railways is a non profitable, technically insolvent public sector entity, which is beholden to the Government for debt servicing, asset replacement and pension payments. The Railways Act has remained unchanged since 1890. While the Act allows for private sector participation in railways, it establishes the Government in conflicting roles both as a competitor and regulator. This Act needs revision to produce effective PPPs in the railways sector47. In addition, a business plan developed for 2005-2011 that emphasizes private sector participation in an attempt to increase responsiveness, efficiency and competitiveness of the railways sector needs to be expeditiously implemented.

178. Airlines: The public sector owned Pakistan International Airlines (PIA) is still the dominant player in Pakistan’s aviation industry in terms of market concentration. The private sector, however, operates four out of the five domestic airlines in Pakistan, spearheaded by Airblue, Pakistan’s fastest growing private airline. PIA is inefficient, bloated by overstaffing and unprofitable. PIA’s losses after taxes significantly increased from Pak Rs. 4.5 billion in 2005 to Pak Rs. 13.2 billion in 200648; it carried 2.5% less passengers; its old planes were grounded; and it was refused landing rights in the EU because of flight safety and maintenance concerns. Based on the development, PIA posted Rs.38.4 billion losses by the end September 2008, compared to a Rs.10 billion loss in the same period last year. Previous attempts to privatize PIA were aborted because of pressure from the highly organized anti-privatization labor unions, lack of real political will, and the poor financial health and structural inefficiency of the airline that made it unattractive for the private sector. After a series of set backs in 2007 including management problems, the privatization of PIA appears to be back on the agenda. But without political will and a well developed and an effectively executed privatization plan, this will continue to prove difficult.

179. Airports: After being dominated fully by the public sector, the private sector is slowly becoming active in the development of airports. The regulator – Pakistan’s Civil Aviation Authority - is proposing private participation in the development of a new international airport at Islamabad. Private sector participation is also being solicited for the new international airport proposed at Gwadar. The private sector has already built an airport at Sialkot on a build, own, and operate basis.

180. Sea Ports: The bulk of Pakistan’s international trade, about 40 million tons per annum of dry and liquid cargo, is handled by the two seaports of Karachi and Port Qasim, located about 50 kms from each other. Both these ports are state owned as is the new port developed at Gwadar. Some functions at these ports have, however, been handed over to the private sector.

47 ADB. 2005. Technical Assistance to Pakistan for Support of Infrastructure Investment. Manila 48 Pakistan International Airlines. 2007. Annual Report 2006. Karachi

68

The Karachi Port Trust (KPT) adopted a Landlord Port Strategy in 1997 under which KPT would own the basic infrastructure and land but lease out regular operations. Accordingly crane operations and crawler crane operations have been given to private operators. The KPT awarded the development of an international container terminal to the private sector on a BOT basis. It also has a proposal to develop a bulk cargo terminal as well as a cargo village through the private sector. Port Qasim too has a privately operated container terminal. The management and operations of the new Gwadar port have been also leased out to the private sector by appointing the Singapore Port Authority (SPA) in-charge of management and operation of the port under a 40 year agreement with the Gwadar Port Authority.

181. The role of the private sector in port operations, continues to be constrained because of significant bottlenecks. Under KPT Act of 1886, the scope of PPPs in port operations remains limited to leasing out specific functions. There is an absence of a clear, transparent and detailed PPP framework in legal and policy terms to attract a greater private sector role in ports management. The port authorities remain victims of a governance over-centralization constraint'49, which is inbuilt into the port statutes. The lack of regulation by contract fails to develop a level playing field for the private sector. This results in discriminatory treatment of port operators.

182. Water Supply and Sanitation: Water supply systems are owned, managed, and operated by public sector agencies through water supply and sewerage boards. Lack of private sector participation, deteriorating institutional capacities of key water sector institutions, inadequate operation and maintenance funding, and poor cost recovery are among the key issues faced in the water sector. Poor management of existing networks suggests that efficiency could be greatly improved by introducing private operators and measures to provide an adequate revenue stream. Globally, the reasons why private sector investment is not generally forthcoming in the water supply and sanitation sector include: the complexity involved in designing flexible pricing models to ensure that costs are met over a medium to long term; the high political interference in the sector; and limited capacities of local governments to deal with complex PPP issues. Pakistan also faces the same issues in this sector. From a private sector perspective, major constraints to increased private investment in the sector in Pakistan include absence of a legal and policy related PPP framework and lack of a rules-based framework for PPP transactions. Also, the National Water Policy is still not approved despite the fact that is was drafted four years ago. Consequently, no urban water supply and sanitation projects have so far been undertaken with private sector participation. The IPDF is currently working on developing a number of water supply and sanitation projects for private sector participation under a PPP framework.

183. Solid Waste Management: Poorly serviced by the public sector, with no participation by the private sector, Pakistan’s existing capacity to dispose off solid waste in Pakistan is estimated at only 25% of the total solid waste generated by municipalities and industries in the country. The main issues in solid waste management are inadequate and inappropriate collection and disposal of solid wastes, and lack of monitoring, collection and disposal of municipal and industrial solid wastes. Private participation in solid waste management is being pursued by the Government and is a priority area for setting up PPPs. Unfortunately, however, solid waste management is a service that have even globally failed to attract much private sector interest due in great part to high risks and lack of effective and adaptive pricing mechanisms. Consequently, there has not been much progress so far in attracting private investment in solid waste management.

49 ADB. 2005. Technical Assistance to Pakistan for Support of Infrastructure Investment- Pakistan. Manila 69

5.4 RECOMMENDATIONS FOR PROMOTING PPP IN PAKISTAN

184. The PPP policy framework and accompanying laws and regulations need to be finalized and approved at the earliest. The capacity in the public sector to develop PPP projects for private sector financing needs to be strengthened by bringing in outside expertise as necessary. The feasibilities for infrastructure projects in the key sectors prepared in the public sector should mandatorily examine the scope and opportunity for private sector participation. Capital markets need to be deepened and encouraged to provide long-term finance to support the role of the private sector in infrastructure development.

185. Given that the responsibility for development of many infrastructure sectors rests with the provincial and local governments, these lower tiers of government must be fully involved in the identification of PPP projects and in closing deals with private sector parties. To do this, provincial and local governments need to significantly build up their capacity to partner with the private sector on infrastructure projects. Provincial and local government, could also consider becoming stakeholders in the IPDF. The IPDF itself needs to be strengthened and its range of services expanded to include training for both the public and private sectors in the development of PPP projects.

186. To overcome financing issues, the establishment of the IPFF needs to be expedited to promote availability of long-term rupee financing to meet the needs of infrastructure investment. The IPFF should have an independent board with representation from the private sector to ensure that financing decisions are transparent and made on merit. At a subsequent stage, the possibility of privatizing both IPDF and IPFF with a minimum 50% stake divested to the private sector should be explored.

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SECTION VI

6.1 ADB AND PRIVATE SECTOR DEVELOPMENT IN PAKISTAN

187. The critical role of the private sector in supporting Pakistan’s development is not a subject of debate. How to strengthen and support, the private sector under an improved enabling framework and environment is the real issue and challenge. From the analysis of the previous sections, the key constraints to private sector development in Pakistan could be summarized as the following: unstable political environment and a deteriorated security situation; macroeconomic deterioration; institutional problems including weak regulatory structures, poor property rights protection and contract enforcement; ineffective policy and legal framework for private sector investment and PPP; and low capacity of state agencies to interact and collaborate with the private sector; inefficient pricing regimes; dilapidated infrastructure with major shortfalls in the energy sector and bottlenecks in the transportation sector; inadequate access to long-term capital and project finance; and a weak and narrow manufacturing base. Important constraints that have yet to be tackled in any effective manner are issues of how to develop the SME sector and how to address the issues and requirements of the informal sector.

188. To effectively tackle these challenges and constraints, ADB is assisting in supporting an enabling environment to reduce the cost of doing business for the private sector, and leveraging equity and debt finance to promote greater private sector in infrastructure, finance, and other sectors. ADB’s focus on private sector development (PSD) in its developing member countries rests on the following four pillars. 50

• Governance in the public and private sectors, including privatization of state- owned enterprises • Financial Intermediation, through financial sector reform, promotion of long-term capital markets, local currency financing, and support for small- and medium- sized enterprises • Public-Private Partnerships in physical and social infrastructure, as well as agricultural and rural sector development • Regional and Subregional Cooperation to support inter-developing member country cooperation toward common goals

189. ADB’S support for the development of the private sector in Pakistan has been channelled through the two windows of public sector operations and private sector operations. The former has focused on improvement in the governance, regulatory, and institutional frameworks to provide a supportive environment for development of the private sector in the country through policy-based budget support. The latter has provided direct financial support for private sector investments in key priority sectors through a combination of debt and equity finance.

6.2 ASSISTANCE TO THE PUBLIC SECTOR FOR DEVELOPING THE PRIVATE SECTOR

190. Selected examples of ADB’s assistance in Pakistan to create an enabling environment for private sector development are summarized in Tables 25. As an example, a Capital Markets Development Program (CMDP) approved in 1997 helped improved corporate governance structures by transforming the erstwhile Corporate Law Authority into the Securities and

50 ADB. 2007. Available: http://www.adb.org 71

Exchange Commission and developed its institutional capacity. It also helped in broadening Pakistan’s capital markets and making them more robust and efficient. Subsequent reforms in the non-bank financial sector were supported through a Financial Markets and Governance Program (FMGP) approved in 2002 that assisted in further strengthening of regulatory capacities and introducing a framework for mobilization of long-term resources for savings and investment through market-based financial instruments and institutional investment. A key contribution of the FMGP was supporting the entrance of asset management companies in Pakistan’s capital markets. Continuing with the financial sector, a Second Generation Capital Markets Reform Program approved in 2007 aims to increase resource mobilization through the capital markets for productive investment and employment generation by providing efficient savings vehicles for retail and institutional investors, and diversified funding sources for enterprises.

191. An Accelerating Economic Transformation Program approved in 2008 seeks to strengthen the supervisory and regulatory environment for the banking sector and support greater autonomy of the State Bank of Pakistan. A Microfinance Sector Development Program helped introduce the legal framework and prudential regulations for the microfinance sector and assisted in the establishment of the largest microfinance bank in the country. A subsequent Access to Financial Services Program approved in 2006 aims to increase access to financial services by the self employed as well as micro and small enterprise companies. A Trade, Export Promotion and Industry Program assisted in liberalizing the economy through rationalizing tariff regimes and improving customs procedures and systems. An SME Sector Development Program supported the privatization of the SME Bank and established a Business Support Fund that provides equity support to ease the financial constraint on SMEs.

Table 25: Public Sector Interventions with PSD Focus: Some Examples SECTOR YEAR AMOUNT DESCRIPTION Capital Market 1997 US$ 250 This loan was designed to augment the mobilization of Development million long-term resources and improve efficiency of Program allocation through a diversified and competitive capital (CMDP) market. Results achieved included modernized infrastructure of the stock exchanges and establishment of the Securities and Exchange Commission of Pakistan as an autonomous regulatory body replacing the Corporate Law Authority, which improved market efficiency and transparency

Trade, Export March US$ 300 The Program focused on supporting trade Promotion, and 1999 million liberalization and modernization of trade policies. The Industry Program was designed to achieve higher and Program (TEPI) sustainable private sector, export led economic growth by promoting competition, and outward orientation, The Program helped in lowering and rationalizing tariff rates and reducing non-tariff barriers. Privatization and restructuring of state-owned enterprises was also supported. Micro Finance 2000 US$ 150 The assistance helped in the creation of a policy Sector million environment and institutional framework to extend the Development outreach of microfinance institutions and encourage Program greater private sector provision of microfinance. (MSDP) 24,750 Community Organizations (COs) were organized as delivery points for financial and social services. MSDP supported the establishment of the

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first microfinance bank (Khushali Bank). Access to 2001 US$ 350 The AJP's objectives were to improve access to Justice million justice of citizens through securing and sustaining Program (AJP) entitlements and creating conditions conducive to pro- poor growth by fostering investor confidence. The program carried out policy provisions for speedy disposal of corporate and business cases. Sindh Road Dec, US$ 223 This intervention supported reforms to provide the Sector 2001 million framework for overall sector development as well as Development policy and institutional reforms and investments Program leading to creation of opportunities for private sector (RSDP) development. The program assisted in strengthening the local contracting industry and road institutions through establishing an effective policy and regulatory enabling environment. Financial (Non- 2002 US$ 260 The FMGP was aimed at facilitating private sector-led bank) Markets million growth, productivity growth and enhanced social and protection by improving mobilization of long-term Governance resources for savings and investment through market- Program based financial instruments and institutions. The (FMGP) Program focused on improving corporate governance to improve investor confidence, increasing depth and diversity of financial intermediation through new capital market issues for saving and investment; improving operational efficiency and risk management of intermediaries and reducing financial sector vulnerabilities. Small and 2003 US$ 220 SMEDP was designed to improve access to finance Medium million and business development services for SMEs. It Enterprise supported the Government in policy reforms to Development improve the business climate with an emphasis on Program leveraging private sector interventions, and (SMEDP) strengthening private financial services and business development services intermediaries in building up the requisite capabilities to serve SMEs. The Program also supported the privatization of the SME Bank. The program supported the establishment of a Business Support Fund for SME entrepreneurs. Punjab Dec, US$ 500 The PRMP included a private sector development Resource 2003 million component, which focused on creating a more Management conducive environment for both the development of Program private sector institutions as well as exploring the (PRMP) modalities of effecting PPPs in service delivery and infrastructure development. Agriculture 2005 US$ 31 The intervention was designed to support institutional Diversification million reforms to strengthen the role of the private sector in and commercial agriculture with a focus on dairy and Agribusiness horticulture subsectors. The Project supported the Development establishment of an agribusiness support fund to program provide financial assistance to agriculture entrepreneurs in setting agribusiness enterprises. to Access to 2006 US$ 320 Designed to build upon the policy and institutional Financial million framework established under the first MSDP, the Services Program is focused on extending the outreach of microfinance institutions and encouraging greater 73

private sector and NGO involvement in provision of microfinance.

Private 2006 US$ 400 The Program's planned outcomes include enhanced Participation million private sector participation in infrastructure and utility Infrastructure investment and maintenance to reduce the Program government's fiscal burden and provide better infrastructure services to consumers. The program will address key constraints to Private Participation in Infrastructure by (i) establishing an overall policy, legal, and regulatory framework for PPI; and (ii) deepening policy, legal, regulatory, and institutional reforms in priority subsectors, including power, highways, and water. Second 2007 US$ 400 This Program will continue ADB’s support for reforms Generation million in the capital markets with a view to support the Reform for development of institutional investors to facilitate long- Capital Markets term capital formation and increase the demand for Development securities; improve the efficiency of securities markets to increase the supply of corporate securities and optimize the allocation of financial resources into productive investment; and strengthen the governance of capital markets to improve market transparency and protect investors. Accelerating 2008 US$ 500 The Program will continue to foster mobilization of Economic Million financial resources and help in developing strong Transformation financial institutions that are better able to channel Program investments to their most productive uses. Under which, a set of reforms are planned in the financial sector to boost public and investor confidence, including, strengthening of SBP’s overall autonomy and governance and the specifically regulating and supervising financial institutions; consolidating supervision of financial conglomerates; strengthening the anti-money laundering (AML) regime, and strengthening payment systems and consumer protection for depositors and borrowers. Source: Asian Development Bank

6.3 PRIVATE SECTOR ASSISTANCE THROUGH THE PRIVATE SECTOR OPERATIONS DEPARTMENT (PSOD)

192. ADB’s direct support to the private sector has focused on those areas that are critical from an economic development perspective but in which the private sector on its own faces barriers to entry for multifarious reasons including business risk and lack of access to capital and finance. Historically, PSOD's support for private sector development in Pakistan has focused on the financial sector including capital markets, and the infrastructure sector through provision of equity and debt financing, advisory services, and monitoring portfolio and management risk.

193. ADB had financed 42 private sector investments in Pakistan totaling $721 million as of end December 2007. These investments have been in the financial sector, capital markets and banking, power (thermal and hydro), oil and gas, and cement industries. Completed private

74

sector investments are listed in Table 26 and ongoing investments in Table 27. The majority of the recently approved ongoing interventions are in the power sector, with one investment in an equity fund (Figure 16).

Table 26: Completed Assistance to the Private Sector ($ million) Equity Investment Date Comp / Company LOE Investment Underwriting OCR Total Combined Approved Loan Loan No 7114/1395 10-Oct-95 Pakistan Industrial 0.000 0.000 0.000 15.000 15.000 0.000 15.000 Leasing Corp. Ltd. III 7113/1394 10-Oct-95 Orix Leasing 0.000 0.000 0.000 20.000 20.000 0.000 20.000 Pakistan Ltd. III 7112/1393 10-Oct-95 National 0.000 0.000 0.000 15.000 15.000 0.000 15.000 Development Leasing Corp. Ltd. IV 7111/1392 10-Oct-95 Atlas BOT Lease Co. 0.000 0.000 0.000 10.000 10.000 0.000 10.000 Ltd. II 7093/1255 30-Sep-93 Fauji Oil Terminal 0.000 1.000 0.000 19.000 20.000 11.800 31.800 and Distribution Co. Ltd. 7086 13-Aug-92 PAK Asian Fund 0.000 2.600 0.000 0.000 2.600 0.000 2.600 7080/1135 26-Nov-91 Pakistan Industrial 0.000 0.000 0.000 8.000 8.000 0.000 8.000 Leasing Corp. Ltd. II 7079/1134 26-Nov-91 Pakistan Industrial 0.000 0.000 0.000 5.000 5.000 0.000 5.000 and Commercial Leasing 7078/1133 26-Nov-91 Orix Leasing 0.000 0.000 0.000 10.000 10.000 0.000 10.000 Pakistan Ltd. II 7077/1132 26-Nov-91 National Dev. 0.000 0.000 0.000 10.000 10.000 0.000 10.000 Leasing Corp. Ltd. III 7076/1131 26-Nov-91 Crescent Investment 0.000 0.000 0.000 10.000 10.000 0.000 10.000 Bank 7075/1130 26-Nov-91 Atlas BOT Lease Co. 0.000 0.000 0.000 5.000 5.000 0.000 5.000 Ltd. 7074/1129 26-Nov-91 Asian Leasing Corp. 0.000 0.000 0.000 7.000 7.000 0.000 7.000 Ltd. II 7017/0856 28-Jun-91 Pakistan Industrial 0.000 0.208 0.000 0.000 0.208 0.000 0.208 Leasing Corp. Ltd. 7066 13-Dec-90 Atlas BOT 0.000 0.920 0.000 0.000 0.920 0.000 0.920 Investment Bank Ltd. 7057 13-Sep-90 International Asset 0.000 0.030 0.000 0.000 0.030 0.000 0.030 Management Co. 7056 13-Sep-90 Pakistan Investment 0.000 0.000 4.320 0.000 4.320 0.000 4.320 Fund Inc. 7017/0856 27-Aug-90 Pakistan Industrial 0.000 0.227 0.000 0.000 0.227 0.000 0.227 Leasing Corp. Ltd. 7050- 26-Apr-90 Asian Leasing Corp. 0.000 0.000 0.000 0.000 0.000 2.000 2.000 C/1008 Ltd. 7049- 26-Apr-90 Orix Leasing 0.000 0.000 0.000 0.000 0.000 5.000 5.000 C/1007 Pakistan Ltd. 7027-C 8-Mar-90 National 0.000 0.000 0.000 0.000 0.000 5.000 5.000 Development Leasing Corporation Ltd. II 7050/1008 21-Dec-89 Asian Leasing Corp. 0.000 0.000 0.000 3.000 3.000 0.000 3.000 Ltd. 7049/1007 21-Dec-89 Orix Leasing 0.000 0.000 0.000 5.000 5.000 0.000 5.000 Pakistan Ltd. 75

Equity Investment Date Comp / Company LOE Investment Underwriting OCR Total Combined Approved Loan Loan No 7047/1003 19-Dec-89 Fauji Fertilizer Co. 0.000 0.000 0.000 30.000 30.000 20.000 50.000 Ltd. 7042/0989 21-Nov-89 Pioneer Cement 0.000 3.500 0.000 11.500 15.000 21.100 36.100 Limited 7034/0958 25-Apr-89 Pakistan Synthetics 0.000 1.200 0.000 4.300 5.500 0.000 5.500 Ltd. 7027/0913 27-Oct-88 National Dev. 0.000 0.000 0.000 15.000 15.000 0.000 15.000 Leasing Corp. Ltd. II 7003/1393 29-Sep-88 National Dev. 0.000 0.165 0.000 0.000 0.165 0.000 0.165 Leasing Corp. Ltd. 7017/0856 10-Nov-87 Pakistan Industrial 0.000 0.575 0.000 2.000 2.575 0.000 2.575 Leasing Corp. Ltd. 7011/0814 9-Dec-86 National Dev. 0.000 0.000 0.000 5.000 5.000 0.000 5.000 Leasing Corp. Ltd. 7009 9-Dec-86 National Dev. 5.000 0.000 0.000 0.000 5.000 0.000 5.000 Finance Corp. and Bankers Equity Ltd. 7010/0809 4-Dec-86 Cherat Cement 0.000 0.000 0.000 0.000 0.000 0.000 0.000 7003/1393 13-Dec-84 National 0.000 0.420 0.000 0.000 0.420 0.000 0.420 Development Leasing Corp. Ltd. 7002 20-Dec-83 Bankers Equity Ltd. 2.000 0.000 0.000 0.000 2.000 0.000 2.000 Total 7.000 10.845 4.320 209.8 231.965 64.9 296.865 LOE = Line of Equity; OCR = OCR is direct LIBOR based loan; BOT = build-own-transfer; SME PCG = small and medium enterprise partial credit guarantee. Source: Asian Development Bank.

Table 27: Ongoing Private Sector Assistance ($ million)

Investment Date Company Investment OCR Total Comp Loan Combined /Loan No Approved 30-Oct-07 Daharki Power a 2.750 0.000 2.750 0.000 46.750 b 7257 17-Jul-07 JS Equity Fund a 20.000 0.000 20.000 0.000 20.000 7254/2329 29-May-07 KESC: Post Privatization 0.000 150.000 150.000 0.000 150.000 Rehabilitation, Upgrade and Expansion 7222 21-Nov-05 New Bong Escape Hydro 0.000 37.300 0.000 0.000 37.30 Power 7190/3709 19-Dec-03 SME PCG Facility 0.000 0.000 0.000 0.000 65.000 7166 7-Dec-00 Pakistan Export Finance 2.000 0.000 2.000 0.000 2.000 Guarantee 7126/1434 23-Apr-96 Fauji Kabirwala Power 5.300 32.000 37.300 65.000 102.300 Co. Ltd. 7062 4-Dec-90 Pakistan Venture Capital 1.160 0.000 1.160 0.000 1.160 Ltd. Total 31.210 219.300 213.210 65.000 424.510 a= Approved, but not yet signed b = Includes a guarantee of $44 million Source: Asian Development Bank.

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Figure 16: ADB’s Private Sector Assistance in Pakistan: Ongoing Portfolio

Finance, 16% Industry, 5%

Energy, 79%

Finance Industry Energy

Source Asian Development Bank Database

194. Complementarities between ADB’s Public and Private Sector Operations: The focus of ADB’s private sector interventions on the financial, energy, renewable energy and power sectors in Pakistan is complementary to the emphasis of ADB’s public sector operations under which the same sectors receive a significant amount of assistance. For example, in accordance with Government policy, ADB is supporting power generation in the private sector through the Fauji Kabirwala Power Company and Daharki Power, while at the same time ADB is providing assistance for strengthening power transmission and distribution systems in the private sector.

195. ADB’s Private Sector Opertions Division (PSOD) is integrated within the developmental vision of the institution and plays an important in furthering its mission and objectives. By focusing on sectors which are important from a development perspective, while leaving away those in which the private sector is already fully mobilized and active, ADB’s private sector operations seeks to leverage assistance to promote private sector investment in areas into which the latter would otherwise find difficult to enter. A recent example in this case is ADB’s approved assistance to the private sector in the area of hydel based generation for the New Bong Escape Hydro Power Project – this is the first ever hydel generation project in the private sector.

196. To further strengthen its effectiveness and impact, ADB’s private sector operations could consider moving away from sector specific investment policies to project specific policies. For example, the PSOD currently is not considering investments in Pakistan’s telecommunications sector given the abundance of private sector interest in the sector. But there remain niche areas within the telecommunication sector that are underserved by existing private sector service providers such as business-to-business and secondary market consumer interfaces, for example, Moblie-commerce and banking access over mobile phones are areas which can supplement Pakistan’s poorly developed low-income personal finance sector. Such specific projects and activities could be considered for assistance given their major developmental payoffs, even when the telecommunication sector as a whole might not as such be in need of ADB’s private sector assistance. 77

197. Need for Greater Synergy: Despite the complementarities noted in para 190, there is still a need to strengthen the functional ties and interlinkages between ADB’s public and private sector assistance to move towards greater strategic harmonization. For example, an impact issue in this regard is the clarification of the role of pure private sector investment (supported by PSOD) relative to public-private partnerships (PPPs) (supported though public sector operations), in the infrastructure development sector. In this case, processing and approvals of public sector projects, PPP projects, and private sector projects in infrastructure follow parallel tracks with few points of convergence. This results in sometimes incongruent objectives and designs of public and private sector operations and conflicting advice and message to country clients.

198. For better coordinated public and private sector operations, inputs from the private sector side into public sector operations, and vice versa, should be sought and incorporated at an early stage. By doing this, PSOD’s strategic advantage of being able to better harmonize with public sector operations by being a department of ADB (unlike IFC which has a separate status in the World Bank Group) will be better utilized. The resulting strengthened “public private partnership” within ADB could generate greater synergies and lead to more successful public and private operations. This “partnership” could go beyond the infrastructure sector to, for example, the agricultural sector where a public sector program to improve efficiency in the agriculture sector could, for instance, complement an ADB assisted private sector investment to develop a viable bioengineering industry and introduce hybrid seed manufacturing in the country.

78

SECTION VII

THE PRIVATE SECTOR SPEAKS

199. An attempt was made to undertake consultations with selected members of the business community during the process of the preparation of this PSA. A series of unstructured meetings and interviews with commercial bankers, heads of mutual funds, domestic and international investment bankers and industrialists were carried out which posed the following set of questions: (i) what factors are most important for private sector development (PSD)?; (ii) what role has the Government played in promoting PSD and how far has it succeeded?; (iii) what role has the private sector played in PSD and has that role been sufficient?; and (iv) what does the future hold for continued PSD and growth in Pakistan? Table 28 captures the most important challenges and issues that emerged from the perspective of the private sector from this process of consultations.

200. The consultations showed that the private sector in Pakistan values and has made use of the relatively stable years, politically and economically, of the initial years of the new millennium. Accesses to cheap capital, deregulation, privatization and macroeconomic stability all helped the private sector to grow and expand. The major constraints articulated by the private sector remain in the area of energy shortages, inadequate human resource availability, and the deteriorated security situation and political transition in the lead up to national elections. The once again worsened macroeconomic indicators are also a cause of concern for the private sector. With respect to the latter, lack of attention to education and health sectors has generated major supply constraints for the private sector. The private sector has grown in size and complexity the services industry with the financial services and telecommunications sectors being key examples of this success. However in the manufacturing sectors, growth has been seen only in a few traditional sectors like textiles with little or no diversification into new areas. Table 28 summarizes the input and concerns of the private sector representatives consulted in the process of the preparation of the assessment.

Table 28: Feedback from the Private Sector Questions Posed Private Sector Responses • What factors are • The most important factors in order of importance were: most important for o Economic and political stability private sector o Access to cheap capital development o Deregulation (PSD)? o Privatization

• What role has the • The Government’s positive role in promoting PSD has been Government through: played in o Strengthening economic and political stability promoting PSD o Private sector friendly policies of liberalization, deregulation and how far has it and privatization succeeded? o Tax reforms and other structural reforms

• Areas where not enough has been done and which will impede PSD are: o Energy and electricity shortfall and the impending crisis o Deteriorating quality of governance o Human resource crunch and lack of quality, trained and 79

educated manpower51 o Inadequate physical infrastructure especially transport and ports o Deterioration in macroeconomic and political stability o Inability to provide environment for expansion of limited productive base • What role has the • Private sector responded to new economic environment by: private sector o Generating high growth in the services sector played in PSD and o Participating in privatization has that role been o Expanding, rebalancing, and modernizing productive assets sufficient? o Developing an efficient financial services sector • The private sector has been deficient in: o Creating self-regulating structures and systems o Rent seeking continues in some sectors (textiles and automobile sectors were most often mentioned) o Its inability to enter new productive areas • What does the • Consensus amongst both Pakistani and foreign investors that future hold for the unstable political and economic environment will pass and continued PSD that fundamentals are in place that will continue to catalyze and growth? private sector investment.

• Pakistani investors feel that the pace of change in both the political and economic dimensions has for the time being increased uncertainty for the private sector. However the private sector now has a greater voice in policymaking. No foreseeable Government structure post elections can neglect the private sector or materially change the policy environment. The private sector remains generally confident about the long- term prospects of the economy.

51 This is such a critical issue that, for example, commercial bankers feel that acquiring manpower is a justifiable reason for bank acquisitions.

80

SECTION VIII

RECOMMENDATIONS FOR FUTURE ADB INTERVENTIONS

201. The structure, challenges, constraints, and the way forward for private sector development in Pakistan have been documented in detail in prevailing chapters. This chapter recommends interventions for ADB’s consideration that will have the potential to generate demonstrable impacts in the short, medium and long term for private sector development in Pakistan.

202. As mentioned in the previous chapter, ADB has provided support for PSD in terms of both direct interventions and public sector interventions that support the creation of a conducive environment for private sector development. What is important is that future interventions from both public and private sector windows be well coordinated and synergetic. It is far better to target a few critical areas for intervention that support and magnify impacts than to have a very wide scope of activities that do not generate sufficient critical mass to achieve desired results.

203. A set of proposed interventions follows the table 29 below split across sectors and areas to be supported by private and public sector wisdom in the short, medium and long term. The areas selected within which the interventions are proposed stem from the critical issues and challenges identified in the Assessment for promoting the private sector in Pakistan.

Table 29: Recommendations for ADB Interventions for PSD AREA/SECTOR PROPOSED INTERVENTION WINDOW: Public Sector / Private Sector I. Strengthening the (i) Technical Assistance (TA) to assess the Public Sector Framework for PSD effectiveness and impact of regulatory bodies established by the Government in various key sectors within a comparative framework developed based on international regulatory best practices. (ii) Policy-based support for strengthening regulatory reforms in key sectors to promote an improved business environment. Policy based regulatory as well as capacity development assistance could also be provided to strengthen contract enforcement for effective property rights protection. II. Financial Markets (i) Support for improving access of the SME sector to Public / Private and Improving formal sources of finance. Credit mechanisms and Sector Access to Finance innovative financial products for the SME sector need to be developed to ease the financial constraint in the growth of small enterprises and their maturation into medium-sized enterprises. Such support should also encompass access to improved technologies for SMEs also and strengthening of their human resource base strengthened for higher productivity and value added. Continuing support could be considered to private sector financial institutions to improve and enhance financing for SMEs. Such support could be built on lessons learnt from previous assistance by the ADB for SME sector development. 81

(ii) A TA to review options for developing the Public Sector regulatory capacity of the Government in the insurance sector whether by strengthening the SECP, by creating a new Regulator, or by assisting in the rationalization of functions between the SECP and the Ministry of Commerce.

(iii) Support for the reinsurance sector by ADB Private Sector acquiring a minority stake in Pakistan Reinsurance Company Limited (PRCL) along with a private sector partner and creating a public-private specialized entity that could develop reinsurance capacities. Support could also be considered for the State Life Insurance Company (SLICP).

(iv) Assistance through the private sector in poor Private Sector friendly financial initiatives. Mobile-commerce and banking access through mobile phones are areas which can supplement the poorly developed Pakistani low income personal finance sector. Proposed support for projects allowing subscribers to transfer balance amounts to others which can then be cashed as well as EBay type services where buy/sell information is circulated to ‘matched’ subscribers using SMS text messages and subsequently payments made using ‘mobile wallet’ technologies can have major poverty alleviating impacts (v) Continued assistance for deepening of financial Public Sector sectors and supporting development of longer maturity financial products to support project finance III. Privatization (i) TA to review Pakistan’s privatization program, Private Sector analyse effectiveness of divestment tools in various sectors vis-à-vis international best practice, and identify successes, failures, and impact of Pakistan’s privatization program. The results of the study could help the Government sharpen the future strategic direction of its privatization program.

IV. Informal Sector (i) Support to help develop better understanding of Private Sector the issues faced by the informal sector. Based on the findings, a program could be developed to provide targeted assistance to address the critical identified challenges to the development of the informal sector.

V. Support Private Efforts initiated under the ADB-assisted Private Public Sector Participation in Participation in Infrastructure Program are proposed and Private Infrastructure to be continued. ADB could work together with the Sector Development Government to ensure that the envisioned steps to improve the enabling environment for private sector

82

investment are taken. In particular, ADB’s assistance would need to focus on establishing appropriate PPP structures and policies and regulatory frameworks. Assistance is also required to develop innovative financial tools for infrastructure project finance to meet local requirements and conditions. ADB’s PSOD should seek to encourage, promote, and leverage private sector assessment in areas where it has so far not been forthcoming: renewable energy, transport, and water supply and sanitation. The PSOD can play a catalyzing role in generating appropriate, sustainable and beneficial PPP projects

VI. Energy (i) A TA to develop climate risk mitigating products for Public Sector Environment and the insurance sector especially for crop insurance and Private Climate change and catastrophe insurance Sector

(ii) A TA to develop a carbon trading regime in Pakistan beyond outright sale of carbon credits as is currently underway. Technical assistance to develop fiscal incentives to promote clean energy investments.

(iii) Enhancing support for investments in clean / renewable power projects for ADB to act as a bridge to attract socially responsible funds and alternate energy investors.

VII. Manufacturing (i) Support the Government in the preparation of a Public Sector and Mining comprehensive industrialization strategy and policy that seeks to eliminate current constraints- regulatory, institutional, financial, infrastructure related and others to attract higher domestic and international private sector investment in the industrial and manufacturing sectors. (ii) A TA to identify reasons for the lack of Public Sector development in the automobile sector with suggestions on how to promote this ‘industry of industries’ for accelerated economic growth. (iii) A TA to identify priority areas in the mining sector Public Sector for reforms at both the federal and provincial levels. An analysis of joint ventures and foreign investment in the mining sector globally could be undertaken in order to develop policy, regulatory and contractual structures based on international best practice for the provincial and federal governments to interface with domestic and foreign investors and get the best possible benefit from such investment. VIII. Strengthening (i) A Program to support the role of the private sector Private and the role of the private in agricultural development. Medium-sized Public Sectors 83 sector in agriculture agricultural commodity procuring, sourcing and forwarding agencies can be set up in the private sector with adequate systems of quality assurance and health safety standards that can supply premium products like tropical fruits and seafood to high end markets such as Europe and the Far East where today the few Pakistani items that do make it to supermarkets are sold at steep discounts relative to other producing countries.

(ii) Possible investment in the private sector in Private Sector biotechnology and hybrid seed production. Specific areas of support in this regard include corporate farming, integrated food handling and distributions systems incorporating standardized, containerized cold chain fresh food handling systems and modern grain storage systems along with strengthening of agricultural commodity markets.

84

LIST OF APPENDIXES

Appendix 1: Pakistan's Investment Incentives at a Glance

Appendix 2: Pakistan’s Insurance Sector

Appendix 3: Privatization in Pakistan 1999-2007

Appendix 4: Constraints and Interventions for Enhancing Private Sector Participation in the Energy Sector

Appendix 5: Constraints and Possible Interventions for Private Sector Participation in Roads, Railways, and Ports

Appendix 6: Constraints and Possible Intervention for Private Sector Participation in the Water Sector Appendix 1 85

APPENDIX 1: PAKISTAN'S INVESTMENT INCENTIVES AT A GLANCE

¾ All economic sectors open to Foreign Direct Investment ¾ Foreign investment fully protected ¾ Equal treatment to local and foreign investors. ¾ 100 % foreign equity on repatriable basis allowed ¾ No Government sanction required. ¾ Attractive tax / tariff incentives package. ¾ Remittance of Royalty, Technical and Franchise Fee, Capital, Profits, Dividends allowed ¾ Zero rated sales tax on import of plant, machinery and equipment ¾ Initial Depreciation Allowance at the rate of 50% is permissible on an “eligible depreciable asset” placed into service in Pakistan for the first time in a tax year. ¾ Amortization of pre-commencement expenses allowed at the rate of 20% annually. ¾ Amortization of intangible assets allowed over a period of ten years. ¾ Rationalization and lowering of corporate tax rates ¾ Full repatriation of capital, capital gains, dividends and profits allowed. ¾ No restriction on payment of royalty and/or technical service fees for the manufacturing sector. ¾ Agreements on Avoidance of Double Taxation with 52 countries ¾ Bilateral Agreements on promotion and protection of investment with 46 countries.

Source: Board of Investment. 2007. Available: http://www.boipak.gov.pk. Please see the BOI website for more details.

86 Appendix 2

APPENDIX 2: PAKISTAN'S INSURANCE SECTOR

I. Life Insurance Sector

1. The life insurance business in Pakistan was nationalized on March 18, 1972. Effective November 1, 1972, the management of life insurance companies was consolidated and entrusted to the State Life Insurance Corporation of Pakistan (SLIC). The life insurance industry since then is a virtual monopoly of SLIC that has a market concentration of 75% (Figure A2.1). In 1992, entry of the private sector into the life insurance sector was permitted but under the specific provision that general and life insurance businesses be managed by separate legal entities. Since then, two multinational and two domestic companies have entered into life insurance with a combined market share of 25%.

Figure A2.1: Share in Gross Premium of Life Insurance

Source: Source: State Bank of Pakistan. 2005. Financial Sector Assessment 2005. Karachi

2. SLIC’s market concentration has created a virtual monopoly environment resulting in strong barriers to entry for other players as potential competitors find it extremely difficult to create a niche in the market. The asset composition of SLIC comprises largely of investments in National Saving Certificates (NSC). These are, however, reducing over time as maturities occur (Figure A2.2). A major current issue for the insurance sector and the life insurance sector in particular is that government regulations now disallow the retention of new NSCs by insurance companies. Because of this insurance companies have begun to invest in equities. But because, the corporate debt and bond markets in Pakistan are still shallow and undeveloped, the insurance sector is not able to play its role in the development of long term financial resources.

Figure A2.2: Investment Composition of Life Insurance Companies

Source: State Bank of Pakistan. 2005. Financial Sector Assessment 2005. Karachi.

Appendix 2 87

3. An analysis of the performance of the life insurance sector reveals only a slight improvement between 2001 and 2005 on indicators of capital adequacy, operating efficiency liquidity ratios (Table A2.1). On the other hand, return on assets (ROA) and assets quality deteriorated during this period.

Table A2.1: Financial Soundness Indicators of Life Insurance

Source: State Bank of Pakistan. 2005. Financial Sector Assessment 2005. Karachi.

II. Non Life Insurance Sector

4. The non life insurance sector is dominated by a small group of large companies along with a host of small companies. There are 46 local and foreign insurance companies in the non- life sector with 43 companies in the private sector and 3 in the public sector52. Over 80% of the general insurance business is underwritten by local companies and the rest by foreign companies. The market concentration is oligopolistic: approximately 71% of the business is underwritten by 5 large companies whereas the remaining 29% is shared by 47 companies. The share of private sector companies in net premiums and assets in the non life sector have been generally increasing (Table A2.2). Between 2001 and 2005, the share of domestic non life insurance companies’ assets grew from 55.2% to 65.5% whereas the share of public sector companies fell from 40.7% to 31.6%.

Table A2.2: Ownership Structure of Non-Life Insurance Sector

Source: SBP State Bank of Pakistan. 2005. Financial Sector Assessment 2005. Karachi

52 State Bank of Pakistan. 2005. Financial Sector Assessment 2005. Karachi.

88 Appendix 2

5. The non life insurance sector is expanding as a result of a surge in industrial and trade activities: a rise in auto-sales on the back of increased credit availability to private sector in recent years resulting in higher motor insurance; the boom in the real estate market resulting in higher fire insurance; and the rise in involvement of multinationals and private firms in business generating an increased demand for insurance services. Resultantly, net premium income of non-life insurance industry witnessed a 27% growth, with all the major areas registering double- digit growth. High growth rates in the non-life insurance sector during this period between 2001 and 2005 were generated by both declines in claims ratios and increasing operational efficiency (Table A2.3). The Return on Assets of non-life insurance companies also increased from 7.7% in 2001 to 10.9% in 2005.

Table A2.3: Financial Soundness Indicators of Non-Life Insurance Industry

Source: State Bank of Pakistan. 2005. Financial Sector Assessment 2005. Karachi.

6. Reinsurance is an important part of the non-life insurance business as it allows greater retention capacity, leads to greater capacity within the domestic insurance industry, and can be useful in reducing the country’s foreign exchange burden. The public sector Pakistan Reinsurance Corporation Limited (PRCL) is currently the only provider of reinsurance services. PRCL’s attempts to increase reinsurance coverage in Pakistan have not been particularly successful in the absence of measures such as pooling schemes and greater use of loss reinsurance protection systems. PRCL’s institutional capacity needs strengthening with the ultimate objective of privatization for it to become an efficient facilitator of reinsurance services in the country. Appendix 3 89

APPENDIX 3: LIST OF PRIVATIZATIONS IN PAKISTAN 1999 – APRIL 2007 No. Unit Name Sale Price Date of Buyer Name (Rs. Transfer Millions) Banking and Finance 1 United Bank Ltd. (51%) 12,350.0 Oct-02 Consortium of Bestway & Abu Dhabi Group 2 Bank Alfalah (30%) 620.0 Dec-02 Abu Dhabi Group 3. Habib Bank (51%) 22,409.0 Dec-03 Aga Khan Fund for Economic Development Capital Market Transactions 4 Muslim Commercial Bank (6.8%) 563.2 Jan-01 MCB Employees-PF & Pension-F 5 Muslim Commercial Bank (4.4%) 364.0 Nov-01 MCB Employees-PF & Pension-F 6 NBP 10% shares IPO (37,300,000) 373.0 Feb-02 Listing/Public Offer 7 Muslim Commercial Bank (CDC 664.0 Oct-02 General Public Thru Stock 24,024,560 shares) Exchange 8 Pakistan Oil Fields Limited (CDC 5,138.0 Oct-02 General Public Thru Stock 28,546,810 shares) Exchange 9 Attock Refinery Limited (CDC 10,206,000 1,039.0 Jan-03 General Public Thru Stock shares) Exchange 10 Investment Corporation of Pakistan (ICP) 175.0 Sep-02 ABAMCO Lot – A 11 ICP Lot – B 303.0 Oct-02 PICIC 12 ICP – SEMF 787.0 Apr-03 PICIC 13 NBP 10% shares SPO (37,303,932) 782.0 Nov-02 General Public Thru Stock Exchange 14 DG Khan Cement shares (CDC) 63.0 Dec-02 General Public Thru Stock Exchange 15 OGDCL 5% shares IPO (215,046,420) 6,851.0 Nov-03 General Public Thru Stock Exchange 16 SSGC10% shares SPO (67,117,000) 1,734.0 Feb-04 General Public Thru Stock Exchange 17 PIA 5.8% shares SPO 1,215.1 Jul-04 General Public Thru Stock Exchange 18 PPL15% shares IPO (102,875,000) 5,632.6 Jul-04 General Public Thru Stock Exchange 19 KAPCO 20% shares IPO (160,798,500) 4,814.8 Apr-05 General Public Thru Stock Exchange 20 UBL 4.2% shares IPO (21,867,000) 1,087.2 Aug-05 General Public Thru Stock Exchange 21 OGDCL - GDR (408,588,000) 46,963.0 Dec-06 GDR offering to international & domestic institutions 22 OGDCL SPO (21,505,000) 2,300.0 Apr-07 General Public Thru Stock Exchange Energy Sector 23 Kot Addu (Escrow A/c) 1,033.0 Apr-02 National Power 24 SSGC LPG business 369.0 Aug-00 Caltex Oil Pak.(Pvt) Ltd. 25 SNGPL LPG business 142.0 Oct-01 Shell Gas LPG Pakistan 26 Badin II (Revised) 516.1 Jun-02 BP Pakistan & Occidental Pakistan 27 Adhi 681.4 May-02 Pakistan Oil Field 28 Dhurnal 230.7 May-02 Western Acquisition 29 Ratana 32.0 May-02 Western Acquisition 30 Badin I 8,599.1 Jun-02 BP Pakistan and Occidental

90 Appendix 3

Pakistan 31 Turkwal 120.3 Jun-02 Attock Oil Company 32 NRL (51% shares) 16,415 May-05 Consortium of Attock Refinery Ltd. KESC (73% GOP shares) 15,859.7 Nov-05 Hassan Associates Others 34 26% (1.326 billion) B class shares of 155,000.0 Jul-05 Etiselat UAE PTCL 35 Carrier Telephone Industries 500.0 Oct-05 Siemens Pakistan Engineering Ltd. 36 Associated Cement Rohri 255.0 Nov-03 National Transport Khi 37 Thatta Cement 793.0 Jan-04 Al Abbass Group 38 10% additional shares – Dandot Cement 8.3 Oct-04 EMG 39 10% additional shares – Kohat Cement 40.7 Oct-04 EMG 40 Mustehkam Cement Limited 3,204.9 Nov-05 Bestway Cement Limited 41 National Petrocarbon (add’l 10% shares) 2.3 Mar-02 Happy Trading 42 Khuram Chemicals (additional 10%) 6.0 Oct-03 Pfizer Pakistan 43 10% additional shares – Ittehad 26.1 Oct-04 EMG Chemicals 44 Pak Saudi Fertilizers Ltd. (90%) 7,335.9 May & Fauji Fertilizers Sep-02 45 Pak Saudi Fertilizers Ltd. (10%) 815.0 Sep-02 Fauji Fertilizers Ltd. 46 Pak Arab Fertilizers (Pvt) Ltd. (94.8%) 14,125.6 May-05 Export Reliance- Consortium 47 Pak Amercian Fertilizers (100%) 15,949.0 Jul-06 Azgard 9 48 Lyallpur Chemical & Fertilizers 280.2 Dec-06 Al Hamd Chemical (Pvt) Limited 49 Punjab Veg. Ghee 18.7 May-99 Canal Associates 50 Burma Oil 20.1 Jan-00 Home Products Intl 51 E&M Oil Mills 94.0 Jul-02 Star Cotton Corp. Ltd. 52 Maqbool Oil Company Ltd. 27.6 Jul-02 Madina Enterprises 53 Kohinoor Oil Mills 80.7 May-04 Iqbal Khan 54 Bolan Textile Mills 128.0 Oct-05 Sadaf Enterprises 55 Lasbela Textile Mills 156.0 Nov-06 Raees Ahmed 56 National Tubewell Const Corp. 18.6 Sep-99 Through Auction 57 Duty Free Shops 12.5 Sep-99 Weitnaur Holding Ltd. 58 Republic Motors (Plot) 6.3 Nov-99 Muhammad Mushtaq 59 Al Haroon Building Karachi 110.0 Sep-02 LG Group 60 International Advertising (Pvt) Ltd. 5.0 Apr-05 EMG 61 Federal Lodges - 1- 4 39.2 Jan-99 Hussain Global Assoc. 62 Dean's Hotel 364.0 Dec-99 Shahid Gul & Partners 63 Falletti's Hotel Lahore 1,211.0 Jul-04 4B Marketing Total 360,859.9 Source: Privatization Commission, Government of Pakistan

Appendix 4 91

APPENDIX 4: CONSTRAINTS AND INTERVENTIONS FOR ENHANCING PRIVATE SECTOR PARTICIPATION IN THE ENERGY SECTOR53 Constraint to Private Sector Intervention Measure Proposed 1. Regulation continues to be ‘reactive’ Revision to National Electric Power Regulatory rather than ‘proactive’ Authority (NEPRA) Act required

Amendment to NEPRA Act, requiring quarterly preparation and dissemination of studies that cover: • sector structure, • status of implementation of Government policies and the regulator’s role in such implementation, • impediments to sectoral growth and regulator’s proposed measures for addressing these, • development plans of the sector players, • consumer issues and the regulator’s vision

2. No ex-ante guidance on tariff for PPIs Revision to NEPRA Act required in thermal, hydel, wind, distribution Amendment of NEPRA Act to regulate end-use and transmission sub-sectors; no tariffs only to be undertaken when DISCOs are predictability of tariffs privatized; as public sector is impervious to financial consequences of a regulatory default

Codify NEPRA tariff principles by issuance as a ‘regulation’ after distillation from its tariff determinations

3. Rule-based framework required under Revision to NEPRA Act required Section 32 of the NEPRA Act to ‘minimize regulatory oversight’ of • Notify NEPRA (Investment Standards and contracts remains absent even after Procedures ) Rules 10 years • Notify NEPRA (Power Acquisition Standards and Procedures) Rules

After undertaking necessary consultations on the proposed drafts with sector stake holders including the consumers 4. NEPRA Act does not provide any Set-up a multi-sectoral regulatory appellate tribunal avenue for appeal against its decisions Amend NEPRA Act to provide for appeal before the High Court in the same manner as a ‘revision’ lies under the Civil Procedure Code 5. Rules in critical areas, despite Whole sale revision to NEPRA Act required NEPRA Act requirements, are still not Make rules required under the Act including on made uniform accounting standards, uniform industry standards, and others 6. Regulator’s capacity is sub-optimal • NEPRA members should have sectoral experience • Enhance tariff cell’s capacity • Add research sections for each regulated activity

53 ADB. 2006.Constraints to Private Sector Investment in Infrastructure. Manila. (TA 4635 PAK).

92 Appendix 4

Constraint to Private Sector Intervention Measure Proposed • Build a power sector economics cell 7. The regulatory and executive policy Whole sale revision to NEPRA Act required making functions are completely muddled 8. Implementing agencies such as PPIB, Create a CCI Secretariat with a PPP Policy AEDB, SHYDO, PPDB and Sind Power Cell are not duly empowered; any decision making of significance remains centralized with the highest echelons of the Government 9. No ‘market-based’ facilities exist as Identify and develop market-based facilities as substitutes for Government substitutes for Government Guarantees guarantees – the Government becomes a direct contracting party in project documents

10. Multitude of agencies with jurisdiction Create CCI Secretariat with a PPP Policy over the projects 11. Capacity Constraints Develop a capacity building program – focus on CCI Secretariat proposal 12. Application of Pakistan law to Seeking ruling from the Ministry of Law for transaction documents application of foreign law to be allowed 13. Access to land is problematic due to Develop a ‘land-bank’ policy in close coordination small holdings, and the fact that land with NTDC and consistent with its system is a provincial and local government expansion plans. Government can acquire land and subject having prolonged procedure – maintain a land-bank for identified projects also the land records system is outdated and unreliable 14. Competitive Bidding Procedures and Create CCI Secretariat with a PPP Policy the accompanying contractual frameworks are not finalized Develop Competitive Bidding Procedures and documentation on a priority basis entire portfolio of projects in pipe-line is of unsolicited projects that constrains international players who do not have established political and business alliances in the country 15. Diminishing gas reserves and Expedite exploration impending privatization of gas utilities has led to Government withdrawing Expedite work on LNG import and IPI Gas pipeline its commitments for gas supply projects

16. Profit on bank deposits being taxed CBR to issue interpretation circular that the by some assessing officers despite exemption under Clause 132, Part 1(exemption the income from power generation from total income) of Second Schedule (Exemption being exempt from income tax & Tax Concessions) of the Income Tax Ordinance 2001 also applies to profit on bank deposits 17. Cost-escalation risk for civil NEPRA to issue a circular stating that feasibility construction in hydel projects is not study costs for site examination will be allowed in efficiently allocated; the project tariff as a percentage of the EPC Costs sponsors are required exclusively to Appendix 4 93

Constraint to Private Sector Intervention Measure Proposed bear this risk Amend current PPA for hydel projects on the basis of practice notes or recommendations of internationally recognized standards, such as those by FIDIC 18. NEPRA Act is not applicable to AJK Cause AJK Council to apply (at least) NEPRA’s where significant hydel sites are tariff making and licensing powers in AJK for located; that prevents direct tariff projects that are located in AJK but the project rights being acquired by the project companies for which are incorporated in Pakistan

19. The Government does not commit to Initiate a deeper review of the issues involved. issuing sovereign guarantees in Build consensus between the AJK Government, the respect of projects developed in AJK AJK Council and the Government of Pakistan. – AJK Government insists on signing the project documents itself, when the executive power for this rests with the AJK Council 20. Hydel tariffs are not predictable; there NEPRA may issue a framework tariff order that sets is no precedent for cost-recovery tariff out the parameters and notional (realistic) values determination by the regulator in the for one of the selected sites, that can then be hydel sector extrapolated to specific projects

NEPRA to issue tariff guidelines for hydel tariff. These to cover civil construction cost escalation issue, either by requiring NTDC to absorb this under internationally accepted norms or by enabling the cost of a highly detailed feasibility and civil construction risks study to be a pass-through in the tariff. 21. Wind energy tariffs remain unsettled; Conduct an independent study into international NEPRA does not accept projects’ projects costs for 50 MW projects in countries with quoted costs, and does not offer any commonalities with Pakistan and make it available realistic upfront tariffs for public consultation 22. Energy Purchase Agreement for wind Cause the Ministry of Water and Power to allow: projects is modeled after the PPA for • partial commissioning; thermal projects that leads to • remove technical acceptance tests that are anomalous technical and financial not applicable to wind energy technology; consequences and • eliminate provisions that are no longer required in view of the Grid Code to make the EPA bankable 23. Land lease terms for wind projects Cause the GoS to issue a new ‘statement of issued by the Government of Sindh conditions’ under the Colonisation of Government (GoS) make the project unfinanceable Lands Act – this is permitted under the Act

These include unrestricted right of withdrawal of lease by the GoS and restrictions on creation of security over land in favor of lenders 24. Grid Code requires amendments to Cause NEPRA, NTDC and Alternate Energy accommodate wind energy projects Development Board to form a common task force to review and amend the Grid Code

94 Appendix 4

Constraint to Private Sector Intervention Measure Proposed 25. There is no framework comprising of NEPRA to issue a framework for PPI in indicative tariffs and other terms and transmission sector under Section 19 of the NEPRA conditions for PPI in transmission Act sector 26. Exclusive franchise rights to DISCOs Whole sale revision to NEPRA Act required inhibit PPI in the distribution sub- sector Amend Section 21 of NEPRA Act to subject exclusive franchise rights to mandatory obligation to Small scale or grid-isolated serve within defined time-limits and parameters, distribution networks cannot be failing which PPI should be enabled as a BOT established under the current legal project until full-cost recovery by the project framework NEPRA to develop an ‘outsourcing’ framework that applies to all grid-isolated or small-scale networks that are declined for construction by DISCOs within the time frame required by end users Appendix 5 95

APPENDIX 5: CONSTRAINTS AND POSSIBLE INTERVENTIONS FOR PRIVATE SECTOR PARTICIPATION IN ROADS, RAILWAYS, AND PORTS54 Constraint Intervention Measure Proposed 1 Decision making for National Highway Authority Amendment to NHA Act for further (NHA) projects is over-centralized with the empowerment of NHA Government– projects above Rs.100 million have to be approved by the National Highway Council and then by the CDWP/ECNEC

2 No Policy Framework for PPP in place Announce Policy Framework and Package of Incentives for roads at the federal level proposed under ADB TA: 4508 (PAK): Facilitating Public-Private Partnership Initiative in National Highway

Development

Provincial and local government levels to adopt the Federal Policy for RRPS

3 No guidelines and procedures for NHA to act as Develop PPP procedures framework for ‘PPP Cell’ for provincial and intra-district roads project referral by provincial and local governments to NHA

4 NHA Act does not permit: Amend NHA Act to provide for these • Assignment of toll receivable statutory measures to reduce project risk • Security over project roads and facilitate project financing • Guarantee against alternate routes This enhances project risk 5 No legal requirement for a PPP Option Analysis Provide for a mandatory requirement for PPP Option Analysis in the NHA Act and/or the policy framework and package of incentives 6 PPP in district roads is constrained by the Amend Section 54 (and other related restriction under the Local Government Ordinance provisions) of the LGO (LGO) on financing of PPP development projects by user fees or charges 7 Railways Act 1890, and allied legislations are Pass a ‘consolidation and restatement’ archaic and do not serve contemporary day PPI single Act requirements 8 The Railway Regulatory Authority (RRA) is The Federal Government to issue a dysfunctional Gazette notification to bring the entire Railway Regulatory Authority Ordinance 2002 (RRAO 2002) in force Appoint members of the RRA

9 Government continues to be the regulator of the As in point 8 above sector 10 Absence of: Amend Section 28 of the RRAO to • Policy / PPP Framework for the intended substitute Council of Common Interests industry and market structure (CCI) for the Federal Government for • contents of licenses to be issued by the issuance of policy guidelines

54 ADB. 2006.Constraints to Private Sector Investment in Infrastructure. Manila. (TA 4635 PAK).

96 Appendix 5

Constraint Intervention Measure Proposed RRA • permitted tariff structures • bidding documents and framework for CCI to issue ‘Policy Guideline’ under licenses Section 28 of the Railway Regulatory • templates for track access agreements Authority Ordinance Appoint members of the RRA

11 Enable PPI in railway infrastructure (tracks) CCI to issue ‘Policy Guideline’ under Section 28 of the Railway Regulatory Authority Ordinance

12 Pakistan Railways functioning as a Government Corporatize Pakistan Railways and department with inadequate cost and accounting cause accounts to be prepared under the systems that prevent costing of lines of business Companies Ordinance, 1984. Pass the (freight, passenger, infrastructure, etc) Railways Corporatization Act 13 Decision of ECC that only Pakistani operators Allow 100% foreign ownership of allowed to operate freight and passenger lines of Pakistani companies in the railway sub- business being interpreted to mean that a sector, as it is allowed in several other Pakistani joint venture partner is required sectors (power, telecommunications, manufacturing, etc.) 14 Absence of a clear, transparent and sufficiently Develop multi-sectoral PPP Framework detailed PPP Framework in legal and policy (Chapter 2 and Annexure A-5) terms.

Replace port statutes with new ones that incorporate contemporary international best practices

15 The policy choice of 'landlord ports' is not Develop multi-sectoral PPP Framework reflected in the port statutes; the law does not restrict port authorities undertaking port operations in competition with their 'tenants'. Replace port statutes with new ones that incorporate contemporary international best practices Insert another chapter in all port statutes that details landlord concept and delineates the landlord versus tenant functions

16 Regulation by contract has not ensured a level Develop multi-sectoral PPP Framework playing field; the port statutes are not effective in preventing discriminatory treatment of operators Replace port statutes with new ones that incorporate contemporary international best practices Insert another chapter in all port statutes prohibiting sole sourcing / direct negotiations and setting out anti- competition provisions Appendix 5 97

Constraint Intervention Measure Proposed 17 All port authorities suffer form the ‘Governance Replace port statutes with new ones that Over-centralization Constraint”: this is built into incorporate contemporary international the port statutes. The strategic steps noted under best practices the Government’s Medium Term Development Framework (MTDF: 2005-2010) towards management reform, corporatization and Pass legislation that introduces norms of autonomous status for the port authorities remain corporate governance in statutory unrealized. corporations and authorities

18 The boards of port authorities do not carry Eligibility criteria to be provided in port adequate experience of port operations. statutes that require at least one-third Board members to have experience of port operations

98 Appendix 6

APPENDIX 6: CONSTRAINTS AND POSSIBLE INTERVENTIONS FOR PRIVATE SECTOR PARTICIPATION IN THE WATER SECTOR55 Constraint Intervention Measure Proposed 1 The National Water Policy remains a draft 4 years Approve and issue the National Water after it was developed Policy after addressing the Constitutional and Legal Constraints identified 2 Water storage projects are uneconomic unless Adopt enabling measures recommended for integrated with hydropower generation the hydropower sector

3 No PPP Law in existence Establish enabling PPP Law

4 The Power Policy 2002 is insufficient to address Specify hydropower sector measures within legal, regulatory and financial issues specific to the the power policy hydropower sector

5 Current outlook views all major storage projects for Under the study into modular approach to implementation by WAPDA with public expenditure development of large storage projects (as opposed to turn-key approach), e.g. power works as a ring-fenced project 6 Legal restriction on local governments against Make necessary amendments to the financing of development projects by user fees or relevant sections of the LGOs charges Establish enabling PPP provincial laws

7 The absence of a rules-based framework that caters Establish enabling PPP provincial laws to the financial viability of urban water supply PPP projects by providing for: • statutory – as opposed to contractual remedies for restraining breach and award of compensation for early termination • cost-recovery tariffs; • elimination of political influence in management and staffing; • disconnection for default; and • a range of options other than BOT, such as management contracts or leases that focus on maintenance and rehabilitation of existing networks that are fast deteriorating.

8 No policy framework for: Establish enabling PPP policy frameworks • Ring-fencing of projects in financial and for water supply projects managerial terms

• Targeted and transparent subsidy mechanisms to address affordability issue (that is cited as the most significant economic constraint to PPP in urban water supply)

55 ADB. 2006.Constraints to Private Sector Investment in Infrastructure. Manila. (TA 4635 PAK).