Document of The World Bank FOR OFFICIAL USE ONLY CONFIDENTIAL Report No. 7095-PAK PAKISTAN INDUSTRIAL REGULATORY POLICIES- Volume I- - ai&Repoirt anunary 15, 1988. nUstr, Trade and Finance Division Country Department I Europe, Midle East and North Africa Regional Office and Industry Development Division Industry and Energy Department Poliey, Planning and Research Office Tu-tt Wä----irns- has a restTCEG -å I-FIWeen.- I*- 1.-v,may bo used by recipen s ontly an $he perForm.I. e or ..es :46.els t cann*ak Day not eetr rwie . a m .e . a . .. t. s.9..s' n. PAKISTAN - - INDUSTRIAL REGULATORY POLICIES - Tabie of Contents Page No. ABBREVIATIONS EXECUTIVE SUMMARY . 1 I INTRODUCTION ....... ....................................... 6 Purpose and Scope of the Report........................ 6 The Context of Domestic Regulatory Policy.............. 7 II. THE REFORM OF INDUSTRIAL REGULATIONS........................12 Overview..4...........*....0.........4.....................12 A. Entry and Investment Sanctioning........******** ......12 Current Policies .......... * ................. ..12 Objectives and Policy Direction...................14 Overall Impact of Sanctioning Policies........... .14 Excess Capacity........ ............. . ........16 Market Concentration................ .............7 Foreign Exchange Rationing...oo... .............18 Delays, Uncertainties and Discretionary Policy....19 B. Access to3 Utilities and Infrastructure.................21 C. Pricing Policies ........*.........#........#.............22 Dbjectives ..................... .. ...............22 Evolution of Price Controls.......................22 D. Exit Policies......*.... ........... .................24 Credit Policies for Ailing Firms...................24 Labor Regulations and Ailing Firms................27 III. Summary and Conclusions...... ...... ........................ 28 LIST OF ANNEXES ANNEX 1.1 Number of Commodity Categories listed on the Negative and Restricted Lists ANNEX 2.1 Project Characteristics and Approval by Project Sanctioning Authorities ANNEX 2.2 List of Specified Industries ANNEX 2.3 Output of Specified Industries 1980/1981 ANNEX 2.4 Number of Projects Sanctioned 1983-1986 ANNEX 2.5 Sanctioned and Actual Investment 1977-1984 ANNEX 2.6 Sanctions Processed by IPB 1979-1986 ANNEX 2.7 Source of Finance for Sanctioned Projects (by PICIC, IDBP, IPB) 1978-1986 00SSR/1.04.88 ABBREVIATIONS BMR Balancing, Modernization, Replacement CCIE Chief Controller of Imports and Exports c.i.f. cost, insurance and freight (border price of imports) CIPC Central Investment Promotion Committee CMI Census of Manufacturing Industries DFC Development Finance Corporation ECC Economic Committee of the Cabinet ERP Effective Rate of Protection f.o.b. free on board (border price of exports) GCP Ghee Corporation of Pakistan GDP Gross Domestic Product GOP Government of Pakistan IIS Industrial Investment Schedule IPB Investment Promotion Board IRC Industrial Relief Committee MOI Ministry of Industries NCB Nationalized Commercial Bank NRI Non-repatriable Investment NOC No-objection Certificate NRP Nominal Rate of Protection PBC Pakistan Banking Council PTC Participation Term Certificate SBP State Bank of Pakistan TCP Trading Corporation of Pakistan 009R/1.04.8 PAKISTAN 4 INDUSMRIAL REGULATORY FOUCIES EXECUTIVE SUMMARY Government Dereulation Policy 1. In the 1980s Pakistan's manufacturing sector resumed the rapid growth that had characterized the post-independence period of the 1950s and 1960s. This renewal has coincided with a policy of deregulating investment and price controls, beginning in the late 70s. In the words of the Government's Deregulation Commission, this policy was based on the premise that "policy controls (in Pakistan were] often weak while administrative controls [were] too detailed and discretionary" and furthermore that "many policy objectives could be achieved through appropriate price signals and fiscal incentives rather than through detailed administrative controls." These views reflect the experience of the 1970s, when many controls were instituted, industries were nationalized, and industrial performance deteriorated. 2. This report supports the reasoning behind the Government's deregulation policy. It analyzes the impact of key regulations on market structure, firm behavior, and industry performance in key subsectors, focussing on investment sanctioning, price controls and policies affecting firm restructuring and closure (i.e. banking and labor regulation). It concludes that these regulations have in the past been at the root of poor performance and inefficiencies in the industrial sector, but that the deregulation policy is moving to correct these causes and should stimulate improved industrial performance if it is continued. In particular, relatively unrestrained entry and exit in an industry would provide a continuous check on market power by incumbent firms and strong incentives to improve productivity to avoid loosing markets to new entrants. Linkages of Deregulation with Trade and Infrastructure Poliy 3. The report notes, however, that the recent renewal of industrial activity which was facilitated by deregulation has been aimed at domestic markets and has not fostered significant improvements in product quality. Export performance has remained below expectations. Despite some exchange rate adjustments, high levels of worker remittances, and falling energy import prices, Pakistan has had to maintain import restrictions and high tariffs to avoid serious balance of payments problems. Domestic regulations continue to reinforce the anti-export bias of the trade regime, by restraining competition and by restricting firm sizes below their internationally competitive scale. Import restrictions in turn are the most important remaining criterion requiring that investors seek Government sanction. As a result, the effectiveness of deregulation is closely linked with trade policy reform. 4. Many of the regulations on pricing and investment were introduced because the high protection established by inward-oriented trade policies gave rise to potential monopoly profits and excess investment. Conversely, as the Government shifts toward a more outward-oriented trade regime, the rationale 0099R'1.04.88 -2- . for these regulations will disappear. Import competition will increasingly serve to discipline domestic monopolies, and export possibilities will permit building plants of minimum efficient scale even if this exceeds the domestic market. The important issue for the medium term is how best to link and sequence deregulation and trade liberalization. The Government has been following a generally appropriate policy of first eliminating price controls and investment restrictions that are no longer necessary. This will help assure a quicker supply response to trade policy reform. 5. Another important linkage exists with infrastructure policies. One function of investment sanctions is to ration access to scarce urban infrastructure such as water and power. As a result, urban firms are often unable to expand production to achieve economies of scale and those firms required to locate in rural areas bear the cost of developing new infrastructure, while urban users gain a scarcity rent from underpriced utilities. This gives the latter little incentive to minimize the use of infrastructure and the utility companies insufficient revenues to undertake new development. Greater use of the pricing system would be more conducive to solving the underlying infrastructural problems, as well as induce more rational location decisions by investors. Objectives of Domestic Reulation of Entry, Exit and Prices 6. As the preceding paragraphs suggest, investment sanctioning, price controls, and other regulatory policies were introduced to serve a variety of purposes. (a) Restricting demand for foreign exchange was and is one objective of investment sanctioning, which determines the level of machinery and raw materials imports. (b) Excessive market entry which might result in excess-capacity was also to be held in check through sanctions. Restrictions on firm closure and measures to provide financial assistance to sick industries likewise were aimed at preventing capacity from sitting idle. (c) Avoidance of unemployment.remains an important objective of labor regulations and other restrictions on exit. (d) Cost-plus pricing has in the past served the objectives of guaranteeing an established rate of return to investors, ensuring the survival of incumbent firms, and restraining the exercise of monopoly power. (e) Excessive concentration of ownership was also to be discouraged through investment sanctions. Restrictions on project size limited the market share firms could acquire. (f) Location restrictions and incentives are used to ration scarce infrastructure such as water and electricity and to promote regional dispersal of new investments. OS9R/1.04.88 -3- ConsequencesofRelation . 7. The report tries to draw conclusions about the success of regulatory policies in meeting these objectives, as well as those of efficiency and international competitiveness. Illustrative evidence is provided on the basis of reviews of seven major industrial subsectors representing 27% of manufacturing GDP, namely: fertilizer, cement, vegetable ghee, vehicle assembly, bicycles, textiles, and polyester. While the data needed for this analysis are sometimes deficient and it is often difficult to sort out complex interactions between policies, several observations consistently emerge. 8. Sanctioning rules limiting access to imported machinery and raw materials led to several inefficient outcomes. Firms in some industries could not reach their most cost-effective scale (e.g. cement). Other industries experienced excessive entry behind high trade barriers into a small domestic market. This is the case of the automobile industry, where a proliferation of models entails uneconomically small production runs. In polyester fiber and yarn, high trade barriers have led to excessive vertical integration into polymerization, where Pakistan's limited domestic market does not allow cost minimizing production scales. 9. Attempts to prevent excess capacity have met with little success. First, statistics on existing industry capacity are notoriously unreliable. Out of 14,000 registered enterprises, as many as 7,000 may no longer be in operation. Second, although forecasts of investment requirements under the industrial investment schedule of the five-year plan have often been highly inaccurate, they at times have been used to restrict new investment. This has caused capacity to lag behind demand in cotton spinning and in polyester. Third, in industries such as ghee where equipment and inputs can be obtained locally, capacity has expanded outside the official system while sanctioned firms have been constrained from expanding in order to lower unit costs. 10. Efforts to restructure or close firms are hampered by bank regulations and practices limiting write-offs and loan loss provisions. Consequently, physical assets which are still valuable sit idle or are underutilized instead of being liquidated and transferred to a new and potentially more productive owner. In some cases loss-making*firms continue to be supported by bank credit, which limits the finance available to new or growing investments while arrears accumulate in declining firms. Productive redeployment of workers is inhibited by pressures to sustain existing employers despite losses rather than closing them and financing retraining schemes for workers. Although a substantial amount of asset transfer and redeployment does occur through various means, especially in smaller firms, procedures could be improved to make legal exit a more active instrument of industrial restructuring. 11. Sanctioning has somewhat limited concentration of ownership at the cost of inefficiently small firm sizes in some industries, such as polyester. Concentration has been controlled even in cases where competitive pressures to discipline potential monopoly behavior exist. Although polyester fiber and yarn production is dominated by a few firms, they face substantial competition from legal and illegal imports, as well as domestic cotton and other synthetic * fiber substitutes. Furthermore, sanctioning limits concentration by 0099R/1 .04.88 -4- controlling market shares, which is the most difficult task for any potential oligopoly to coordinate. Sanctioning thus actually facilitates oligopolistic coordination among firms and forestalls aggressive efforts to compete for shares. Import competition or export rivalry would provide a more effective check on market power in industries where minimum efficient scale is large relative to the domestic market. 12. The regulatory policies discussed in the report have not necessarily been prohibitive, although they have raised costs and inhibited responsiveness. The fertilizer industry for example, seems to have fared reasonably well under a regulated environment, but its efficiency and ability to adjust to market conditions appear to be improving under liberalisation. On balance, regulations have not performed better than indirect policies and they have had adverse effects. These were exacerbated by uncertainties caused by fluctuations in their restrictiveness and arbitrariness in their application. The Government has moved decisively to eliminate these problems through its policy of deregulation. The preliminary evidence of this report suggests that this is already paying off in terms of more dynamic growth of efficient industries and greater responsiveness to changing market conditions. Polley Foeus 13. Deregulation policy needs to be complemented by reform of two major areas. First, further exchange rate and trade policy reform are needed to reduce the anti-export bias of the trade regime and open domestic industry to greater competition both from imports and in export markets. Import restrictions should be replaced by tariffs and then tariff barriers should be lowered over time, with exchange rate adjustment as necessary. This will eliminate the need to retain import limits on capital and raw materials as a criteria for investment sanctioning, permitting further deregulation. It will also permit lifting constraints on firm size to obtain economies of scale, by maintaining competitive pressures on domestic monopolists. Second, infrastructure should increasingly be rationed through pricing policy rather than location restrictions. This would not only improve the allocation of resources but also provide relief for the government budget. As customs duties are lowered, domestic sales taxes and higher prices for non-tradeables would provide the major source of public revenue. Offsetting adjustments in the exchange rate would improve the trade balance and lower the cost of non-tradeables vis-a-vis the outside world. 14. With respect to deregulation policy itself, short-run emphasis should be placed on making the reforms already undertaken more effective. The I complementary reforms discussed in the preceding paragraph are a critical step in this direction. For example, increases in the size limit for investment sanctioning have had limited impact because most investments that stand to benefit still require sanctions on the basis of import requirements or location. In addition, managers of state enterprises need to be encouraged to take fuller advantage of deregulation. The role of government agencies which today exercise controls that are to be abolished would need to be rethought. In general it should shift toward greater efforts to collect data, monitor trends and conduct policy analysis, while encouraging administrators to adopt a pro-competitive rather than controlling attitude toward business operation, in keeping with the spirit of deregulation policy. At the same time, the 0099R/1.04.88 longer-run strategy of deregulation can proceed along the lines set out by the Deregulation Commission. The Government and the Commission are fully aware both of what needs to be done av of the political difficulties involved. 15. The report's specific recommendations which would fit inco this overall approach are listed below: Re: Investment Sanctionina a) abolish all sanctioning requirements based on project eise; b) delete all industries from the Specified List except for those regulated for religious and social reasons or for reasons of national security; c) abolish all sanctioning requirements related to import of capital goods, raw materials, etc.; d) align sanctioning requirements for foreign investors with those of domestic investors (see Bank report "Towards a new Technology Policy" April 15, 1986); e) improve implementation of remaining sanctioning requirements which may remain at any one time (e.g. infrastructure related sanctions) to reduce delays and ambiguities. If the Industrial Investment Schedule is maintained it should be for indicative purposes only; Re: Price Controls a) maintain price deregulation for manufactured goods; b) discontinue informal practices amounting to price controls (e.g. for bicycles); c) deregulate remaining price controls for manufactured goods (e.g. motor vehicles); Re: Exit Policies (see recommendations in Bank report on Financial Sector, December 11, 1987); a) improve standards for non-performing loans; b) improve regulations and instruments for debt recovery and takeovers of firms; c) improve financial health and autonomy of financial institutions and provide managers with clear incentives to improve long run profitability; and Re: Institutional Arrangements a) review role of institutions presently involved in designing and administering the above policies (e.g. Provincial and Federal Departments/Ministry of Industry, IPB, CIPC, Financial Institutions etc.). 0099R/10.4 88 -6- PAKISTAN RMTDUSTRIAL REGULATORY POLICIES L INTRODUCTION Purpose and So of the Reprt 1.01 Since 1980 the Government of Pakistan (GOP) has taken significant steps to deregulate the domestic economy and to liberalize its foreign trade regime. These liberalization measures are intended to move away from restrictions on investment, mobility, growth and inter-firm rivalry in the domestic economy, and to expose domestic firms to greater levels of foreign competition. The long-term objective is to establish an incentive structure compatible with Pakistan's comparative advantage and to enable investors to respond to these incentives. 1.02 The domestic deregulation and trade liberalization measures are part of a general program of economic reform intended to lead to a more efficient, competitive industrial sector. This program aims to reduce reliance on direct administrative controls, which are complex, costly to administer, and have had only mixed success in achieving their stated objectives, in favor of trade and regulatory policies that influence performance through indirect forces. Industrial peformance is expected to improve through reduced static efficiency losses due to high-cost production units or to the exercise of monopoly power in a protected environment. Dynamic gains are possible from increased pressures to reduce costs, raise productivity and undertake technological innovation. 1.03 The present study of industrial regulatory policies was undertaken to provide GOP and Bank management with an analysis of the effects of barriers to entry, growth and exit on competition, responsiveness to incentives and industry performance in the context of the deregulation program. The study is intended to complement the in-depth industrial efficiency study being carried out by consultants under the Export Development Loan, as well as the recent Bank study on the Trade Regime in Pakistan. This report was written by Michele de Nevers (team leader), William Steel, Ann Harrison and Kun-Kyung Lee following missions to Pakistan in March and May 1987. Background subsector papers were prepared by: William Steel (polyester, yarn and fiber), Malathi Jayawickrama (cement), Sajjat Akhtar (vegetable - ghee), Ann Harrison (bicycles, vehicle assembly and nitrogenous fertilizers), and Michele de Nevers (cotton textile). Secretaries in the Pakistan Industry, Trade and Finance Operations Division, under the supervision of Helen Chin, provided wordprocessing and secretarial support. The team wishes to convey its appreciation to the Ministries and agencies of tie Government of Pakistan * that provided information and support for the report. OOS9R/1.04.88 1.04 The main objectives of the report are to examine toe impact that previous regulatory policies have had on market structure, firm behavior and industry performance, and to evaluate the preliminary supply and competitive responses to recent relaxations in regulatory policies. The study also highlights potential issues of supply response that might arise in the context of further trade policy x..forms, and outlines issuas of timing and coordination between trade and regulatory policy reform. The emphasis is on the private sector since it is expected to be the principal source of new industrial investment, allnough the effects of public ownership on market structure, behavior and performance are reviewed for some subsectors. 1.05 Although the analysis in this study was based on brief reviews of the impact of regulatory studies on several specific subsectors, this report does not include detailed subsector reviews or recommendations for subsector-specific policy actions, since these are to be provided by the Industrial Efficiency Study. The report does not evaluate the impact of technology acquisition or direct foreign investment policies, which were discussed in detail in a 1986 Bank report, "Toward a New Technology Policy in Pakistan." Nor does the report analyze in depth the nature and characteristics of industrial development in Pakistan, since this is available from sector reports and economic memoranda. 1.06 The National Deregulation Commission has identified most areas of domestic regulation in which reform can usefully by undertaken, and has proposed specific measures in a wide range of areas. This report finds that this deregulation program has generally been consistent with the objectives, and it does not, therefore, attempt to provide a comprehensive blueprint for specific regulatory keferm measures. Rather, it proposes a general approach toward continued reform and the replacement of direct controls with indirect, pro-competitive policies. The report contains a few specific recommendations regarding further revisions of investment sanctioning and import licensing rules, and outlines steps toward identifying problems and possible approaches toward firm-level and subsector closure and restructuring. These measures will become more important as controls on domestic and international competition are loosened. 1.07 The rest of this chapter briefly reviews the objectives of industrial policy in Pakistan and the impact of trade policies on the extent and nature of competitive pressures on domestic firms. Chapter II describes the key regulatory policies and highlights their impact on easing or creating barriers to new firm entry, output growth and exit of unsuccessful units. The main conclusions are drawn and an approach for further regulatory reform is proposed. Volume II of this report provides empirical evidence on market structure and firm behavior and examines the influence of regulatory policies on industry performance, both directly and through the intermediation of market structure and firm behavior. The Context of Domestic Reoudatory Policy 1.08 Phases of Industrial Policy in Pakistan. The evolution of industrial development policy in Pakistan can be described in three phases. Following Pakistan's independence in 1948, industrial policy was geared to stimulate rapid development of an initial industrial base. To overcome the virtual OOSSR/1.04.88 absence of industrial infrastructure and an industrial class, policies afforded high protection from import competition, large incentives for investment, relatively few domestic regulations, and easy access to international capital goods and inputs. An industrial base was established quickly and industrial output grew rapidly. * 1.09 One unintended consequence of this phase of development was the concentration of the asset ownership and income in a few large family groups. The second industrial development phase, starting in the early 1970s, constituted, in part, a reaction to this concentration. From 1972 to 1977, assets in a number of industries were nationalized and the public sector developed a major role in industry. Government control over new investments was tightened, in part as a measure to avoid further concentration. In addition, as both imports and the level of protection for domestic production grew, a number of regulatory controls were introduced to defend the exchange rate by rationing foreign exchange and to set prices or profit margins for certain protected commodities. While Government attempted to regulate many facets of the economy, intervention in the economy does not appear to have been as stringent as e.g. in the case of India. This is supported by considering the distribution of total factor productivitity (TFP)±' growth rates in Pakistan. The distribution is relatively wide compared to other countries, and the average is quite high, roughly comparable to Turkey and Argentina (figure 1.1). This fairly wide range of TFP growth is typical of most countries, and it is consistent with a situation in which resources are moving from stagnant industries to those with higher growth and more rapid technological change. In contrast, countries such as India, where the regulatory environment tends to support sick firms and to prevent firm closure more stingently than in Pakistan and where entry is tightly restricted, show a relatively concentrated distribution of TFP. 1.10 In the third, current phase, industrial policy h&s been turned around. The Industrial Policy Statement of 1984 heralds the-renewed role of the private industrial sector along with continued public sector participation. A variety of policies ranging from denationalization to deregulation exposed firms more and more to market forces at home. Competition became more intense. In response to the new industrial policy framework and incentives, development has been impressive as industry grew by 9% p.a. between 1977 and 1987 surpassing Korea's performance. 1.11 Issues in Industrial Performance However, dynamism at home went along with a mediocre performance in world markets. And despite positive quantitative indicators of industrial performance, recent evidence shows stagnation in qualitative indicators. Technological dynamism is lacking in- many industry groups. Firms have been slow to improve product quality and reduce prices, and productivity growth has not been sufficiently dynamic to improve export performance. -' As part of the background work for this report calculations of TFP were performed for 11 subsectors. TFP is a measure of the joint productivity of all production inputs (capital, labor, raw materials). However, due to data problems only the result about the distribution of TFP growth rates appears reliable. Other results are therefore not reported. 0099R/1.04.88 HfiNUfICTURING TOTL FfICTOR PRODUCTIVITY GROfitt SELECTED COUNTRIES Pakltan (1963-Sl) I f XIi e Japan (1960-73) blblSetSOa bn - ArHasta (196-m 3). UOe eMÆ bl bl Nete,(195-80) om .å .u 0 Korea (1960-b) 'TOTfil FnCTO PRDUTIIT OMT tIlp.Sucn ihma en -1. blåg ,FUsatsal I&Uleel atdrtdsfavtjda:al1 16041h4 ltell søst cuøn limsta dag §", a~ Tuarkey (19616) U* lt 0ss vadåe (1966-ti 4* 1 l -3 . -4 *-2 0 2 4 6 8 10 12 a TOTflI. UFlCTOR PRODJUCTIVITY GRtINTUI Surcee: ii. Midhialsu and .1. £sage. "trsne utc lolliaa and V.,auutevIIV yIS tiam en admmstry An Intiesa Sønal I·u.g.. *uuun". Unald 1.1 nåk mneo; and eui aS tussna tadi. taased e- ,st.- * , ej'. ,* . . . • t • i .. .: ..I sy>.-.i - ' i .. i ' Mad tasÉ s. .. -10- .. 1.12 The Bank's recent report on the Trade Policy Regime in Pakistan discusses import and export competition and its impact on e.g export performance in some detail. Suffice it to say, here, that Pakistan's trade barriers remain high sheltering firms from foreign competition. Tariff barriers in 1986 were only surpassed by India in the sample of eighteen developing countries shown below. Over 402 of all 1011 4-digit commodity headings were subject to licensing requirements. At the same time, the real rate of export growth has been erratic during the 80's ind even negative for two years. Exports continued to be produced mostly by traditional sectors. Since 1982/83 the contribution of the top five and top ten export commodities has actually risen (cotton, cotton products and rice). Yet, at the same time, Pakistan's share in the world textile trade declined (see Volume II para -). 1.13 All this suggests that a shift toward more outward-looking trade policies would have a beneficial effect in stimulating greater competitiveness in Pakistan's industries vis-a-vis the outside world. Reduced protection would, of course, adversely affect those firms that are unable to adjust their cost structures, but it would generally keep domestic costs of production in check and prevent the exercise of monopoly power. Stronger incentives for exports would help industries take advantage of scale economies and encourage entry in industries that would otherwise be restricted by the size of the domestic market. It would also help revive productivity growth by orienting more firms toward the technological innovation necessary to remain competitive in world markets. For such policy changes to effect the implied shift toward more efficient, dynamic industrial investments, close coordination is needed between trade policy reform and -idvstrial deregulation. Issues pertaining to industrial regulatory policy are discussed in the following chapters, 0099R/1.04.88 - 11 - . . Table 1.3 UNWEIGHTED MEAN NOMINAL TARIFF RATES FOR MANUFACTURING INDUSTRIES, 1986 (% ad valorem) Whole Economy Manufacturing Standard Coefficient Standard Coefficient Mean Deviation of Variation Mean Deviation of Variation Pakistan 65.5 53.2 81.2 67.5 39.8 59.0 Argentina 21.8 13.7 62.8 21.7 13.9 64.1 Costa Rica 22.2 23.1 104.1 22.9 23.3 101.7 Ecuador 32.7 33.3 101.8 32.2 23.5 73.0 Egypt 30.3 30.7 101.3 31.5 33.8 107.3 Hungary 15.1 13.7 90.7 15.7 5.5 35.0 India 99.8 49.9 50.0 99.6 50.6 50.8 Kenya 37.2 23.1 62.1 37.7 21..7 57.6 Mexico 22.2 14.2 64.0 22.4 15.1 67.4 Morocco 23.3 15.4 66.1 24.0 14.1 58.8 PRC (China) 50.9 34.2 67.2 52.2 34.9 66.9 Philippines 27.9 15.1 54.1 28.0 15.8 56.4 Senegal 12.1 5.9 48.8 11.9 6.0 50.4 Sri Lanka 30.8 31.8 103.3 29.9 28.3 94.6 Thailand 33.8 27.3 80.8 34.3 25.3 73.8 Turkey 36.0 31.0 86.1 37.9 38.2 100.8 Yugoslavia 11.5 5.6 48.7 12.2 4.7 38.5 Madagascar 45.1 38.2 84.7 45.2 37.8 83.6 Source: World Bank, "The Trade Regime in Pakistan", November 1987. 0099R L .04.88 t -12- IL THE REFORM OF INDUSTRIAL REGULATIONS Overview 2.01 This chapter describes key regulatory instruments and the Government's policy to make them less restrictive in three areas: entry (investment sanctioning), pricing, and exit (firm closure). .Sanctioning determines the ability of investors to realize their proposals and may set limits on the size, nature, and location of new investments. Pricing policies affect profitability and hence the incentive to invest, while e%it policies determine how readily resources can be moved from one activity to another. Together with the trade polices reviewed in the preceding chapter, these policies strongly influence the efficiency and competitiveness of domestic industry through their impact on market structure, firm behavior, and performance.1' In particular, relatively unrestrained entry and exit in an industry provides a continuous check on market power by incumbent firms and strong incentives to improve productivity to avoid loosing markets to a new entrant. This chapter concludes that the Government's deregulation policy over the last years has been a success and recommends a limited number of remaining steps to.take. The role of the public sector is not discussed in this chapter because direct public investment has not been a significant source of new entry in most industrial subsectors. But public ownership (through nationalization) in some industries has affected market structure, behavior, and performance (see Volume II). A. Entry and Investment Sanetoning Current Pollcies 2.02 Investment sanctioning (licensing) policies consist of criteria that require private investors to obtain clearance from federal and provincial governments prior to establishing certain new projects or expanding existing capacity. The need for sanctioning and the level at which it is decided depend on the project's size, location, and amount of machinery and raw materials to be imported. 2.03 Today sanctions.are required: (a) For any project whose cost exceeds Rs 500 million (about US$27.9 million). However, an implementing memo to the financial institutions issued by the Ministry of Industries on December 30, 1984, remains de facto in force requiring all projects larger than Rs 100 million to seek authorization from the *' Volume II provides more detailed evidence based on reviews of semr subsectors: fertilizer, cement, automobiles, bicycles, vegetable ghee, polyester and cotton textiles. At the same time it has to be kept in mind that other policies e.g. rules on foreign investment, the behavior of public enterprises or informal interactions in the economy affect entry and exit. 0099R/1.04.88 -13- Central Investment Promotion Committee (CIPC) (see para 2.05) even though a ministerial decision is not required. (b) For a project on the list of "Specified Industries", which today comprise 10 subsectors related to (M) national*security and defense, (ii) religious and socio-economic considerations or subject to (iii) "indigenization" programs and (iv) price regulation (see Annex 2.2). (c) When a project requires (i) capital goods imports exceeding Rs 50 million (about US$2.8 million) for now and expansion projects, or exceeding Rs 10 million (about US$0.6 million) for commercial importers, projects on the specified list and balancing, modernization and rehabilitation projects (BMR) ; (ii) imports of second-hand machinery, except if financed through non-repatriable investment (NRI); and (iii) annual material inputs which exceed 60% of the project's total annual material input costs, if they also exceed 20% of fixed assets. (d) When a project is financed in whole or in part by foreign investors. 2.04 In addition, proposals for industrial investments usually must get provincial clearance prior to approval of the investment sanction. One condition for provincial clearance is to demonstrate that water and electricity are available. Even if a provincial sanction is not explicitly required, applications to the Investment Promotion Board (IPB) are referred to the provincial authorities to ensure that they have no objection. However, firms locating in an industrial estate require provincial approval only if they are on the restricted list for that area (see paragraph 2.30). 2.05 The decision to issue the sanction may be taken at the level of one of four development finance corporations (DFCs), the Central Investment Promotion Committee (CIPC), the Ministry of Industries or the Economic Coordination Committee (ECC) of the Cabinet, depending on the size and characteristics of the proposed project (see Annex 2.1). The sanction letter is issued either by a DFC or by the Investment Promotion Board (IPB), acting on behalf of the CIPC (an inter-ministerial body that in turn acts for the Ministry of Industries or the ECC). Projects requiring a ministerial level sanction are submitted by the DFC or by the CIPC to the Ministry of Industries, which can authorize a sanction for a project exceeding Rs 500 million in investment if it is not on the Specified List and is under the import limits. Other projects must be reviewed by the ECC. 1' Prior to 1987 the BMR limit was Rs 5 million. Separate limits - from Rs 5 million Rs 50 million - apply to BMR proaects in textiles depending on the kind of machinery and the size of 'the project. Imports under BMR benefit from concessional rates of import duty. 0099R/1.04. 9 - 14 - Obetives and Poley Direetion 2.06 The explicit objective of investment sanctioning, as stated e.g. in the Industrial Policy Statement of June 1984, is "to ensure that in major projects of national significance the final decision is based on a careful analysis of the implications for the overall economy." In particular, investment sanctioning was to: (i) avoid investment in "excess capacity"; (ii) reduce market concentration; (iii) restrict demand for imported inputs; (iv) allocate physical and financial resources to priority areas; and (v) limit overcrowding and demand for infrastructure in urban areas. The interpretation of these objectives has become more anc more liberal in recent years in reaction to the experience of the 1970s. 2.07 During the 1970s the investment sanctioning policy had become an important barrier to entry and growth for private investors. Since 1977, restrictions on private investment have been relaxed gradually, with the objective of encouraging competition and efficiency in Pakistan's manufacturing sector. In particular, in 1982 the Government instituted a Cabinet Committee which was to critically review and evaluate existing regulations and to make recommendations to dismantle unnecessary controls while proposing a framework to encourage both economic efficiency and economic justice. By 1987 the Committee had submitted reports on industrial sanctioning procedures in general and on deregulation in six subsectors (wheat, sugar, rice, edible oils, fertilizer and telephone and telegraph department). The thrust of the new policy was reflected in the 1984 Industrial Policy Statement which states that the "bulk of investment activity would be free from sanctioning procedures". As a consequence the criteria for projects requiring government approval through the sanctioning process continue to be eased gradually. The effects of past policies and issues arising out of remaining sanctioning procedures are discussed in the following. Overall Impact of Sanctioning Policies 2.08 It appears that in general, Pakistan's sanctioning policies have presented relatively low and declinihg-1arriers to entry. Investment sanction approval rates have been high. Between 1978 and 198., 74% of all applications received by the Investment Promotion Bureau (IPB) were approved by CIPC and only about 12 percent were rejected and the remainder referred to the ECC. Durin1 the same period, the value of industrial sanctions in most groups issued annually far exceeded actual private investment in manufacturing. This suggests that investment sanctioning is no longer a major constraint on entry. 0099R/I.04.88 Table 2.1: Sanctioned Investment Project (values in billion rupees) 1977/78 1983/84 1984/85 1985/86 Number of projects a 619 386 431 Value of projects: (in current rupees) 4.5 19.7 11.2 17.9 (in constant 1975/76 rupees) 3.8 10.3 5.7 9.0 Realized investment (in current rupees) 1.0 5.8 n.a. n.a. Source: Annex 2.5 2.09 In fact, during the past decade, various sanctioning requirements have been relaxed. The size limit was raised from Rs 5 million in 1979 to Ra 500 million today. Thirteen industries had been removed from the "Specified List" by 1987, namely defense-oriented electronics, basic steel, basic metals and alloys, heavy mechanical and heavy electrical plants, basic chemicals, public utilities, petro-chemicals, ships, aircrafts and railway locomotives, fertilizers, cement, sugar, vegetable ghee and cotton spinning. While prior to 1987. subsectors on the Specified List accounted for about 40% of total industrial output (based on 1980/81 Census of Manufacturing Industries data), those remaining after the 1987 liberalization account for only about 7 (see Annex 2.3). Import ceilings for capital goods have been raised continuously in the 1980s, starting from Rs 2.5 million in 1980/1981 and reaching Rs 50 million for new projects as well as expansion projects by 1987. 2.10 Relaxation of sanctioning requirements in the 1980s has been associated with strong increases in investment. Real investment in manufacturing grew at 6% p.a. between 1982 and 1987 and value added by 7.8% p.a. (Table 2.2). Between 1983 and 1986 a total of 1,236 new sanctions, with a value of Rs 48,805 million were approved. The value of investment sanctioned annually increased from Rs 4.5 billion in 1977/78 to Rs 17.9 billion in 1985/86 (Rs 3.8 billion and Rs 9.0 billion in 1975/76 prices; Table 2.1). Thus during a period of rapid economic growth the sanctioning system processed a higher value of investment proposals, under a simpler system of sanctioning requirements. It therefore appears that Government policy has. encouraged growth and in response processed investment applications flexibly. 009SR/1.04.88 - 16 - . Table 2.2: GROWTH OF THE MANUFACTURING SECTOR (in percent p.a. based on constant prices) Period Value (end of fiscal year) added Investment 1964-70 8.4 1.4 1970-77 3.7 6.2 1977-82 10.8 -2.6 1982-87 7.8 6.1 Source: Economic Survey, Ministry of Finance, 1986-87. 2.11 While, in general, the Government's deregulation policy seems to have progressed well and supported rapid growth in the economy some issues regarding sanctioning requirements remain. In the following, these issues will be defined and recommendations made to address them. Excess Capacity 2.12 One objective of investment sanctioning has been to avoid investment in "excess capacity" so as to minimize under-utilization of capacity and consequent debt-servicing problems in incumbent firms. li practice, however, restrictions on new entry and growth in industries with "excess capacity", appear to have protected inefficient incumbents while limiting expansion by efficient firms.1' In addition, investment sanctioning has not succeeded in preventing the creation of excess capacity in some industries. For example, domestic capacity in tractors, on a single shift basis, is estimated to be twice as much as domestic demand. And in another case the availability of domestically-produced equipment has enabled vegetable ghee capacity to grow well beyond sanctioned limits. 2.13 Government neither possesses reliable data on the number of firms operating in various industries nor on measures of capacity utilization relevant for economic decision making. It is also not realistic to expect that Government could obtain sufficiently complete data on a timely basis. Even if Government were to improve its data base, it would not be in a position to determine which firm in a given industry is most efficient and would merit expansion and which one is in need of restructuring or closure or whether new firms should be allowed to enter a given market. However, without knowing this good decisions would be difficult to take. 2.14 In practice, Government decisions to prevent excess capacity rely on the Industrial Investment Schedule (IIS) of the Five-Year Plan which sets out the aggregate amount of "additional capacity required" iniiench industry. Government has recognized the difficulty of obtaining useful comprehensive data and made it clear that the IIS is intended to be only indicative. Also, i-' See Volume II for a more detailed subsectoral analysis. 0099R/1.04.88 *17 - q '* - the IIS has mostly not constrained sanctioning e.g., during the Sixth Five year plan period (1983-1988), on average, only 57 percent of the Industrial Investment Schedule (IIS) estimates of planned additional capacity have been sanctioned so far. (see.Annex 2.5). Nevertheless, until recently, the Specified List of products that always require a sanction included a category of products characterized by excess capacity (sugar and cotton spinning). For these and several other products (such as vegetable ghee), the IIS provision for "additional capacity required" vas zero, and approval of new sanctions was consequently restricted. 2.15 By now sugar and cotton spinning have been removed from the Specified List. It appears even more doubtful whether government needs any sanctioning instrument at all to prevent excess capacity or in other words whether authorities can effectively discharge the responsibility for achieving the "right" level of capacity. Rather investors should be left free to bear the risk of trying to enter an already well-supplied industry. The latter approach would also require exit policies that facilitate the departure of inefficient firms. Market Concentration 2.16 In some industries, investment sanctioning has been used to avoid market concentration by ensuring that the market is divided up among two or more entrants rather than a single large firm. Previous policy interventions to control market power focussed (a) on ensuring a minimum number of firms by restricting firm size and (b) on controlling prices (see paras 2.35 to 2.40). These policies resulted from the lack of import and export competition under the high trade barriers that have been used both to promote industrial expansion and to defend the balance of payments. Past efforts to create a competitive market structure have proven self-defeating for two principal reasons: they have reduced competitive pressures by fixing market shares and removing the threat of aggressive expansion or entry; and th&y have prevented firms from reaching minimum efficient size in industries where economies of scale are significant (e.g., cement, vegetable ghee, polyester yarn). Suboptimal firm sizes restrict an industry's ability to export and to provide efficient import substitution. In addition, price controls had distorting effect s on the amount and location of new investment (e.g. cement, fertilizer), discouraged cost reduction (e.g., vehicles), and made firms unresponsive to changes in world market conditions (e.g., edible oils). 2.17 The need to regulate monopolistic industries through direct intervention is diminishing over time as the domestic market expands and the threat of new entry at a cost-minimizing scale becomes more credible. Thus., on-going measures to liberalize investment decisions (including removal of price controls) are one appropriate means of enforcing competitive behavior. Nevertheless, the danger of excess profits and investment exists as long as trade barriers are high. Deregulation of investment and pricing therefore needs to be complemented by corresponding libexalization of trade policy. Potential competition from imports is the most direct and responsive means of preventing firms from realizing excess profits and forcing them to minimize costs. 009SR/1.04.80 -18- '4 2.18 Conclusion - Investment sanctions have in the past rarely contributed to the stated aims of controlling market power or preventing excess capacity, nor have they effectively directed resources into priority areas. Therefore, it is recommended to abolish all sanctioning requirements based on project size (presently Rs 500 million). Investment sanctioning requirements could be replaced by reporting requirements, which will help the Government in designing and monitoring indirect competition policies. 2.19 Furthermore, it is recommended to reduce further the "Specified List" of industries requiring sanctions for Projects regardless of size. Today only a few sectors remain on the specified list, i.e.: (i) a few industries of special concern for national security and defense; (ii) industries regulated for religious and social reasons (alcoholic beverages; (iii) industries subject to indigenization programs (e.g. electric appliances, cars, etc.); and (iv) drugs and pharmaceuticals. Industries subject to indigenization rules should be taken off the list. A proper mix of trade policy, domestic competition, excise taxation and restructuring programs is more likely to improve performance in these industries. Drugs and pnarmaceuticals which also continue to be subject to price controls could simply be subjected to domestic health and safety standards. However, in view of important health and safety issues involved a review of the feasibility of such a policy should be initiated first. Companies directly related to national security and defense and industries with religious or social implication could remain subject to direct Government control. Foreign Exchange Rationing 2.20 A third major reason for sanctioning requirements has been the attempt to ration foreign exchange. An import license is required for all capital goods and industrial input imports. The Chief Controller of Imports and Exports (CCIE) can issue import licenses to firms without'investment sanctions only when small amounts are involved. This is done on the basis of passbooks issued by provincial authorities which specify the annual amount of imports which CCIE is permitted to license. Beyond specific import limits (see para 2.03), the amount of imported capital goods and annual raw materials amounts for which CCIE can issue licenses is laid down in the investment sanction. As a result of these provisions, firms depending on imported raw-: materials or equipment cannot operate without an investment sanction either by the Central or the provincial Government. Investment sanctions set quantitative restrictions on capital and raw material imports, although there is no explicit foreign exchange allocation process. 2.21 While the import limits in principle only indicate when prior investment sanction is needed from the Ministry of Industry or its designate, they may be used in practice as a criterion for acceptability of an investment proposal. Several private investors indicate that their proposals were rejected out of hand because they "did not conform with the 1984 Policy Statement", in that they exceeded the specified import values. 0099R/1.04.98 2.22 Therefore despite the liberalization measures mentioned above (para 2.10), many projects will continue to require investment sanction approvals because of capital goods or rew material imports. The foreign exchange component of projects sanctioned between 1977-1986 was generally around 50% (see Annex 2.7). Under the current capital goods import license limits of Rs 50 million, the average project larger than Rs 100 million would in practice continue to require a central government sahction, on the basis of import requirements even though it is well below the official size .limit. As a result even if the size limit and the Specified List were totally eliminated, the import limits would continue to be a binding sanctioning requirement for many investments that currently require a sanction. In this sense further deregulation is identical with trade liberalization. 2.23 Conclusion In line with the Bank's recommendations on trade policy reform, it is therefore recommended to abolish all quantitative restrictions for the import of capital goods and raw materials. This policy would have to be phased in along with other measures such as exchange rate adjustments to restrain excess demand for imports and stimulate increased exports. Eventually, tariffs would govern import decisions as proposed in the Bank's Trade Policy Report of November 1987. As recommended there, tariffs could initially be set so as to reflect the difference between domestic and international prices. This would enable industries to remain viable and give them time to develop strategies to cope with greater import competition as tariff barriers are progressively lowered. In addition, firm and industry specific restructuring programs could support this adjustment effort. Major issues of sequencing between domestic deregulation and trade reform no longer arise. Government has already largely dismantled most restrictions (incl. price controls (para 2.36) which are not identical to trade barriers. Domestic industry would therefore be in a position to adjust in response to further trade liberalization. What remains to be done is to expose firms to more international competition while continuing to improve the supply of infrastructure to them (para 2.32). Delays, Uncertainties and Discretionary Policy 2.24 While the rate of approval of investment sanction applications has been high, delays have been a significant source of concern to investors. Delays are evidently due to a combination of the amount and complexity of information required, uncertainty as to what is required, failure of firms to provide complete data with their application, the political implications of decisions and corrupt practices. For projects requiring an investment sanction, applications are submitted either to the Investment Promotion Boar,d (IPB) or to one of four authorized DFCs. The IPB requires a detailed economi!c analysis as well as the financial plan which is a normal part of a DFC loan application . Several firms indicated that preparation of a project .L/ Sanctioning can be understood as a substituta for an efficient loan appraisal by a commercially run bank in a deregulated economy. However, in the presence of effective trade barriers world prices are either not really used for project evaluation or the trade barriers are not effective. Reforms t, make banks more autonomous combined with trade liberalization would best lead to efficient economic and financial evaluation of projects. 0099R/1.04.88 1 -20- proposal in a form acceptable to IPB meant delays of several months before acceptance for review by IPB. The greatest delays occur - often because of the political implications of decisions - with projects to be reviewed by the , ECC (about 185 of the of applications approved by CIPC). 2.25 Such delays affect the speed of adjustment and the transfer of resources in response to changes in domestic and global conditions. They often result in increases in project costs, which in turn causes problems with the financing package. Also, the length and complexity of investment controls have encouraged rent-seeking activities - i.e., acquiring sanctions to sell them for a premium - at the expense of directly productive activities. Delays from investment sanctioning have prevented firm from responding flexibly to changing market conditions. In cotton spinning, for example, restrictions on capacity creation led to spinning capacity shortages relative to increased international demand; this resulted in "voluntary" export restraints and lost foreign exchange earnings. At the same time speculative purchase of sanctions has somewhat offset the restrictiveness of the system. Some investors acquire sanctions when policy is liberal. In periods when new investment is restricted in a particular industry, sanctions can then be sold at a premium (even though they are not officially transferrable). Thus, the volume of sanction applications may exceed actual current investment 4emand. The Government has tried to counter such moves by limiting the validity of sanctions to a maximum of one year. 2.26 Not only delays but also periodic and unforseeable changes in investment sanctioning, price controls, import licensing, tariffs, and exchange rate have in the past created significant variations over time in the height of entry and growth barriers and in investment risk/return profiles. In addition, "informal" instructions from the Ministry of Industry or the Cabinet have also been issued to DFCs imposing temporary moratoria on new lending to particular industries. In a number of key industries, such as cotton spinning and cement, Government has used investment sanctioning as an instrument for subsector-specific and overall resource allocation by imposing temporary restraints on new entry or expansion. The result has been reduced levels of domestic competition and increased costs in terms of delays and uncertainty. 2.27 Conclusion - The recent liberalization of pricing and investment sanction policies, and opering up of the economy to international competition need to be sustained ina steady and progressive manner designed to convince investors and producers that policy changes will not be reversed. Liberalization by itself reduces delays and opportunities for rent-seeking behavior. Another step in this direction would be to reduce the number of ad hoc orders that provide special exemptions from import duties or other prevailing policies, as well as other direct interventions that encourage rent-seeking activities such as interest group lobbying and corruption. Reducing the number of interventions and exceptions wodld reassure investors that they can respond freely to the incentive environment. When immediate implementation of policy changes is not feasible because of political factors or the need to allow an adjustment period, the correct signals can nevertheless be given by pre-announcing the measures to be taken, together with a realistic schedule for implementation that is followed rigorously. Until the credibility of the reform program is fully established, however, the 099R/1.04.88 --21- Government must be prepared to resist intense pressures from the parties affected by such changes. L Access to Utilities and Intrastructure 2.28 While most investment sanctioning rules have been relaxed gradually, location policy has become more restrictive, as pressures on urban development Increase. Provincial location policies have two main objectives: to ration scarce urban infrastructure, and to promote regional equity by dispersing industrial production. The concentration of labor and the strain on infrastructure, notably water, in urban areas are particularly important concerns, especially in Karachi. In Karachi, the list of industries in which investment was permitted was reduced from 31 in 1979 to 21 in 1984. An increase in the range of industries permitted, is however under consideration. 2.29 At present the Sind Government restricts new investment in Karachi, Dhabeji, and Ghare to the twenty-one specified industries, mostly consumer products and repairs. Industries not on this list, and expansion of existing units, require provincial government approval, generally not given due to pressures on water and electricity. The Punjab Government specifies industries that require locational approval; allows only certain consumer-oriented and export industries within Lahore; prohibits small-scale industries from locating outside industrial estates in towns where such estates exist; and regulates establishment of industries close to the Indian border. Baluchistan requires that industries in the Hub Chowki area locate within the industrial estate, except for major investments such as cement and fertilizer which can negotiate their location. 2.30 Today, the location decisions of many firms are governed by a sanctioning mechanism and not primarily by infrastructure prices which reflect the economic cost of supplying additional users. Firms torced by location policy to locate or expand outside major urban areas incur substantial extra costs in several areas: building infrastructure such as utilities, housing, and roads; and transporting imported raw materials; and moving products over large distances to markets. This cost is then partially reimbursed to the firm through tax advantages and the creation of industrial estates. At the same time those firms actually using the scarce urban infrastructure pay less for it than its market value or than the cost of expanding it. Thus, this system of rationing limited water and electricity supply through location policy rather than prices provides no incentive for incumbents to reduce usage, nor for utilities to invest in increased supply, while burdening the Government budget with extra expense for special incentives. 2.31 Conclusion Thus next to trade liberalization the second major issue for further deregulation is the approach to rationing infrastructure. Movement from rationing by sanctions to rationing by tariffs (e.g. power and water rates) would improve the access to resources by firms with the highest ability to pay and therefore the highest profitability.-' It would also .L/ In the short-run a more effective load management program could improve the allocation of scarce infrastructure services such as electricity. 00998/1 .04.88 -22- q4 encourage more conservative and efficient use of scarce services such as water. Higher revenues would improve the ability and willingness of public utilities to expand service and at the same time help the Government budget. * This would not make locAtion policy unnecessary, but would focus it on economic criteria and permit focussing on incentives rather than restrictions to achieve the objective of dispersing investment and employment opportunities. While the social implications of utility rates cannot be neglected, failure to begin adjusting the tariff structure will aggravate rather than solve the problems that have given rise to location restrictions. 2.32 Increases in the cost of energy, water, and other services would by themselves tend to reduce the international competitiveness of Pakistan's producers. However, the exchange rate adjustment necessary to complement trade policy reform would provide offsetting improvements in the cost of non-tradeables such as infrastructure and labor. At the same time, the structure of taxation should be shifted from mainly trade-related sources to taxation of transactions regardless of product origin. These combined trade infrastructure deregulation and tax policy reforms should maintain Government revenue, enable price signals to replace direct investment controls, improve efficiency of resource use, and maintain or improve international competitiveness. 2.33 Environmental concerns could be addressed by charging special taxes or surcharges reflecting the deemed cost of such pollution to the community. This would be imposed in addition to remaining zoning regulations defined by the appropriate authorities. To support regional development and in particular employment creation, labor tax reductions or employment tax credits could be adopted for target locations. This would provide a price-based incentive which investors can incorporate into their decision-making in evaluating the additional cost of setting up a project in a non-industrial area. In addition, some minimum health and safety standards would always impose limits on a firm's choice of location. C. Pricing Policies Objectives 2.34 Government has controlled prices of manufactured goods in order to: (i) redistribute income and minimize political disruption by keeping prices of critical consumer goods low and stable (ghee, pharmaceuticals); (ii) stimulate downstream industries by keeping down prices of intermediate products (fertilizer, fuel); (iii) stimulate investment by ensuring an adequate return (cement); and (iv) limit inflation I'. Evolution of Price Controls 2.35 Historically, ex-factory and retair prices for a wide range of products have been regulated through a dombination of informal guidelines and Pakistan Economic Survey, 1979/1980, page 112 states price controls as a means for curbing inflation. 0099R/1.04.88 -23- official procedures at both the provincial and the federal levels. In the 1970s, ex-factory prices of selected industrial products were set. either directly or by adding sufficient margins to costs to allow a 15% to 20% return on equity for a plant operating at a specified capacity utilization level. The government, however, has recognized that price controls aaw stifle production, and that cost-plus pricing discourages cost reduction. In the 1984 Industrial Policy Statement, the Government declared its intention to move from cost-plus pricing to pricing based on supply and demand forces for traded goods. Although most traded products are now free from controls, the Government has implemented this policy cautiously for a number of key commodities, as the following illustrations show (the impact of pricing policies on firm behavior is discussed in Chapter III, Section 3).-"' 2.36 Price controls on cement after the industry was nationalized in 1972 resulted in shortages relative to increased demand. In 1978, the Government lifted the ban on private investment and introduced a price fixing scheme that guaranteed 151 to 201 return on equity. This target rate was applied plant-by-plant on the basis of fixed and variable costs at 90% capacity utilization. A variable development surcharge was added (or subsidy subtracted) to yield a uniform ex-factory price. Freight charges also were subsidized to distant locations to equalize retail prices. These pricing arrangements were abandoned in 1985 in favor of free market pricing, although the State Cement Corporation of Pakistan (the dominant, state-owned firm) has introduced only limited flexibility for pricing at the plant level. 2.37 Prior to 1986 the return on equity, and ex-factory and retail prices for nitrogenous fertilizer plants were fixed by the Economic Coordination Committee, in consultation with appropriate ministries. As in cement, uniform retail prices for fertilizer were set while ex-factory prices were determined by applying return-on-equity formulae to individual plants. When producers' costs plus agreed profits exceeded retail prices, GOP provided a development subsidy; plants with costs plus agreed profits falling below.the retail price were tequired to pay a development surcharge. Marketing expenses also were fixed for each factory separately. In May 1986 ex-factory and retail prices were decontrolled for nitrogenous fertilizers and imports were partly liberalized. Although prices for phosphatic and potassic fertilizers are not decontrolled, informal pressures have been created through,a policy of importing if the price of the urea rises above a certain threshold. 2.38 Until April 1986, the prices of ghee and its main input, edible oil, were regulated. For ghee, a basic and politically sensitive consumer good, prices were fixed at low levels, sometimes with no increase for several years. As input prices increased, subsidies on ghee production and . consumption rose to 421 of all subsidies in 1984/85. Short-term stability in domestic ghee prices was maintained by controls on both edible oil imports and local cottonseed oil, which the Ghee Corporation of Pakistan (GCP) purchased and distributed at set prices. To stabilize the price of imported edible oil, While output prices of traded goods may be decontrolled, distorted production decisions may still arise from uneconomically priced non-traded inputs (e.g. electricity). 009R/31.04.88* -24 - an import duty was introduced that fluctuates inversely with international prices. Prior to 1983, the Trading Corporation of Pakistan (TCP) imported edible oil for both GCP and private firms. If the international price exceeded the domestically set price, units paid the international price. If the international price was lower, TCP collected a variable import tax on edible oil imported for public sector units while the private sector was . allowed to import independently. After mid-1983, international prices regularly exceeded domestic prices, inducing all private ghee producers to purchase oil from GCP, which took over importing. Since April 1986, private producers have been free to import and to set prices. Retail prices have nevertheless been informally regulated through the pricing policies of the state-owned GCP, which supplies over half the market. 2.39 The Government continues to control prices of refinery products, motor vehicles, and bicycles. Vehicle prices a:e how'ever, liberalized de facto because official price ceilings are set :igher than the market will bear. Although formal price controls on bicycles wert lifted in July 1979, prices continue to be regulated informally by the the provincial Minister of Industries who must be consulted if a producer wants to raise prices. All in all price deregulation has progressed very far. 2.40 Conclusion - An issue that remains is hidden price controls which may at times be exercised through the pricing policy of public enterprises or informal pressures on firms to adhere to certain pricing rules. The Government's policy of awarding greater autonomy to state enterprises and greater reliance on indirect industrial policies should help remove remaining .obstacles for efficient firm behavior. D. Exit Policies 2.41 For resources to be available to new and growing industries in response to changing domestic and international incentives, they must not remain tied up in industries that are no longer competitive. In Pakistan, however, government and banking policies tend to keep financial resources in ailing activities. This stems partly from financial practices and partly from the Government's reluctance to lay off workers or let physical capacity sit idle. Credit Policies for Ailins Frms 2.42 Non-Performing Loans - Provision for and liquidation of non-performing loans is an important means for banks to avoid tying up resources in or ascribing income to loans that are unlikely to be collected. The national commercial banks (NCBs), for example, are required by the State Bank of Pakistan to make provisions for 50% of "doubtful" debts (those that are not fully secured, but have some recoverable debt) and 100% of "losses" (debts that are not recoverable, including for lack of adequate documentation). NCBs must also classify overdue loans with sufficient security as "substandard." Furthermore, they are prohibited from accruing interest on loans for companies whose operations have been closed continuously for one year, have been unprofitable for three years, or are subjected to liquidation proceedings. 0099R 1 04 aS - 25 - 2.43 The DFCs, on the other hand, are not subject to the same standard requirements for making provisions for substandard loans. Indeed, this practice is discouraged by the requirement that such provisions be certified by the State Bank of Pakistan before being eligible for tax exemption. Each DFC has its own rules and procedures, and on the whole they bend to underestimate doubtful debt in order to avoid deterioration in their balance sheets. Accumulated provisions amount to only 2.4-4.91 of DFCs' total outstanding loans (Table 2.4), which is less thsa the 5.41 shown for the co mmercial bank and is reportedly lower than it would be if the criteria mentioned in the proceeding paragraph were strictly applied. To the extent that doubtful debts are carried as if they were performing and interest accrued on them, the balance sheets of DFCs overstate their liquidity position. Since DFCs are the main source of industrial term leading, this tends to restrict the liquid funds available for new long-term investment while sustaining activities that are unlikely to be competitive over time. Table 2.4: PROVISIONS FOR DOUBTFUL DEBTS (in million rupees) PICIC NDFC IDBP NBP 1986 1985 1985 1985 Advances Outstanding (1) 5,918.0 7,191.8 4,089.5 33,053.0 Provisions for Doubtful Debts (2) 247.1 173.8 202.8 1,789.0 As Percentage of (1) (4.2) (2.4) (4.9) (5.4) Effective Advances Outstanding (1-2) 5,670.9 7,018.0 3,886.7 31,264.0 Provisions for Doubtful Debts made during the year 26.2 6.7 60.0 n.a Write-offs and Remissions 43.8 84 : 1.2 - n.a 85 : 0 NOTE: PICIC - Pakistan Industrial Credits and Investment Corporation. NDFC - National Development Finance Corporation. IDBP - Industrial Development Bank of Pakistan NBP - National Bank of Pakistan. The first three are DFCS, the last a commercial bank. 2.44 Writing off bad loans is not a common.practice, partly because it is discouraged by cumbersome procedures. Prior approval of the Pakistan Banking Council is required to write off loan defaults exceeding Rs 25,000 (equivalent to about US$1,400), or Rs 100,000 for foreign banks (about US$5,600). Although a centralized audit is reasonable in principle, greater use of write-offs when appropriate could be encouraged by raising the limit for central review (the rupee amount has not changed since 1974) and by shifting to ex post auditing. 0099R/1.04.88 -26- 2.45 Credit and Collateral Recovery - One reason why banks in Pakistan tend to prefer financing an ailing client to foreclosing, is the uncertainty and delay involved in credit recovery. The 1979 Banking companies Loan Recovery Ordinance was an attempt to make it easier for banks to recover loans. It expanded coverage under the civil code from documents of payment and letters of credit to all bank loans, requiring defending debtors to deposit equivalent money or securities with the court and get the court's permission to defend. To expedite the loan recovery process., the Ordinance also set up special courts: the District Court for loans up to Rs 1 million, and the High Court for larger loans. This has helped to shorten the process, which previously took an average of seven to eight years. Nevertheless, it still takes four to five years to finalize a case and realize the collateral through public auction. This is partly because the special courts have not been adequate to handle the backlog of cases, which were on the order of 500 or more per special court in 1986. Another problem is locating borrowers and obtaining their acknowledgement of notice to appear in court. These delays give borrowers time to milk assets out of the enterprise. Banks thus generally prefer keeping existing borrowers afloat in hopes of getting a partial but steady return. 2.46 Restructuring Assistance - Government policies to ass..t sick companies provide some supplement to bank resources for ailing debtors, but do not encourage debt write-offs. The Committee of Sick Industrial Units was established in 1981 to assist private companies experiencing difficulties due to the effects of the 1972 devaluation. In 1985 this committee was replaced by the Industrial Rehabilitation Committee (IRC) and the scope enlarged to cover all sick companies for whatever reason. The IRC is headed by the chairman of the Pakistan Banking Council (rather than the Ministry of Finance), reflecting the Government's intention to shift responsibility for resolving such cases to the banks and the debtors themselves. In the last five years, the committees have approved 432 out of 500 applications, with about 60% of approvals reported as successful rehabilitations and the remaining 40% including both unsuccessful cases and those still under implementation. 2.47 The guidelines on IRC relief do not state any eligibility criteria other than "honest and creditworthy" management and a detailed study by the lead creditor of the reasons for sickness and the proposal for rehabilitation. The latter typically should include: (i) change of management; (ii) fresh financing for BMR investments (60% from the lead institution, 40% in fresh equity from sponsors); (iii) recommendations to the Government for adjustment of tariffs and levies; (iv) working capital on a fully secured basis; and (v), reduction of the debt burden to a level that can be serviced by the company!s' cash flow, taking into account BMR and other rehabilitation expenditures. The Government then finances the excess debt that cannot be serviced by converting it into special Participation Term Certificates (PTCs). The holders of PTCs (usually the Government or banks) do not share inithe profits until the restructured debt is liquidated. PTCs 're redeemed in installments over ten years. Thus, most debt restructuring is through deferral and rescheduling, rather than write-off. This method is attractive to the banks because it allows them to hold asset claims and does not affect current balance sheet profitability. Thus, it is a rtisonable method to restructure existing firms. At the same time by providing public funds to rehabilitate sick 0099R/1 .04.88 a -27- . industries it strengthens the incentives of banks and firms to rehabilitate existing firms rather than to channel funds into new activities.' 2.48 Bankruptcy - F.irms can be formally closed either voluntarily or through bankruptcy proceedings. Voluntary winding up requires a declaration of solvency, a meeting with creditors, paying all the debts and dues, and allocating the remaining resources to shareholders. It is reportedly rarely used in Pakistan, either because owners are reluctant to admit to failure by going out of business or because they find it more profitable to sell their enterprise or assets. Bankruptcy proceedings are initiated upon petition to the court by a company, creditor, or shareholder to wind up the company because of inability to pay debts, or other reasons. These proceedings are subject to the delays and problems described above in paragraph 2.45. 2.49 Conclusions Restrictions on the transfer of resources will have an increasing cost in terms of reduced allocative efficiency as firm entry and expansion are liberalized. As competitive pressures are increased, measures to facilitate the flow into efficient industries will be important to promote growth and avoid the otherwise inevitable rise in the incidence of "sick" industries, and the need for subsidies or other forms of government support for them. The key to success in this area will be reforms regarding the banking system. The relevant issues are discussed in more detail in the Bank's report on the financial sector. The principle recommendations are: (a) to establish an arms-length relationship between bankers, borrowers and the Government; (b) to provide bank managers with clear incentives to improve long run stability and profitability; and (c) to give banks the means and incentives to exercise their function in disciplining firm behavior (e.g. by taking over insolvent firms) and to provide constructive help in restructuring ailing companies. Measures to improve the ability of the courts to dispose of bankruptcy cases would also facilitate exit and the recovery of collateral. Labor ReOiations and Aling Firms 2.50 By its nature, labor regulations increase the cost of exit as they tend to make it difficult for firms to close or reduce labor costs. Up to a point this is desirable: first for social reasons, namely to protect workers and second for reasons of efficiency; e.g. because higher costs of dismissing employees provide additional incentives to employers to train their workers as the relative cost of improving the work force through training is lowered. The issue is whether labor regulations provide "excessive" protection to workers. In Pakistan employers of more than 10 workers are prohibited from closing an establishment or terminating more than 50% of the workers without prior permission of the Labor Court, which is charged with investigating . * whether the retrenchment is for bona fide reasons. If, however, the employer and workers reach agreement on compensation for terminated workers, then the employer need only register the agreement with the Labor Court. The Provincial Governments are particularly concerned to avoid labor unrest, and Tariff policies also tend to favor rehablitation of existing capacity over investment in new industries. Machinery imported under BMR is exempt from tariff, and a tax credit of 15% of amounts invested from July 1976 to June 1988 is allowed against company debts. 0099d/1.04.88 -28- .4 often play a role in negotiating a satisfactory settlement., Of the twenty or so cases per year filed with the Labor Court in Sind Province, about half are settled with "golden handshakes" accepted by the workers. Only about 10% of * the remaining applications by employers are rejected. Thus, the provisions do not constitute an absolute barrier to exit so much as raise the cost and time required. 2.51 In addition a good number of firms have shifted to "contract labor" to avoid problems in laying off workers. A worker becomes "permanent" after 90 days probation. This entitles him to termination benefits of 20 days wages for every year of service or his entitlement in the provident fund (companies must contribute 5% of profits to a Worker Participation Fund). Companies must also make contribution to the Social Security Fund, Old Age Benefit, and Group Insurance for permanent workers. Some companies have attempted to avoid these provisions by rotating workers every 90 days or by hiring a contractor to provide the labor, although the Government discourages such practices. 2.52 Employers can also put workers on temporary lay-off at half-pay for up to 14 days. By then paying a full day's wage and starting another 14-day cycle, firms can keep workers at half-pay for an extended time. This provides an alternative to outright retrenchment during a temporary production cut-back, but it clearly can aggravate the financial problems of a sick industry. Although workers can take cases of temporary lay-off to the Labor court, they usually are content to work elsewhere while collecting their half-pay. 2.53 Conclusion While many private firms, particularly small ones do not appear to suffer from excessive labor protection, large firms, e.g. state enterprises may be unduly constrained at times. In these cases greater flexibility may be needed to encourage the mobility of labor and the shift of employment opportunities to growing "sunrise" industries and to allow for smooth reduction in "sunset" or declining industries. In general labor issues in the case of firm closure or restructuring need to be tackled by improving opportunities and incentives for retraining workers and by establishing constructive relationships between management and unions, particularly in large state enterprises. Concrete recommendations on this issue would, however, require more detailed investigation. IIL SUMMARY AND CONCLUSIONS 2.54 In sum, the Government's deregulation policy appears to have progressed well. The ill-effects of past regulations, which are described in some detail in Volume II would be expected to subside. The Industrial secter. has been exposed to increased competition at home. More firms have learned and are learning to adjust in response to market forces. Trade reform has become both sensible and possible in such an environment to further improve export performance and efficient production for the home markets. 2.55 To further improve the policy framework for industry the Government would now need to concentrate on: (a) liberalizing the trade regime, by first switching from non-tariff barriers (in this case investment sanctions) to tariff protection and subsequently by lowering tariffs. 009SR/1.04.88 -29- (b) allocating demand for scarce infrastructure on the,basis of prices, which reflect the economic cost of supply, instead of rationing infrastructure through sanctions. (c) improve the banking system (including credit recovery and bankruptcy mechanisms) not only to improve the health of banks but also to improve project selection, as well as to facilitate resource flow from ailing to promising industries and the restructuring of illiquid firms. 2.56 In addition, Government should continue to simplify or abolish remaining sanctioning rules. In particular the size limit on investments should be abolished and the specified list of industries reduced to those relating to national security and religious considerations. Equally discrimination of commercial importers and at least minority foreign investors should be ended. Further steps to commercialize government enterprises would make price liberalization more effective and increase labor mobility. The role of Government agencies which today exercise controls that are to be abolished would need to be rethought. In general it should shift toward greater efforts to collect data, monitor trends and conduct policy analysis, while encouraging administrators to adopt a pro-competitive rather than controlling attitude toward business operations, in keeping with the spirit of deregulation policy. 009SR/1.04.8g 〕.!.;:丰 ‘。1。•州斤”&“坤細由“。d‘鳥 唱煙目口物口目,.•認 •。細戶”.吋“•開鳥...&,一鳥i f。:亂••.論神州細亂.••細1.唱t•. •馴”么g么。•劇目比•么••..一2t .。細戶“劇州必”•購“喊認 •馴嗚么t細d么‘&&.誡。《••滷口, .煙hd么嚇由“認亂視•口口計1弱 &.細••.曉ih&&“一、“c.t&.•〝”&.t。.一t&,L,.•遞細.& 一細•鳥,么”U牌飼陶••‘ ’主他望‘勸:lda戲由“&&.:&h&.取g也••“,•k名at.,?•hl.”。z ■•■■■■■■■■■•■■.• ’忽‘了不•開。助二;P.矗0.二.二魷濺‘下二•。‘,_&1 贊開。間仲濺江,•二叫。;hR當.下二訪,即ul T7&L96T二.q.鳥d.s夠ITI -&,·〕 唱叩網向•馴心 •d物 細目b〕A :”馴悶O馴”魚叭 間陣華”開•.馳戶•由《. ,目.。一 馮用戶權― •,甲自祖綢學遞,^ 。蠶滌羈戰築篆 。讀開牌目啊 鄙 。p心闖••州年 。侈編寫旬屆歸州年 嗡撇,&“玲””。蓄〕A〝,閑常袖哺吧勿戶權h二. •甲啊州物啊‘A! ,州單•嗡”他系必寧吧p•馴陽,州織唱 憤中挪O規調戶d ”卸開戶嗎才個中d 仰網同膩O啊開囉 ,•啊鑪神導躍馴言必開啊戶•州寫調嗎”州必助H 州曉州戶,甲騰劉牌”囉神•他萬戶•州 .戶嗎網口g -仰自呵戶州網膩神鑼喝劇號不n .必“系吃牌州p“中仰‘鉤‘狗開觀引”勵•‘神開哺,”用,率馴階. •叩點神甲田O神.閱個復.戶吃戶••瞬妒〔’n 囉闖司悶闖•解謬卜悶戶闐學 •粤戶織閱煙神勻•網心開憫中q 細戶神權綢馴. ”嶼Wp•顱也叫哈,“挪學d勾“觔嗎. .•喂啊纖••V戶此〝“V. •,甲囉戶”盧學”弓戶悶同紀’l 斤悶口馴U矗口山個馴口膩認鱸歸 • . 。- 、個. ,. t&2 x.雙UV ■•■•••■■•••••••• Anne% af prolects sanctioned Nu %KUMS a§* til tis 93 319 tever"e Tatilm 10 44 225 IV. Rdhf and 7 2 13 RuMr P~cts v. how & Pulp 20 12 13 45 VI. ~ Als, Phar- 42 n 41 U& amticall 4 Petrole" Proa. Vil. Petroleu Re- 35 27 fining and P*trufteolcals ¥M. C~ t & oth« 32 19 u 72 non mullic me- @ral ~ Cts 11. Usic fttals 3 12 27 1. fttal vaducts 17 20 1.7 b4 gachinen atiller 37 than flectrtcal 111. Electr" 17 14 46 Elettr~ 4 4 1, [IV. Tra~ FAG 12 13 12 31 IV. Service ad 411 Må 4U au Annex 2.3 V111. haut Mptal a.iaactieSe, car - .8 8 12 ta 75 19 99 ,4019 5attud, ca 12 6 60 44 g17 51 203: 4 C.3a41226 42 10 90 13 a 1.9790 e. c.!a. 7.93 0. I0 0.10 1.0 0.01 . 11. Hetal raCts a.Sa t~hU, cer 66 68 9 40 16 225 1127 370 107 b3.01 b.samtucu, ca 55 54 i 26 117 13 591 191 5 c.Neali:td 13 2 4 29 49 74 40 . .*a. 0.23 0.03 0.04 0.73 0.26 0.33 0.04 1. Nach"iner ethe tha electrical a.Suctiffuf, cer 11 9 13 170 436 487 171 409 7194 b.Sctiosd, cos 9 7 9 110 274 2U 93 314 3634 c.Aflue 5 1 165 3 438 d. c.a. 0.45 0.11 0.38 0.17 2.46 XI. £l.str:cal Rachiin a.Sacti~. cur 45 241 50 .33 256 147 49 274 -259 3. b.Sactience, can 38 190 36 219 161 I7 246 141 131 ? c.Ratued 20 11 46 115 157 115 d. c.a. 0.44 0.05 0.92 0.34 0.61 0.25 i1. Electrots a.Sactoned. cur 1 '20 11 17 22 207 225 15754.11 4.Sanctiaed, ca. 1 14 7 11 13 10 116 79 c.RuaNGau* 7 21 14 54 a. c.ia. 7.00 1.24 0.64 0.26 ItUl. 7eaasort Est. &.Jactinet. cur 86 51 19 116 207 140 812 392 258 12. . 5.Sanction. can 72 40 14 75 130 83 426 202 130 c.3ealiz@d 4 2 20 12 197 39 4, .a. 0.05 0.11 0.17 0.06 1.41 0.05 XIV. Service aue miscellasmams &a.ctionet, cur 295 1196 379 9 483 541 982 71t 1251 d.ol 5.sdactinms, ca 246 944 271 58 304 322 515 397 632 c.Realiz 61 19 151 99 715 25 29 4. c./a. 0.21 0.02 0.40 1.11 1.48 0.05 0.30 TOTAL.-curet r.me 4512 7483 6872 918 9420 1219 19742 11162 17901 57..V coMat ruos 3763 5907 4912 6179 5920 7214 10347 5749 9042 1 . . a. U current Rug~es D. * constat 1975176 ruoms ur:taf uannqCf IMtätat :.u , :tr åap .19 :9 ..... .,n , . . 'fl-fl fl., fl. . . . . . . .... 'f.lll 'lf.fl .a...... . , ,*a*W . .D:bIpsee -. n ern * . a. . . . . . . ... .. - -~fl. *esteen! W a8 ' .. ...*..... ..-. ..... .. .. -- . .- - f. - - -- - . f. -a . ' s .5,. . .. . . ,. .. .. . y fl3. .. f.. . ....l , .. . iif l f. l f l f l. f * p8ff ~hS,S .fff§l -fl. fl.l.~ffl fl~flfflfflf