The leasing sector in Pakistan and its role in capital investment
By Saima Shah
[Saima Shah, MBA from Institute of Business Administration, works for National Development Leasing Company, a premier leasing company in Pakistan. Saima is also one of the editors of an Internet magazine [http://www.chowk.com] where she writes regularly on issues of current interest.]
From the Third World perspective where a major source of economic capital is a form of foreign or local debt, Leasing acts as a hybrid form of debt cum investment. In the 80’s, when Pakistan floated its first leasing company, the characteristic of ‘asset-based’ financing made it a more ‘Islamic’ form of lending. (Asset based lending is a permitted form of debt-financing in Islam). From the perspective of developmental finance, Leasing provided an alternative to interest based debt.Author’s Note: The article attempts to question some of the traditional perspectives on finance. The objective is to present an alternative view point . The perspective with which I have written this article is holistic rather than linear.
Leasing as investment indicator
Hypothetically, since leasing is directly related to the acquisition of an asset, indicating the Aggregate Investment in Leasing (AIL) of the leasing sector, in a country and at a point in time, would indicate the amount of incremental and fresh capital investment in a year. Hypothetically, we may ignore ‘leakages’ such as rescheduling and duplicate leasing.
The aggregate figure for ‘Investment in Leasing’ for the leasing sector in Pakistan has been ranging between PKR18bn to PKR25bn over the past three years. We do not have statistics regarding the exact percentage of new investment in plant and machinery or other income generating assets. I think I can safely estimate about 90% of the AIL is plant and machinery. Of-course, the AIL is only indicative of new capital investment if compared with the same over the previous year. A fairly rough estimate of incremental capital investment would therefore be an average of Rs3billion per year. This does not mean all new investment in a year. That would be much higher since part of the AIL would be paid back, depending on the life of the lease contract.
The cost of leasing for a Pakistani lessee averages around 20-25% per annum. The effective cost for a tax-paying lessee may be 16-20%. Assuming an 18% cost of capital (weighted average) for the lessee, the asset can only generate a net income for the lessee, if the lessee in turn earns at least 19-21% per annum from the asset. This would only be possible in high growth sectors of the economy. In my experience, it is rare to see a gross profit margin of 20%, especially in the manufacturing sectors who are the prime clients for leasing Plant and Machinery. The obvious and glaring fact seems to be that the biggest market of leasing cannot afford the product. The question then remains, “who is able to buy?”
The other target markets of leasing are commercial-trade/service enterprises and small pockets of manufacturers. Commercial-trade/service enterprises for obvious reasons do not invest in capital machinery. Small pockets of manufacturers boil down to the ubiquitous multinational or the established Pakistani Group who invests in a new project or modernizes existing operations. The reason why this market may find leasing cost effective is because their overall cost of capital is effectively low enough to absorb the cost of leasing; in effect they use an already cash rich company/division to finance a new venture. The other possibility is that the new project has foreign equity interest, which acts as a source of comfort for the Pakistani lessor and provides support for import costs. A third reason for choosing leasing is as hedge against investing equity. In a macro-economic scenario where debt is the lynchpin of most investment, an investor would like to reduce the risk of investing equity.
Leasing as working capital
Due to the reasons stated above, the product is being used as a source of working capital and quite often as a competing product with short term loans from commercial banks. A sale and lease back transaction is an instant source of funds, payable over the long-term. However, these days an SLB transaction is being used as a vehicle for a direct lease quite often. Because of the enhanced rate of tax at source on direct leases levied from July 98 as against a nil rate for sale and lease-back transactions, lessees prefer to show the lease as a Sale and Leaseback transaction. At the time of processing and obtaining approval, the asset may not have been purchased; but once the lessee is assured of the financing, the asset is purchased and necessary documents processed.
Lessors as financial intermediaries
With the demise of the development financial institution of Pakistan, a source of cheaper funds for long-term capital investment has dried-up. The private financial sector has grown tremendously in the last decade after the IMF’s directives of liberalization and de-regulation were effected. Greater economic efficiency, in terms of resource mobilization and allocation, was expected after the deregulation of the economy.
However, the expected economic efficiency is still a long-way away. The private sector has not been able to satisfy the long-term capital needs of the economy. Lessors are suffering from chronic mismatch of funds and lack of availability of long-term funds. Foreign investors are a moody resource at the best of times and relying on foreign funds is a risky strategy. Contrary to the idea that the South Asian nuclear tests were responsible for driving away investors and the low popularity of Pakistan’s investment market, the absence of investors, be they foreign or local, is a symptom of deteriorating economic conditions over the past 3-4 years.
The true cost of leasing or the ‘economic’ cost of leasing
Based on the principles of a ‘free market’, the true cost of leasing (from an economic perspective) is its return to the economy as a whole. If there is a marked and substantial difference between the rate of return of the lessor and the cost of the lessee (like in Pakistan), there may be inefficiency in the sector-a big gap in demand and supply or some other dis-equilibrium. Of-course, this is not true for manufacturing sectors and other services and products where the value added to a product is perceived to be high. In the financial services, value added cannot be high due to the nature of the product. In Pakistan, the net profit margin of the lessor ranges between 3% and 5%. The cost of lease to the lessee is 18-20%. Where is the bulk in between the two going? Who/what is earning this difference and Who is being burdened with the cost of the difference?
Poor credit policy, corruption, high uncertainty and poor quality of information available are a few of the symptoms and reasons for the disparity in returns. The ‘real’ reason may well be the outflow of capital from developing countries to the developed countries like the USA, because of the ‘dollarization’ of their economies….and consequent rapid devaluation of their own currency.