The Leasing Sector in Pakistan and its Role in Capital Investment

<< Leasing Companies:Basic Purpose of Leasing, Technological Benefits
Role of Insurance Companies:Indemnification, Insurer’s business model >>
Management of Financial Institutions - MGT 604
Lecture # 34
The Leasing Sector in Pakistan and its Role in Capital Investment
From the Third World perspective where a major source of economic capital is a form of
foreign or local debt, Leasing acts as a hybrid form of debt cum investment. In the 80's,
when Pakistan floated its first leasing company, the characteristic of `asset-based' financing
made it a more `Islamic' form of lending. (Asset based lending is a permitted form of debt-
financing in Islam). From the perspective of developmental finance, Leasing provided an
alternative to interest based debt.
Leasing as investment indicator
Hypothetically, since leasing is directly related to the acquisition of an asset, indicating the
Aggregate Investment in Leasing (AIL) of the leasing sector, in a country and at a point in
time, would indicate the amount of incremental and fresh capital investment in a year.
Hypothetically, we may ignore `leakages' such as rescheduling and duplicate leasing.
The aggregate figure for `Investment in Leasing' for the leasing sector in Pakistan has been
ranging between PKR18bn to PKR25bn over the past three years. We do not have statistics
regarding the exact percentage of new investment in plant and machinery or other income
generating assets. I think I can safely estimate about 90% of the AIL is plant and machinery.
Of-course, the AIL is only indicative of new capital investment if compared with the same
over the previous year. A fairly rough estimate of incremental capital investment would
therefore be an average of Rs3billion per year. This does not mean all new investment in a
year. That would be much higher since part of the AIL would be paid back, depending on
the life of the lease contract.
The cost of leasing for a Pakistani lessee averages around 20-25% per annum. The effective
cost for a tax-paying lessee may be 16-20%. Assuming an 18% cost of capital (weighted
average) for the lessee, the asset can only generate a net income for the lessee, if the lessee
in turn earns at least 19-21% per annum from the asset. This would only be possible in high
growth sectors of the economy. In my experience, it is rare to see a gross profit margin of
20%, especially in the manufacturing sectors who are the prime clients for leasing Plant and
Machinery. The obvious and glaring fact seems to be that the biggest market of leasing
cannot afford the product. The question then remains, "who is able to buy?"
The other target markets of leasing are commercial-trade/service enterprises and small
pockets of manufacturers. Commercial-trade/service enterprises for obvious reasons do not
invest in capital machinery. Small pockets of manufacturers boil down to the ubiquitous
multinational or the established Pakistani Group who invests in a new project or modernizes
existing operations. The reason why this market may find leasing cost effective is because
their overall cost of capital is effectively low enough to absorb the cost of leasing; in effect
they use an already cash rich company/division to finance a new venture. The other
possibility is that the new project has foreign equity interest, which acts as a source of
comfort for the Pakistani lessor and provides support for import costs. A third reason for
choosing leasing is as hedge against investing equity. In a macro-economic scenario where
debt is the lynchpin of most investment, an investor would like to reduce the risk of
investing equity.
Management of Financial Institutions - MGT 604
Leasing as working capital
Due to the reasons stated above, the product is being used as a source of working capital
and quite often as a competing product with short term loans from commercial banks. A
sale and lease back transaction is an instant source of funds, payable over the long-term.
However, these days an SLB transaction is being used as a vehicle for a direct lease quite
often. Because of the enhanced rate of tax at source on direct leases levied from July 98 as
against a nil rate for sale and lease-back transactions, lessees prefer to show the lease as a
Sale and Leaseback transaction. At the time of processing and obtaining approval, the asset
may not have been purchased; but once the lessee is assured of the financing, the asset is
purchased and necessary documents processed.
Lessors as financial intermediaries
With the demise of the development financial institution of Pakistan, a source of cheaper
funds for long-term capital investment has dried-up. The private financial sector has grown
tremendously in the last decade after the IMF's directives of liberalization and de-regulation
were effected. Greater economic efficiency, in terms of resource mobilization and
allocation, was expected after the deregulation of the economy.
However, the expected economic efficiency is still a long-way away. The private sector has
not been able to satisfy the long-term capital needs of the economy. Lessor are suffering
from chronic mismatch of funds and lack of availability of long-term funds. Foreign
investors are a moody resource at the best of times and relying on foreign funds is a risky
strategy. Contrary to the idea that the South Asian nuclear tests were responsible for driving
away investors and the low popularity of Pakistan's investment market, the absence of
investors, be they foreign or local, is a symptom of deteriorating economic conditions over
the past 3-4 years.
The true cost of leasing or the `economic' cost of leasing
Based on the principles of a `free market', the true cost of leasing (from an economic
perspective) is its return to the economy as a whole. If there is a marked and substantial
difference between the rate of return of the lessor and the cost of the lessee (like in
Pakistan), there may be inefficiency in the sector--a big gap in demand and supply or some
other dis-equilibrium. Of-course, this is not true for manufacturing sectors and other
services and products where the value added to a product is perceived to be high. In the
financial services, value added cannot be high due to the nature of the product. In Pakistan,
the net profit margin of the lessor ranges between 3% and 5%. The cost of lease to the
lessee is 18-20%. Where is the bulk in between the two going? Who/what is earning this
difference and Who is being burdened with the cost of the difference?Poor credit policy,
corruption, high uncertainty, and poor quality of information available are a few of the
symptoms and reasons for the disparity in returns. The `real' reason may well be the
outflow of capital from developing countries to the developed countries like the USA,
because of the `dollarization' of their economies ... and consequent rapid devaluation of
their own currency.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday