By Shahid Sattar and Absar Ali

The fundamental premise upon which the foundations of modern-day economics stand is that resources are finite and therefore must be allocated to their most productive use.

However, our policymakers’ erroneous pursuit of political mileage over economic growth has guided resources towards low productivity uses. Electricity is one such resource.

As in most of the world, electricity tariffs in Pakistan are based on their end-use with separate tariff-categories for residential, commercial, industrial and agricultural consumers. Our prices, however, are not set to achieve the optimal allocation of resources.

Industrial users—whose productivity is highest in terms of value added per KWh consumed—have historically been charged substantially higher tariffs compared to relatively less productive residential and agricultural users.

In advanced economies and developing regional competitors like India and Bangladesh, industrial sectors are provided with competitive rates for electricity.

Energy is where structural reform must begin.

Pakistan’s total external debt stands at approximately $127 billion, and annual debt servicing costs are upwards of $18 billion. In FY23, we imported around $60 billion worth of goods and services, down from $80 billion in FY22 due to import restrictions. To pay for this, we exported only $35 billion worth of goods and services and received about $30 billion in remittances. The difference was borrowed.

“The only way out of this chronic cycle of external balance crises is to build a strong and sustainable export base. But standard models of international trade tell us that this is practically impossible without providing industry with competitive energy tariffs.”

A firm’s decision to export is based on a cost function which comprises costs of fixed capital, raw material, wages, and factory overheads, including electricity to power production equipment. It decides to export only if its total cost of production is less than the international price of the goods it produces.

If the cost of an input increases beyond a certain threshold that pushes the total cost above international prices, it is unable to compete in the international market andexits the export sector. When multiple firms face the same dynamics, the export sector is crowded out, with a subsequent reduction in exports and further implications for the aggregate economy.

Figure 1 illustrates how Pakistan’s textile sector is being similarly crowded out.

In 2020, the government provided export firms with a regionally competitive energy tariff (RCET) of 9 cents/KWh under which exports increased from $27.9 billion in 2020 to $39.4 billion in 2022. In October 2022, RCET was converted to a rupee-based fixed rate of Rs 19.9/KWh and subsequently withdrawn in March 2023. With electricity costs accounting for 30-40% of conversion costs, this caused over 30% of Punjab’s textile industry to cease production and another 25% is expected to shut down by August if business as usual continues, increasing the number of laid-off textile workers from 4.3 million to over 7.8 million—approximately 10% of Pakistan’s total workforce.

If we are to take the economy out of this vicious cycle of crisis after crisis, a sizable and sustainable increase in exports is immediately needed. This requires a continuous commitment to support exporters through all possible means.

The prevalent argument against government support is that exporters should no longer benefit from government subsidies, and that such subsidies are not compliant with the current IMF Stand-by Agreement (SBA).

This is simply not true. First, the provision of competitive energy tariffs is not a subsidy because it involves no transfer or discount from the government to the industry on the actual cost of service, which includes power generation, transmission and other applicable costs. What the cost-of-service tariff does exclude is economic inefficiencies like stranded costs, cross-subsidies to lifeline consumers and distribution losses—all of which are penalties on the government and power-sector’s own inefficiencies, both past and present, that consumers are now having to pay for.

Second, even if this were an actual subsidy, the IMF programme only prohibits untargeted and unbudgeted subsidies. Since cost-of-service tariffs would only be provided to exporters, they are indeed targeted.

To make them fully compliant, the government must spread the resulting revenue differential of Rs 100 billion over other consumer categories. This represents an upper bound increase of Rs 2/KWh that should be loaded towards high-end residential, commercial and non-exporting industrial users.

Compared to the Rs 7.5/KWh increase already recommended by Nepra, the short-term costs of an additional Rs 2 hike are heavily outweighed by medium- and long-term benefits. First, it will enable the resumption and expansion of export industries.

This will bring in much-needed foreign exchange and secure the economy’s external position, build resilience against exchange rate shocks and pass-through inflation, provide productive employment, and attract investment. It will also serve as an incentive to divert investment away from less productive non-export sectors towards export-oriented sectors—further reinforcing the first-order effects discussed above.

Rationalization of power tariffs with an export-oriented outlook is one of those “difficult decisions” that the government has repeatedly asserted it is willing to take for the betterment of the economy. It is now time to walk the walk.

Dr. Gohar Ejaz

In FY23, textile exports plunged by $2.8 billion (15% decline) compared to FY22, derailing positive developments achieved over the last two years. This decline, along with a provisional 13% decrease in June-23 compared to June-22, requires a closer examination of causes like energy costs, liquidity crises, tax refund issues, import restrictions, non-implementation of policies, market dynamics, competition, and supply chain disruptions. Recognizing and addressing these factors is crucial to reverse the decline. However, a misinformed narrative has distorted Pakistan’s textile sector’s image, making it difficult to comprehend associated challenges and formulate well-informed policies.

Pakistan’s textile exports decreased by $2.8 billion (15%) in FY23 compared to FY22.

Source: Research Department – APTMA

Devaluation Does Not Increase Exports

Constructive developments in Pakistan’s export sector are being hindered by a number of obstructions, including problems with the devaluation strategy that is intended to increase exports. Pakistan is sensitive to currency changes because of its heavy reliance on dollar-linked inputs and foreign markets, which drives up the cost of imported inputs and reduces the profitability of exporters. To meet production demands and reduce currency impact, the industry needs a two-fold increase in working capital. However, there is a lack of readily available capital and interest rates of 22% prohibit borrowing and export growth, making it challenging to maintain export levels in dollars. The non-payment on time of FBR refunds (explained later) further restricts the recycling of funds, limiting liquidity for investment and growth.

Policy Stability

Unreliable information and non-implementation of approved policies undermine confidence, deterring investments and stifling the growth of exports. The industry has not witnessed implementation of textile policies from the first one in 2014-2019 to the current 2020-2025 policy. If these policies had been fully implemented, it is estimated that textile exports could have increased by 25 to 40 percent annually.

TERF: A Catalyst for Industrial Growth in Pakistan

Pakistan’s exportable surplus is currently only in textile, the bulk of which is largely directed towards exports. However, to increase the exports, there is a need to increase the capacity for creating the exportable surplus. To increase that exportable surplus, investments in the form of modern machinery is required for which TERF was introduced.

A hundred new textile units were set up as a consequence of TERF. Approximately 50% of them are currently operational. Once all the units start working, additional exportable surplus of between 8-10 billion dollars is expected. These units, set up under TERF, are mostly downstream and rely on the already installed capacity of spinning and weaving for intermediate products. The machinery which has been added through TERF is state-of-the-art, aimed at increasing the efficiency of the sector Hence, the country stands to gain through higher value addition.

For this capacity to operate, energy inputs at competitive rates are required, without which all these projects will not be viable anymore. New projects, upgradation, and capacity enhancement are stranded because of non-provision of electricity/gas connections to start production. More than $5 billion installed capacity, most of which has not been energized. This affects long-term productivity and global competitiveness of the industry and carries a risk of banks defaulting as the industry cannot service debt.

The funds provided through TERF were not gratis. A concessional fixed interest rate was applied for a period of 10 years, allowing for the approval of Rs. 425 billion for investment in local and imported plant and machinery. Land and building investments were not covered. The total investment generated by TERF is projected to surpass Rs. 800 billion. Commercial banks diligently evaluated each project before issuing L/C’s for the machinery portion only.

Regrettably, certain elements are attempting to cast aspersions on this scheme, aiming to portray it as a criminal endeavor. Such actions pose a significant threat to the policy continuity, investment climate, and trust in the government. If this trend persists, it will hamper progress and perpetuate the current negative economic outlook of Pakistan.

Debunking the Subsidy Myth

High energy costs increase operating costs to an extent that it makes it difficult for manufacturers to maintain competitiveness. The discontinuation of the Competitive Electricity Tariff (RCET) has had a devastating impact on the export industry, which has a negative impact on the Balance of Payments and the economic outlook. Export-oriented businesses suffer from cross-subsidies and stranded costs in the power tariff system, depriving them of the support essential for competitive success. Energy sources that are reliable and affordable are vital for keeping the textile industry competitive. The textile sector operates on a high volume, low-margin business. Even a small difference of 5% in costs can significantly impact profitability, as witnessed by the discontinuation of the RCET. The high energy costs have consumed the sector’s profitability, stressing the sensitivity of the industry to apparently small changes in margins.

Source: NEPRA/CPPA 2022

One critical reform required is the formation of a separate tariff category for exports without cross subsidies/stranded costs. By establishing such a category, it would promote fair competition and encourage sustainable export growth within the guidelines set by the IMF.

Disparity in Gas/RLNG Pricing

Punjab-based industries in Pakistan, which account for over 50% of installed capacity, have substantial operational issues as a result of differences in gas accessibility and pricing between Punjab and Sindh. While Sindh-based Export-Oriented Units (EOUs) benefit from subsidized gas supply, their operations are hindered by high gas prices, a lack of supply, and erratic electricity supply. These inequalities have a negative impact on operating capacity, shutdowns, unemployment, and circular debt. A uniform gas price of $8/MMBtu for the export industry and a reassessment of distribution based on value-added contributions to the GDP are two urgent actions that must be taken.

A competitive electricity tariff applicable across the country would to some extent overcome the gas price differential.

Domestic Sales and Under Collection of Sales Tax

By tackling tax evasion and underreporting, the implementation of retail-level taxing measures in Pakistan’s textile industry can increase revenue collection. To find these glitches and execute targeted solutions, comparisons of domestic sales to under-invoiced imports need to be analyzed. Because of the current system of sales tax collection and refunds, new projects and export growth are hindered by growing inventory and capital expenditures. These problems can be solved by only charging sales tax at the point of sale for all domestically sold goods which would capture sale of all smuggled item. It is critical to balance the GST rate to decrease the danger of smuggling while assuring optimal revenue collection. Other vital initiatives include addressing the problems with used clothing imports and bringing unregistered dealers into the tax net.

Working Capital Requirements/ Zero Rating

The withdrawal of Zero-Rating (SRO 1125) and the imposition of an 18% General Sales Tax (GST) on export-oriented sectors have had a substantial negative impact on the industry in Pakistan especially now that the FASTER system is not working and refunds are held up. The higher cost of doing business, unsustainable working capital levels, higher interest rates, and currency depreciation have formed obstacles for new projects and export expansion. Accumulated “Deferred Sales Tax” without timely refunds and the complex refund process have further burdened the industry. To promote export growth, restoring SRO 1125, reintroducing zero rating for the textile value chain, collecting sales tax at the point of sale for domestic sales, and expediting the refund process are essential.

Focusing on Retailers and Collaborating with the Industry

To improve the taxation system in Pakistan’s textile industry, the focus should shift from taxing compliant businesses to targeting potential tax evasion practices among industries and retailers. Questioning the Federal Board of Revenue’s (FBR) emphasis on taxing compliant businesses does not ensure a fair and equitable tax system. Redirecting attention towards retailers helps identify instances of tax evasion, promoting a level playing field.

APTMA has been instrumental in fostering collaboration and conducting research in the textile industry. Their cooperative efforts with government bodies and industry experts provide valuable insights for policymakers. APTMA’s advocacy for technological advancements, investment attraction, and innovation has enhanced efficiency, stimulated growth, and created employment opportunities. Recognizing APTMA’s contributions underscores the need for ongoing collaboration to ensure sustainable development in the textile sector.

Way Forward:

• Policy Stability and Trust: Policy stability, honoring contractual agreements, and maintaining consistency in policies are paramount for the government. Transparent communication and commitment to refund commitments build trust among stakeholders, encouraging long-term investments, industry growth, and export potential.
• Energy Sector Reforms: Ensuring affordable and accessible energy is crucial for the competitiveness of the textile industry. The government should prioritize energy cost reduction through reforms, enhance efficiency, and eliminate corruption. It is essential to create a separate tariff category for exports, guaranteeing it is designed without cross subsidies or stranded costs. This would foster equitable competition and support the sustainable expansion of exports, aligning with the guidelines established by the IMF.
• Gas Pricing Disparities: Establishing a uniform gas price for the export industry and prioritizing gas supply to export-oriented sectors will address disparities in pricing and availability. Reviewing the gas allocation mechanism based on value-added contributions to the GDP ensures fair distribution, while pricing reforms foster a transparent and efficient gas market. A competitive electricity tariff applicable across the country would to some extent overcome the gas price difference. For this to happen, judicious use of system charge and third-party access rules need to be fair and transparent.
• Domestic Sales and Tax Collection: To enhance revenue collection in Pakistan’s textile industry, implementing taxing mechanisms at the retail stage is necessary. This involves identifying tax evasion and under-reporting by comparing domestic sales with under-invoiced imports, while accurate estimation of domestic sales tax requires analyzing market size, production volumes, and tax rates. Balancing revenue generation and smuggling risks is crucial, necessitating measures such as border control initiatives and enhanced monitoring systems. Addressing challenges from used clothing imports involves promoting local production, enforcing anti-dumping laws, and conducting inspections. Deducting sales tax at the Point of Sale ensures proper taxation, while a comprehensive and balanced approach is needed to avoid negative impacts on production costs, competitiveness, exports, employment, and investment.
• Working Capital Requirements and Zero Rating: Restoring Zero-Rating (SRO 1125) and expediting the refund process for deferred sales tax and outstanding dues will supply the textile industry with crucial working capital. Reintroducing zero rating for the textile value chain, collecting sales tax at the point of sale for domestic transactions, and streamlining the refund process will alleviate the burden on businesses, foster compliance, and stimulate export growth.
• Ensure Implementation of Policies: The government should prioritize the development and implementation of supportive policies tailored to the textile sector, encompassing reliable energy supply, improved infrastructure, accessible financing, and export-friendly regulations. By promoting innovation, attracting investment, and ensuring a level playing field, the industry can overcome challenges and contribute to a sustainable Balance of Payments.
• Continuous Monitoring and Evaluation of Implementation: Regular monitoring and evaluation of policies in the textile sector, along with engagement with industry stakeholders, are crucial for ensuring their effectiveness. Periodic reviews and necessary adjustments by the government will facilitate timely interventions and promote the sustainable development of Pakistan’s textile industry.
• Financing Facility for Exports Expansion: To achieve its goal of reaching $50 billion in the next five years, APTMA plans to establish 1,000 garment units with 500,000 stitching machines, requiring a $7 billion investment. This expansion aims to increase exports by $20 billion annually, create employment opportunities for 700,000 workers, and contribute to the country’s economy. To facilitate this growth, exporters should be provided with low-interest loan financing facilities to overcome the current challenge of high interest rates and create the exportable surplus. This is especially attractive as it is not energy intensive but will require all the back-end industry already installed to operate on competitive rates.

Addressing misconceptions and providing accurate information is crucial for Pakistan’s textile industry to make informed policy decisions and ensure progress. Creating an export-culture is sine qua non. Selective allocation of funds to prioritize the export sector and focus on economic challenges will drive sustainable job creation, foreign investment, and economic growth. Prompt action, consensus building, and critical reforms are needed to address energy tariffs, taxation, and promote export facilitation, propelling the economy forward. Policymakers must consider the long-term implications of their decisions to enhance the industry’s competitiveness, generate employment, and increase exports for sustainable economic development.