By Shahid Sattar | Syed Absar Ali
Distortions caused by a distraught policy landscape — from high energy costs to an industry-wide liquidity crisis — have made it next to impossible for Pakistani exporters to compete in international markets.
To put things into perspective, Bangladesh exported more in ready-made garments ($15.7 billion) in the past four months than Pakistan’s total exports since January of this year ($13.3 billion).
While Pakistan has no shortage of rhetoric around increasing exports, policy makers remain dangerously oblivious to the fact that export sectors require a distortion-free environment to enable them to compete in international markets.
Currently, they are provided with anything but a level playing field.
Energy, on average, accounts for between 12 and 18 percent of input costs across the textile and apparel value chain. A cross subsidy of Rs 10.84-16/kWh embedded in power tariffs for industrial makes them almost twice the average for major textile exporting countries in the region (Figure 1A). Similarly, manufacturers across the country are faced with constant gas shortages with no end in sight while the impact of the gas pricing reforms, that place RLNG/gas rates well above a regionally competitive level (Figure 1B), is yet to be seen and evaluated.
The industry is also faced with a severe liquidity crisis. Due to rampant exchange rate depreciation and inflation experienced over the past year, the same dollar-denominated export order requires around 40% more rupees to process.
However, there is a severe shortage of working capital, and what little is available comes at exorbitant interest rates. Non-bank credit across the supply chain is a lifeline for Pakistani businesses, but with interest rates at over 22 percent investors are finding it more profitable to simply park money in banks. And over 70 percent of banking credit is being used to finance the government’s fiscal deficits, crowding out borrowing by the private sector.
The liquidity crisis is further propagated by around $1.3 billion (Rs. 370 billion) being stuck in the tax refund regime at any given time. FBR persistently delays issuance of sales tax refunds despite a 72-hour commitment under law and refuses to issue other refunds, including income tax refunds, non-FASTER refunds, custom duty drawbacks, etc., that have been pending for years. There is no logical reason for this except that the government needs this money to manage its own troubled cash flows, but at what cost?
Then there is the issue of close to no fixed capital investment in up-gradation and expansion of production capacity—one of the reasons for a long-term decline in manufacturing productivity. According to industry estimates, 50 percent of spindles in the textile sector will be scrapped without replacement over the coming year.
This means that Pakistan will not have enough upstream capacity to produce high-quality yarns that can be used in modern air-jet looms in downstream processes. The sizable investment that was made in up-gradation and expansion under TERF and other export financing schemes was either left incomplete due to restrictions on L/Cs on import of machinery or is sitting idle due to high energy and other operating costs.
If fixed capital investments remain abysmal, we will see an increase in imported intermediate products and a decline in domestic value added in exports over the coming months and years, further adding to the economy’s balance of trade deficit and external sector vulnerabilities.
Another issue is that of polyester staple fiber (PSF) prices. Domestic PSF suppliers—the basic raw material for man-made filaments and synthetic fibers—are exhibiting a ‘monopolistic’ behavior, keeping PSF prices artificially high.
This is made possible by heavy protection in the form of prohibitive import and anti-dumping duties on imports of cheaper and higher quality PSF.
This has created a “cotton-bias” in the industry, rendering it vulnerable to exogenous cotton supply and price shocks, and is a major challenge to export diversification within the textile sector export basket.
Add to this the plethora of bureaucratic red tape and regulatory sludge that exporters must regularly put up, Pakistan’s textile sector prices and turnaround times are simply too high to be able to compete with firms from regional textile and apparel hubs.
However, it is still not too late: given how the international policy landscape is shifting, the textile sector is still well-positioned to take advantage of these shifts, given a conducive policy environment at home, but further inaction could very well result in continued deterioration. Two important examples are discussed below.
First, the Carbon Border Adjustment Mechanism (CBAM) in Europe is expected to become fully functional at the end of this decade. Accordingly, by 2030, imports to the EU will be taxed for the energy emissions generated in their production outside the EU, effectively imposing an import tariff on any exports to the EU depending on their energy emissions.
To overcome CBAM-related taxes requires net-zero energy emissions across the export sector value chain. Bangladesh has already started to incentivize this: a recent policy requires new buildings with a rooftop area of over 92.2 square meters to have net-metered solar power to be eligible for a grid connection.
But in Pakistan, industrial consumers are subject to a cap of 1MW on solar net-metering. Furthermore, the textile sector has pledged to generate its own electricity using clean geothermal energy, but this requires B2B contracts with a wheeling charge of no more than 1 cents/kWh, all inclusive. The government refuses to increase the cap from 1MW up to 5MW or allow B2B contracts, only to protect its own distorted revenue streams.
Second is the Western movement to decouple from China. According to the USFIA’s annual textiles and apparel industry benchmarking exercise, 80 percent of the largest apparel and clothing firms in the United States are planning to reduce sourcing from China over the next two years, and shift from a “China plus Vietnam plus Rest of the World” sourcing model to an “Asia plus Rest of the World” model.
Once again, Bangladesh and Vietnam have already taken advantage of this, and their shares in international textile and apparel markets have gradually increased since around 2014, while those of China have declined (Figure 2).
Both countries are also offering very attractive incentives to further expand their textile and apparel manufacturing capacities. In Bangladesh new ready-made garment factories pay income tax at preferential rates of 10-12%, with many firms being eligible for further exemptions of up to10 years.
In Vietnam, new projects are offered preferential income tax rates of 10 percent for 15 years, including a 2-year tax holiday and a 50 percent reduction for the subsequent 9 years. In both countries, these are in addition to other incentives such as duty-free import of raw materials and reduced tax rates on export earnings.
India, to counter the growing importance of Bangladesh and Vietnam, is setting up seven mega textile and apparel manufacturing parks with full vertical integration. These include ‘plug and play’ facilities, all sorts of ancillary infrastructure, common processing houses, design centers, testing facilities, workers’ hostels and housing, and training and skill development facilities. Additionally, $36 million has been allocated to each textile park to provide a rebate of up to 3 percent of annual turnovers to newly established factories.
This begs a very simple question: Why would any investor anywhere in the world choose to invest in Pakistan when this is what they are being offered right next door, in a much more stable and export-oriented economic environment? The answer is they would not, which is why our entire economy is functioning on a hand-to-mouth, loan-to-loan basis with abysmal investment — foreign direct or domestic — in any sort of productive activities.
The way forward is simple:
The government must ensure a distortion-free supply of inputs to export sectors, whether energy or raw materials. It must remove the cross-subsidy embedded in power tariffs for exporters, allow B2B power contracts with a wheeling change of 1 cents/kWh all inclusive, raise the cap on solar net metering for all industrial consumers from 1MW up to 5MW to support the move towards net-zero, and ensure adequate supply of gas/RLNG at regionally competitive prices.
On PSF, import duties must be rationalized and irrational anti-dumping duties removed entirely. All imported inputs for the textile sector must be duty-free at the point of entry because duty rebates are economically inefficient and cause a loss of purchasing power to the exporters when they are inevitably and indefinitely delayed.
FBR must get its house in order, issue all pending tax refunds at once, and honor the commitment of issuing all FASTER refunds within the stipulated timeframe of 72 hours. Customs procedures for exports and export-sector imports must also be simplified and processing times reduced to enable faster turnaround times for export orders.
“Furthermore, there is an overall need to cut down on regulatory sludge, reduce the government’s economic footprint, and rationalize fiscal expenditures and revenues within a growth-oriented framework. This will reduce government borrowing, bring down inflation, allow for a reduction in the policy rate, and free up credit for private sector investment.”
To take full advantage of emerging opportunities, incentives offered by competing economies must also be matched or exceeded to stimulate investment in up-gradation and expansion of manufacturing and export capacity, both for domestic and foreign investors alike.
These may be bitter pills for policy makers to swallow but the only alternative is another crisis on the horizon—one we really cannot afford.