A matter of incentives

In a dynamic world, where the developed economies are already making technological advancements in the post-industrial stage, the growth of a substantial local engineering industry is essential for economic and social development.

The engineering sector has undergone a long gestation period. Its development involves much more than the acquisition of machinery and equipment. The development and understanding of technologies and its continued operation and maintenance requires substantial investment in technical development of human resource.

Most of our engineering fixed assets were acquired several years ago and the size of Pakistan’s engineering sector remains small. As a result, there is both a need to expand the capacity for developing a sizeable manufacturing sector and also to replace, balance and extensively modernise the existing facilities. Both these needs will help a dynamic industry grow. In this regard, the recent growth in the automotive sector – two-wheeler and four-wheeler – bodes well for BMR, new model and greenfield investments. Historically, low interest rates, enhanced consumer financing, higher per capita income and low fuel prices are likely to propel the auto industry to the next level.

Due to the lack of vertically integrated raw material production – such as pig iron, aluminum, copper and brass – in Pakistan, inventory turnover levels tend to be much lower than in other industries. This makes the engineering industry less efficient, requiring heavier financing for raw materials and components. Due to the changing dynamics in the auto sector, scalability is now very much on the cards and there are plentiful opportunities to become more efficient and competitive in the future. The favourable economic conditions therefore suggest continued heavy investments for growth for which there would be a need both for the high-level retention of profits, new venture capital and credit. Retention and fresh ventures capital can be encouraged through favourable fiscal policies. These have to be formulated in view of the opportunity costs of investment today.

A punitive approach for providing credit is extremely discouraging for entrepreneurs – especially those who take their obligations to lenders seriously. This approach appears to be behaviorally unsound. A more positive approach to designing financial terms will allow for the imposition of restrictions in case a company failed to manage its affairs effectively and efficiently. This impediment is predominantly faced by the vendor industry and the SME sector.

The lending restriction, in particular, for vendors and the SME sector as a whole are onerous. Banks remain shy of lending to these critical sectors which are engines for economic growth and employment. Moreover, the terms take away entrepreneurial freedom, dilute interest and bind stakeholders personally for a business in which the stakes have been drastically reduced. Such conditions, such as personal guarantees, are among the major factors discouraging private entrepreneurs from seeking and obtaining finance for investment, particularly in the engineering sector.

While it is customary and reasonable to ask for and obtain personal guarantees from directors of private limited companies as further securities towards loans granted to a private limited company, it is neither fair nor customary or desirable to demand such personal guarantees from directors of public limited companies.

In the early stages of our industrialisation, the debt-to-equity ratio used to be as low as 80:20 for new projects and 70:30 for old projects. Since 1977, these ratios have been tightened to 60:40 for new projects and 50:50 for the old projects. These ratios are usually applied mechanically without any reference to the bonafides, past history, performance, the repayment record of enterprises and the technological and financial requirements of specific industries. Exceptions to these formulas were made in the case of the sugar (70:30) and cement (75:25) industries. The engineering sector involves more and more investment with ever-changing technology and merits application of similar ratios which may be brought back to the old levels – 80:20 for new projects and 70:30 for old projects. Such ratios are quite common in other countries – like Japan, Korea, Taiwan and Hong Kong – where even lower ratios – such as 90:10 – are applied.

The financial institutions have, at times, been demanding and getting directorships on the boards of public limited companies – both for representing their equity holdings as well as for the credit given. In the past, the financial institutions frequently pooled their voting rights to obtain directorships on the boards of such companies. Since all financial institutions were then state-controlled, the increasing presence of these directors meant the infusion of state control in the private sector.

The financial sector today is much more dynamic and progressive. In fact, with historically low advance-to-deposit ratios, banks are keen to lend on fairly attractive terms. But these terms are confined for those who no longer require leverage – such large, listed, blue chip companies. However, the financial sector needs to take bolder steps in assisting the backbone of our economy: the SME and vendor base. These companies are ancillary to the OEM companies and their fortunes are aligned with those of the OEM themselves. This, in itself, should give comfort to the banks that the fundamentals of the engineering sector and auto sector, in particular, are now strong and dynamic.

Similarly, banks can do a lot more to support the consumer through more innovative consumer-financing products that go beyond car loans. The two-wheeler industry will benefit enormously if banks start offering consumer financing solutions to the customer. In Pakistan, only 35 percent of the motorcycles are sold on credit while in Indonesia (which has a similar population), the figure stands at 80 percent.

Growth in investment in the engineering manufacturing industry can be encouraged by providing finance at attractive terms, especially for equipment and tools which are procured locally. For locally-produced engineering capital goods, financing may be provided at an increased rate while for imported capital goods, the rate of interest must be reduced to incentivise localisation and investment.

The financial sector should facilitate the financing requirements of OEM vendors and SMEs – which are the backbones of the engineering sector and the national economy. Debt-equity ratios for the engineering industry and projects should also brought back to old levels – 80:20 for new projects and 70:30 for old projects.

Enhanced consumer financing is needed on attractive terms for the auto sector and, in particular, for motorcycle consumers – which constitute a large segment of the lower middle class, a burgeoning segment of our population. In order to utilise all possible avenues for obtaining credit, usance for the import of engineering goods, manufactured machinery and tools is required and is not available locally. Furthermore, specific credit facilities must be earmarked for the engineering goods industry in the public and private sectors. Growth in investment in the engineering manufacturing industry must be encouraged by providing finance at attractive terms – especially for equipment and tools procured locally. State-of-the-art cash management solutions for facilitating OEMs and large dealer/vendor networks are also the need of the house. Penal interest rate should also be no more than the nominal amount.

The acceptance of these proposals is bound to accelerate interest among the investors and further develop the engineering industry which is the backbone of all industries and a key to our economic self-reliance.

The writer is the chairman of the Atlas group of companies.

Email: yhs@atlas.com.pk