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Document or

The World Bank FILE

FOR OFFICIAL USE ONLY

Report No. 5823-PAK

J

STAFF APPRAISAL REPORT

December 6, 1985

Industrial Development and Finance DivisionSouth Asia Projects Department

This document has a restricted distrbution and may be used by recipients only in the perrormance oftheir official duties. Its contents may not otherwise be disclosed without World Dank mautorization.

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Currency Equivalents

Currency Unit = Pakistan Rupees (Rs)US$1 = Rs 15.7Rs 1 = US$ 0.0637 -

Abbreviations Used

ABL Allied Bank LimitedADB Asian Development BankADBP Agricultural Development Bank of PakistanBEL Banker's Equity LimitedCCI Controller of Capital IssuesDBI Development Banking Institute*1 DFIs Development Finance InstitutionsDSCR Debt Service Coverage RatlioGOP Government of PakistsnHBL Habib Bank LimitedICP Investment Corporation of PakistanIDBP Industrial Development Bank of PakistaniiC Industrial Investment CreditKSE Karachi Stock ExchangeMCB Muslim Commercial BankNBP National Bank of PakistanNCBs National Commercial BanksNDFC National Development Finance CorporationNIT National Investment TrustPBC Pakistan Banking CouncilPICIC Pakistan Industrial Credit and Investment CorporationPFIs Participating Financial InstitutionsSALs Structural Adjustment LoansSBFC Small Business Finance CorporationSBP State Band of PakistanSFYP Sixth Five Year Plan - FY83-FY87SLIC State Life Insurance CorporationUBL United Bank Limited

FOR OMCIAL USE ONLYPAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

STAFF APPRAISAL REPORT

Table of ContentsPage No.

PROJECT SUMMARY ....... iii...... .......... *. ................ iii-iv

Is INTRODUCTION ...... ** ... *... * * *........*... ... .......... 1

II. THE INDUSTRIAL SECTOR ....... ........... 2A. Economic Setting .. ...................................... 2

- B. Industrial Structure and Recent Performance ............. 3C. Industrial Strategy and Issues ................... 6-0... 4D. Investment Prospects ................ **** ................ 5

III. THE FINANCIAL SECTOR ......................s. .... ..o. .o..o. .o 5A. The Financial System ............ :....................... 5B. Industrial Finance 8C. Financial Policy ..... 9D. The Capital Market s....o..oo...o.;o... .. 11

IV. BANK'S INDUSTRIAL LENDING STRATEGY AND PROJECT OBJECTIVES 14A. Past Lending and Industrial Strategy ....... o........... 14B. Impact of Past Operations 15C. Rationale and Strategy for Future Institutional Lending . 17

Vs. THE PROJECT oesoooooooeeosoooooseoooo17A. Project Objectives .....0..0.0........ 0...0.0.... 0...... 17B. Prcject Description and Design 18............ -....... os i8C. Policy and Procedural Changes .......18........... o.... i8D. Technical Assistance 20...** ........ . . ..... 20E. Project Cost, Components and Financing Plan ............. 20

VI. PARTICIPATING FINANCIAL INSTITUTIONS (PFIS) ................ 21A. Participating NCBs . 21

- ~~~~B. Participating DEIs 26C. Conditions for Participation.........0"00.0.00000000*0 37

VII. THE PROPOSED LOAN 39................... o 39A. Amount and Allocation of Funds .......................... 39B. Financial Package 39C. Administration ...... W00....41

VIII. PROJECT BENEFITS AND RISKS .......... 42

IXo RECOMMENDATIONS o ... 43

This report is based on the findings of an appraisal mission to Pakistan inJune 1985. The mission members were Messrs. Dalla, Vivado (ASPrD), Bannon(ASAPA), Mirza (CCMD) and H. Qureshi (RMP). Mr. Groves and Miss Barry(ASPID) provided detailed imput on financial and institutional aspects.

This document has a resricted distributo and uay be used by reXip ets only i. the peo,mm oftbeir ofrlci duties. Its contents may not otberwis be disclosed witout World Bhk aut |

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Annexes

1. Projected Private Industrial Investment (FY85-FYB8)

2. The Commercial Banking System

3. Islamization of Pakistan's Financial System: A Preliminary Assessment

4. The Capital Market

5. Industrial Development Bank of Pakistan (IDBP)

6. National Development Finance Corporation (UDFC)

7. Pakistan Industrial Credit and Investment Corporation (PICIC)

8. Projected Disbursements -

9. Selected Documents and Data Availa6le in Project File

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PAKISTAN

PROPOSED SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Project Summary

Borrower: Islamic Republic of Pakistan

Beneficiaries: Participating Financial Institutions (PFIs) whichmeet agreed eligibility criteria. These presentlyinclude three development financing institutions(IDBP, NDFC, PICIC) and three commercial banks(Habib Bank, United Bank and Muslim CommercialBank). The National Bank of Pakistan will beeligible for technical assistance. In turn, allprivate sector industrial activities and relatedservices will be eligible for financing togetherwith the financing of balancing, modernising andrehabilitation (BMR) projects in the publicindustriaL sector. The Bank's funds will be usedto finance both fixed assets and permanent workingcapital.

Amount: US$150.0 million equivalent consisting of Loan ofUS$148 million and Credit of US$2 millionequivalent for technical assistance.

Co-Financing: ADB will also provide US$i50 million equivalent onterms and conditions similar to the proposed loan.

Terms: The proposed loan would be at the Bank's standardterms of interest (8.82Z p.a.) and repayment (20years inclusive of 5-year grace period), while theCredit would be on standard IDA Credit terms.Onlending from GOP to the PFIs would be at 10Z p.a.for PICIC and IDBP and at 11Z p.a. for other PFIs,with onlending to subborrowers at 141 p.a.Subproject loans would have maturities of up to 15years including a grace period of three years. Theforeign exchange and interest rate risks would beborne by GOP. The funds would finance 100% offoreign exchange costs of direct imports of goodsand services, and up to 60Z of goods made locallywith imported inputs. Local currency financingwould be made avaiLable by PFIs and sponsors.

Project Description: The Project constitutes a major vehicle for Bankinvolvement in strengthening the financial sectorin Pakistan, and supports the movement towardfinancial sector liberalisation and developmentof the capital markets.

Tne Project would provide credit to cover theforeign exchange cost of industrial equipment

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imported by private firms seeking to acquire, build,modernise or replace productive assets. The economicrate of return estimated for subprojects approvedunder the first Industrial Investment Credit wasbetween 15Z and 202, and similar investment perform-ance is expected under the proposed project.

The Project would also provide technical assistancefor the training of managers in the 'participatingfinancial institutions and in reLated Governmentagencies. The Project would also address financialand institutional issues related to IDBP and PICICwhich were initiated under previous projects involv-ing these institutions.

Given the record of the selected PFIs in utilizingthe previous Bank loan, institutional risks in theproposed Project are acceptable. The institutionalarrangements for-the technical assistance component -

will require careful supervision because of thenature and the number of institutions that areexpected to participate. The only significantrisk is whether utilisation and financiaL sectorreform would progress more slowly than expectedbecause of unforeseen changes in domestic andinternational conditions. The Government remainscommitted to the gradual implementation of financialsector reform; its cautious and copsistent approachappears likely to succeed.

Disbursements:

Bank Fiscal Year FY87 FY88 FY89 FY90 FY91 FY92 FY93~~~(dS-$MI milon)T---~

Annual 22.5 22.5 30.0 37.5 15.0 15.0 7.5Cumulative 22.5 45.0 75.0 112.' 127.5 142.5 150.0Z 15.0 30.0 50.0 75.0 85.0 95.0 100.0

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (rIC) PROJECT

STAFF APPRAISAL REPORT

I. INTRODUCTION

1.01 Since 1977, GOP, has given greater emphasis to the role of privateindustry. This policy shift is reflected in GOP's decisions to divest a number ofindustrial units which were nationalized in 1972, open restricted industries toprivate investment, limit investment in public sector manufacturing enterprises tobalancing and modernization and increase resource mobilization for investment inprivate industry. Also, the government has reLaxed investment sanctioningrequirements and other industrial controls, and has increased investment andezport incentives for private industry. These- policy measures have succeeded -instimulating private investment and performance improvements. In May 1985, GOPtook a number of major measures to stimulate the capital market for privateinvestment. These included: a reduction in corporate taz rate from 50X to 40Zfor publicly listed companies; total exemption of dividends from income tax;disinvestment of profitable public sector companies with an estimated market valueof Rs 2.0 billion; and permission for private investors to set up investmentcompanies. However, sustained growth will depend on a stable political andeconomic climate as well as contin6ous measures to improve trade and industrialpolicies and the financial system. -

1.02 The Project. The proposed second Industrial Investment Credit (ic It)seeks to improve the efficiency with which funds for industrial investment aredelivered by focusing on both the system and individual institutions. The projectalso aims at increasing availability of equity -finance and non-bank long-termresources through the development of a more efficient capital market. IIC II willcapitalize on the successful implementation of the first IIC project which hasimproved the system of industrial finance involving the major development andcommercial banks (para. 4.04). The project would continue the Bank Group's directinvolvement with leading conmercial banks, initiated with the first IndustrialInvestment Credit (IIC) project. The proposed IIC II Project incorporatesprograms to continue strengthening appraisal and supervision capabilities ofparticipating commercial banks, and to improve the operating performance of thedevelopment financing institutions (DFIs), particularly the Industrial DevelopmentBank of Pakistan (IDBP) and the Pakistan Industrial Credit and InvestmentCorporation (PICIC). This report outlines a US$300 million project of whichUS$150 million would be provided by the Bank Group. A paralleL line of credit ofUS$150 million would be provided by the Asian Development Bank (ADB) to financeother subprojects in the PFI pipeline. Bank Group financing would incorporate aBank loan of US$148 million to meet a portion of the foreign ezchange term lending

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requirements of industry, and an IDA Credit of US$2 million for technical assis-tance to help meet policy and institutional objectives. The proposed IIC IIProject forms an integral part of the Bank Group's industrial lending strategy inPakistan, in which a set of operations are geared to supporc expanded privateinvestment, efficiency improvements in public and private industrial enterprise,and increased manufactured exports.

II. THE INDUSTRIAL SECTOR

A. Economic Setting

2.01 Beginning in the late 1970s, GOP embarked on a program of reforms toachieve financial stability, high growth and revival of private sector confidence.Progress during the Fifth Plan (FY79-FY83) was considerable despite adverse exter-nal factors, including a world recession, a 30Z decline in the external terms oftrade, and the Afghanistan crisis with its attendant requirements for increaseddefense and refugee expenditures. GOP restored financial discipline by reducingbudget deficits and bank borrowings' and by enforcing stricter monetary policies.Improvements in financial management were combined with price adjustments aimed atcorrecting economic distortions and a program of longer-term reforms in keyproductive sectors. As a result of these actions, during the eighties GDP growthhas averaged over 6%; inflation rates have declined giadually, private sectorconfidence has increased and, during the early eighties, a manageable balance ofpayments situation was maintained. Growth performance was good in industry,agriculture, energy and exports.

2.02 The steadily improving performance of recent years was interrupted in FY84due to an unexpected downturn in agriculture and migrant remittances, and thecarry-over of inflationary pressures from FY83. GDP growth slowed to 3.5% as aresult of a 6.2% fall in agricultural value added caused by adverse weather andpest attacks. Manufacturing grew by 8.3% and services by 6.2Z. Fixed investmentrose by 6.5Z with private investment increasing by 11.5%, inflation levels reached9% in FY84, up from 5.2% in FY83. Budgetary policies in FY84 continued to beprudent. Current revenues and expenditures both increased by 20Z. As a result ofstagnant exports and lower remittances, balance of payments deteriorated, leadingto a reserve drawdown of US$113 million. Yet, considering the importance ofagriculture, the achievement of creditable growth in FY84 points to resilience inPakistan's economic structure, which is partly the result of recent Governmentefforts to begin removing structural imbalances in the economy.

2.03 Although GDP growth rebounded to 8.4% in FY85, balance of payments andbudgetary performance deteriorated markedly. Higher GDP growth was the result ofrecovery in agriculture, which expanded by 9.9%, and continued growth of 8.6% inmanufacturing. However, the strain on the balance of payments which emerged inFY84 was further intensified in FY85. The current account deficit is estimated tobe US$1.6 billion compared to US$1 billion the preceding year. While importsregistered growth of only 3.7Z, exports are expected to fall by 1.3Z and workers'remittances by 10.5%. At the end FY85, gross reserves were below US$600 million,or less than one month of imports, reflecting a reserve loss of more than US$1billion in one year, due mainly to decline in remittances from Pakistanis

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overseas. As a resuLt of shortfalls in revenue receipts and higher expenditures,the budget deficit increased by 40% in FY85 (from 5.6Z to 8X of GDP). Domesticbank borrowings doubled to 3.4% of GDP, reversing the declining trend in deficitfinancing since FY80. Inflation is expected to be about 6% to 7% as measured bythe GNP deflator, compared to 9Z in FY84.

2.04 The Government is in the process of implementing adjustment programs toprovide for greater public resource mobilization effort, including tax reform,user charges, lower subsidies and increased self-financing by public enterprises.Measures announced by GOP in the 1985 Budget Speech are initial steps in theseadjustments (para. 3.17). Given the more constrained outlook for official assis-tance and migrant remittances, sustained improvements in exports and efficientimport substitution will be necessary to reduce foreign capital requirements. Theefficiency of the industrial sector will be a key factor in meeting theseobjectives.

B. Industrial Structure and-Recent Performance

2.05 Pakistan has a fairly diversified industrial base. Textiles, whichaccounted for about 30% of manufacturing value added in the early 1970s, nowconstitute only 15%. Other important sectors include food processing, engineeringgoods, cement and fertilizers. In FY84, manufacturing contributed 18% of GDP andemployed 13% of the economically active population. Manufactured and semi-manufactured goods represented 71X of total exports, of wbich more than half werecotton products. Other important exports are carpets, leather -products, synthetictextiles and fish products. During the early 1970s, the Government nationaLizedlarge segments of Pakistan's industrial sector. The present Government, whichtook office in 1977, has reversed these policies by assigning the private sector aleading role in industrial development, denationalizing most agro-processing and afew manufacturing units, opening up areas for private investment and reducinginvestment in public sector enterprises. Private industrial investment grew by anaverage of 13.4% p.a. during FY78-FY84. The private sector, which in FY78accounted for only 26% of manufacturing investment, increased its share to 59% inFY84. However, while private industry now constitutes 85Z of value added inmanufacturing, the public enterprises remain important, due to their dominance ina number of key subsectors, i.e., namely cement, fertilizers, chemicals,petroleum, steel, motor vehicles and heavy engineering.

2.06 Government poLicies have contributed significantly to the recovery of theindustrial sector. The improved policy environment has been responsible for aresurgence of private sector confidence which has led to growth in output andinvestment. Although the poor cotton crop affected textile exports, with a fewexceptions other manufactured exports recorded strong growth. During FY84,manufacturing value added growth slowed to 8.3% in real terms compared to anaverage of 10.4Z over the previous five years, due to sluggish groiwth in textiles,public enterprises ard exports. Private industrial investment a-hieved recordgrowth while public investment fdll sharply, continuing the decline characteristic

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of recent years. While the performance of public manufacturing enterprisesremained substantially better than during the late 1970s, production growth andprofits declined in FY84. Output growth was strong, especially in cement, someagro-processing aDd chemicals.

C. Industrial Strategy and Issues

2.07 As proposed in the Sixth Plan, in July 1984 the Government issued a newIndustrial Policy Statement (IFS). The IPS reemphasizes the Government's coomit-ment to a mixed economy, with the private sector as the "engine of growth" and thepublic sector as investor of last resort. The IPS emphasizes the need to ration-alize the tariff structure and continue a realistic exchange rate policy toimprove resource allocation and strengthen competitiveness of industry.Investment sanctioning limits were raised from Rs 60 million to Rs 300 million inproject size, and from Rs 30 million to Rs 50 million in foreign exchangerequirements. The IPS reiterated the Goverinment's commitment to the developmentof the Signalling System to monitor public enterprise performance, and link finan-cial incentives to enterprise efficiency. The IPS also established standard, moreliberal terms for obtaining foreign private loans, suppliers' credits, technicalfees and royalty payments. All agreements conforming.to theie terms will beapproved automatically and need only be registered with the State Bank.

2.08 Although improved industrial performance in the eighties has beennoteworthy, sustained growth wilt depend on continued improvements in the incen-tive structure, infrastructure, public enterprises, the development of the capitalmarket and further relaxation of government controls. The tariff structurerequires modification to provide a more uniform level of effective protection andreduce the import substitution bias. Although industrial controls have beenliberalized, industry is still hampered by government controls on investments,imports, access to foreign exchange, company formation and pricing. Industriesaffected by price controls operate under cost-plus arrangements which discourageoperational efficiency; recognizing this, GOP removed price controls on cement inJuly 1985. Infrastructure deficiencies, especially in energy, are a major causeof project delays and undermine capacity utilization. In public enterprises, GOPhas delegated increased decision-making authority to the holding corporations andincreased salaries and performance incentives; these measures need to be comple-mented by relaxation of price controls, increased autonomy at the enterpriselevel, and more active consideration of divestiture options. In developing thecapital market, there is a need to expand the access of private investors toequity finance from non-bank sources (Chapter III).

.

D. Investment Prospects

2.09 During FY80-FY84, growth in private industrial investme1it averaged 17Zp.a. in nominal terms and 12.1Z in real terms. Private investment in medium- andlarge-scale industries (MLSI), 1/ the client base of the proposed project, grew by18.5Z p.a. in nominal and 13.7Z in real terms. In FY84, private investment inMLSI amounted to Rs 5.1 billion, a nominal increase of 29% over the precedingyear. The total value of investments sanctioned since FY80 is Rs 63.4 billion;major subsectors have been chemicals and petroleum products, non-metallic mineralproducts (mainly cement), food products, textiles, metals and metal products.Barring major political or economic setbacks, prospects appear favorable for acontinuation of buoyant investment trends.

2.10 Assuming nominal growth of 20Z p.a., private investment in MLSI duringFY8S-FY87 is estimated at Bs 22.1 bilrion, of which Rs 12.2 billion (US$794million) or 55Z would be in foreign exchange (Annex 1). These estimates areconservative when compaied with recent investment trends, the pipelines of PFIsand investments recently sanctioned by the Investment Bureau. The proposed loan-of US$150 million would support private investment in Pakistan by meeting part ofthe demand for foreign exchange financing.

III. THE FINANCIAL SECTOR

A. The Financial System

3.01 Background. The financial system in Pakistan consists of: five national-ized commercial banks (NCBs); seventeen foreign commercial banks (FCBs); fourspecialized financial institutions; nine development finance institutions (DFIs);several insurance companies; two leasing companies; two stock exchanges; and ahousing finance corporation. The State Bank of Pakistan (SBP), the central bank,directs and regulates the financial system within overall policies set by GOP.The Pakistan Banking Council (PBC) oversees and coordinates the activities of NCBsand fulfills many of the functions previously discharged by commercial bankshareholders. The Ministry of Finance monitors the operations of the other finan-cial institutions. While domestic currency for term financing has not been aconstraint in recent years, industrial investment has been hampered by weaknessesin the financial delivery system. The first IIC project successfully addressedthis problem by expanding the number of channels for industrial finance, encourag-ing competition among PFIs and strengthening industrial lending capabilities ofmajor financial intermediaries. However, with the accelerated pace of industrialinvestment since 1981, most investment has been financed through debt due to

1/ Medium- and large-scale industries are defined as those with fixed assets(excluding Land and buildings) exceeding Rs 5 million at their original value.

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inadequate depth in the capital market and lack of equity finance from the formalcapital markets. Moreover, the FY86 Budget Speech announced a number of importantmeasures designed to strengthen the financial sectors through the development ofcapital markets and increased incentivesJfor equity financing relative to cowuer-cial borrowing. TZgether with new pragmatic financing modes being introduced aspart of the Islamization process, these represent modest but important stepstoward more efficient financial markets in Pakistan.

3.02 The Courercial Banking System. 1/ Commercial banks play a dominant rolein Pakistan's financial system. As of June 30, 1983, assets totalled Rs 254billion, or about 80Z of the assets of the financial system. The five MCBstogether accounted Ear about 94Z of deposits, 90% of advances and 87% of commer-cial banks' net profits. Selected indicators for the commercial banking systemare presented in Table 1.

Table 1: The Comimercial Banking System,Key Indicatorsg 1978-1984 /a

NCBs FCBs1978 1983 l984 1978 1983 1984 /c

Deposits (Rs billion) 63.2 159.7 175..1 3.6 10.3 n.a.Advances (Rs billion) 37.0 91.6 100.4 3.3 10.2 n.a.Total Assets (Rs billion) 95.0 225.3 246.7 9.6 28.6 n.a.Advances/Deposits (Z) 58.5 57.4 57.3 92.0 99.0 n.a.Capital and Reserves (Rs billion) 1.0 4.5 5.3. 0.2 0.8 n.a.Capital/Deposit (Z) 1.6 2.8 3.0 4.1 4.7 n.a.Net Profits (Rs billion) 0.15 0.74 0.97 0.06 0.11 n.a.Return on Total Assets Z 0.14 0.30 0.64 0.62 0.52 n.a.Operating Costs as Z of AverageTotal Deposits 3.8 3.0 3.1 5.2 5.2 n.a.

Number of branches /b 7,038 6,931 6,777 39 59 n.a.

/a As of December 31.T{ As of June 30.7& Figures will be available in October 1985.

Source: Crindlays Bank, June 30, 1983 and staff estimates.

3.03 Since 1979, a number of steps have been taken to improve the performanceof NCBs. NCBs have been aLlowed to build up their capital to more prudent levelsby limiting dividends to GOP. In turn this has increased the lending ratio baseof the NCBs, allowing them to undertake increased lending operations. Theseactions have Led t.. a subsatntial increase in profitability with the share of NCBs

1/ Annex 2 provides a comprehensive discussion of the commercial bankingsystem.

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in total commercial bank profitability increasing from 71Z in 1978 to about 90X in1984. Branch expansion is no longer automatic and through a program of branchconsolidation a number of uneconomical branches have been closed. 1/ Expansion ofstaffing, with the exception of recruitment of MBAs at middle management level,has been stopped. A performance review system has been introduced and bankemployees can now be fired with three months' notice; increasingly, promotions arebased on merit rather than seniority. Central training institutes (e.g.,Institute of Bankers) have been strengthened. More recently, GOP, announced anumber of additional measures to improve the performance of the NCBs, includingthe granting of greater operational autonomy, establishment of aperformance/profitability monitoring system with specific performance targets foreach NCB, and introduction of performance incentives based on after-tazprofitability.

3.04 The measures taken by GOP and PBC since 1979 have contributed to theconsiderable improvement in overall performance and profitability of NCBs. Thecombined net profit after tax of the NCBs increased from Rs 150 million in 1978 toRs 970 million in 1984,*an annual compound grnwth rate of 36Z. However, the.absolute profitability level remains relatively low and performance amoa NCBsremains mixed with the return on total assets raftging from 0.9Z to 0.3%. Themajor causes of relatively low NCB profitability are: GOP's high reserve require-ments (35Z of deposits) and credit allocation policy, which directs NCBs tofinance priority sectors at low interest rates; & large network of low profitbranches in rural areas; non-payment of interest on loans to the public sector;and general overstaffing. FBCs achieve profitability by catering to selectedcorporate clients, and by undertaking a larger proportion of fee-based businessfor which profit margins are higher.

3.05 Specialized Institutions. 2/ A number of specialized institutions alsoprovide assistance to industry, small business and housing. Some of theseinstitutions are deposit takers while others offer only term financing facilities.Key amongst these institutions for industrial financing are the DFIs, their sub-sidiaries and the various mutual 'rust funds and underwriters. Among the DFIsBanker's Equity Ltd. (BEL), which was originalLy set up to promote Islamicinstruments, especially equity finance, provides capital to private industry byunderwriting equity issues and arranging consortia finance participation fromNCBs. IDBP Lends to medium- and small-scale manufacturing units, directly andthrough selected commercial banks. NDFC provides term financing and workingcapital to public and private sector industrial enterprises. A RegionalDevelopment Finance Corporation was set up in FY84 as a subsidiary of NDFC to

1/ Over 200 branches were closed in 1984.

2/ The Agricultural Development Bank of Pakistan (ADBP), the Federal Bank forCooperatives (FBC), and the Punjab Provincial Cooperative Bank (PPCB) providefunds for rural agro-industries while the House Building Finance Corporation(HBFC) provide home loans.

finance projects in less developed areas and recently, NDFC and the Rafiq HabibGroup have established a leasirg company (National Development LeasingCorporation) with financial and technical assistance from IFC. PICIC, the onLyfinancial institution with private ownership, makes foreign exchange loans tomedium- and large-scale industry. The Investment Corporation of Pakistan (ICP)arranges industrial finar.ing through consortia of NCBs, underwrites equity issuesand operates a number of mutual fundt while the National Investment Trust (NIT)also operates mutual funds and unit trust savings s-chemes. Three joint venturecompanies, Pak-Kuwair,-Pak-Libya and Pak-Saudi, were estabLished in 1982 toprovide loans and venture capital to industry.. A Small Business FinanceCorporation (SBFC) provides short- and long-term loans to small-scale industriesand businesses while the Equity Participatian Fund (EPF) also provides equitysupport to small-scaLz projects mainly in underdeveloped areas.

3.06 Due to historical developments, different Legal structures and changinggovernment policies, the DFIs became excessively compartmentalized and were con-straiued in the range of financial sarvices which they could provide to industrialclients. As discussed in Chapter 4, during 1983-1984, GOP took a number of -measures to rationalize regulations affecting DFIs. These measures have Led toincreased competition among DFIs, a sounder financial basis especially for IDBPand PICIC, and the provision of more comprehensive .i-tancial packages to privatein-westors. As a result, the ef_iciency of the industrial cre4it delivery systemhas improved considerably.

B. Industrial Finance

3.07 Notable changes in the industrial financing system during the last decadehave included: the creation of a number of non-bank financial institutions; thedecline in the relative importance of established DFIs; and the emergence of theNCBs as a force in term lending. Initially, IDBP and PICIC were the main institu-tions providirg term financing for industrial development. However, in 1982 NDFCwas allowed to expand its clientele to include the large- and madium-scale privatefirms as well as public sector enterprises. Among the DFIs, NDFC is now thelargest industrial lending institution in Pakistan. Other institutions such asBEL, ICP and the three joint venture compan.es also have increased their role interm financing for private industry.

3.08 In FY79, the State Bank of Pakistan (SBP) began assigning mandatory lend-ing targets to NCBs on term loans to industry, to prevent the NCBs from avoidingmaking loans at the concessional 11Z interest rate. The targets were discontinuedafter FY81 because NCBs found it difficult to use their allocations due to otherconstraints on industrial investment, particularly foreign exchange shortages andthe banks' limited capacity to undertake project evaluation. Since FY82, SBP hasincorporated allocations for fixed industrial investment in the Annual CreditPlan. If not fully utilized, the NCBs could not lend these amounts for otherpurposes. Between FY81 and FY85, SBP allocations for fixed industrial investmentincreased from Rs 0.6 billion in FY81 to Rs 2.2 billion (or by 350%), whileallocation utilization increased from 671 in FY81 to 78Z in FY85. Historically,NCBs were relatively passive participants in industrial term lending. The NCBs

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were members of consortia led by ICP, BEL and NDFC, relying on the project evalua-tions of these institutions. With technical assistance under IIC I, HBL and UBLupgraded their term lending skills. Under the the proposed project, UBL andMuslim Commercial Bank (MCB), are also expected to be involved in direct termlending to industry.

C. Financial Policy

3.09 Islamization. 17 As of July 1985, Pakistan's financial system and alldomestic currency transactions are based on new financing modes consistent withIslamic principles. Interest rates have officially been removed from the system.New financing arrangements, proposed or in operation, relevant to industrialfinance include: (i) mark-ups, a sale with a profit margin which varies accordingto the term; (ii) Term Finance Certificates (TFCs),21 which would be bonds with arisk premium; (iii) Musharikas, designed to meet working capital needs, in whichprofits are shared according to a pre-:agreed formula; (iv) Modaraba companies,which operate as investment funds in accordance with Islamic tenets; and(v) hire-purchase and lqasing.

3.10 Although it is too early to determine the impact of Islamization on thefinancial system and industrial finance, initial indications are that, on thewhole, Islamization is having a positive effect. By not imposing restrictions onthe terms and conditions which can be negotiated between lenders and borrowers,GOP is effectively freeing financial rates of return. This liberalization appliesin particular to term financing under TFCs and the arrangements for hire-purchaseand leasing. As TFCs are expected to carry effective rates of 14% - 15% p.a., incontrast with past term lending of 11, which should increase incentives forfinancial institutions to engage in Lending for fixed industrial investment. 31In addition, the introduction of new financing mechanisms such as hire-purchase,leasing and Modarabas has expanded both financing options available and the roleof the private sector in financial intermediation. Modarabas in particular offerthe opportunity for project sponsors to raise funds directly from the public.Islamization, with its emphasis on equity or quasi-equity forms of financinginvestment, also should lead to a deepening of the capital market. It is nowclear that most financing will take place through mark-ups, both short and long-term, which offer security of principal and reguLar income flows, thus avoidingmost of the uncertainty and risk in an rslamic system based on profit-and-losssharing.

1/ See Annex 3 for a detailed discussion of Islamization.

Z/ Some TFCs have been issued, but use has shown that some modifications to theconcept are needed before they can become a major financing instrument.

2/ Under the Islamic system, there is no ceiling on rates of return for termlending.

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3.11 Interest Rates. Before the full conversion to Islamization, Pakistan'sinterest rate scructure was characterized by a crossing of rates; deposit ratesrose whiLe lending rates fell with maturity. The interest rate structure provideda clear incentive for banks to favor short-term lending at 14% and short-termdeposits at 5.5Z rather than making Long-term loans at llZ and mobilizing termdeposits at 9% to 12Z. With 14Z - 15% interest rates on TFCs and 10 to 20% onmark-ups, the distortions in the interest structure have been reduced markedly. 1/Also with Islamization, interest rates for priority sector lending have beenincreased and will be the same as for non-priority sectors. 2/ With inflationrates projected to remain below 10, interest rates are expected to be substan-tially positive. However, if interest rates were to become negative, PFIs couLdadjust rates for term and working capital loans, under parameters established bySBP.

3.12 Credit Allocation. While the growth and distribution of domestic creditin Pakistan is predominantly governed by a centralized allocation system, GOP isusing the impact of Islamisation and the resulting market-determined interest ratestructure to substitute for this process. Currently the SBP is responsible fordetermining and managing the Annual Credit Plan (ACP) in close consultation withGOP. The ACP has a central role in determinini the overall level of credit andits distribution, setting maximum volumes of lending for each bank and financialinstitution. Overall ceilings are disaggregated by economic-sector and betweenprivate and public sectors. This detailed system of credit allocation somewhatpreempts the intermediating and allocative functions of the financial system.However, in practice the system is impLemented with considerable flexibility. TheNational Credit Consultative Council, charged with developing each ACP, is com-posed of representatives of financial institutions and the private sector as wellas government officials. Performance in utilizing credit allocations and theappropriateness of individual ceilings are reviewed quarterly , with neededadjustments made. To introduce additional flexibility, the SBP has allowed finan-cial institutions to trade ceilings within the overall credit expansion targetsand has set up an Industrial Credit Cell to monitor and improve the flow ofcredit to the industrial sector. To date the credit allocation system has func-tioned reasonably well in channeling resources to priority sectors as well asmeeting the credit needs of private industry. With greater reliance on market-determined interest rates, further relaxation in the credit allocation system maybe possible.

1/ Long-term interest rates of 14% - 15% are considered a realistic indicatorof the cost of capital in Pakistan.

2/ SBP specifies mandatory credit targets for NCB lending to priority sectors:agriculture, small businesses, small-scale industries and tobacco marketing.Total priority lending accounts for a small proportion of NCB advances-lessthan 10% in FY84-and in most cases these minimum targets are exceeded. Ofthese, lending for fixed agricultural and industrial investment carried theconcessional 11% interest rate.

3.13 Credit aLlocations to the private sector are based on the overall moneysupply growth target. To date, GOP's domestic bank borrowing has not crowded outlending to the private sector although inadequate domestic resource mobilizationefforts and the increasing financing requirements of a growing economy couldsqueeze credit to the rapidly expanding private industrial sector. During FY85,GOP's domestic bank borrowing was substantially higher than projected in theCredit Plan and these pressures are expected to continue, indicatLng a precaution-ary need to widen the sources and methods of financing private sector industrialinvestment. Strengthening the stock market, improving incentives for equityfinancing and encouraging the development of secondary markets to enhance theliquidity of long-term and equity financing would widen the presently restrictivepattern of industrial finance considerably. One of the main objectives in thepreparation and design of the proposed second IIC project has been to assist GOPin developing more efficient capital and secondary markets for securities.

D. The Capital Market 1/

3.14 Stock exchanges which functioned in Karachi and Lahore prior to independ-ence were re-established in 1949 and 1970 respectively. The Karachi StockExchange (KSE) was buoyant during the late 1950s and most of the 1960s.Constraints on private sector profitability in the late 1960s,-followed by theloss of East Pakistan, the massive devaluation in 1972, and the Government'snationalization program depressed the capital market which continued to stagnatethroughout the 1970s. Although the stock market has revived somewhat as a resultof the improved economic climate and government measures to encourage the privatesector, it remains a relatively marginal source of funds for industrialinvestment.

3.15 Structure. About 8OZ of listed shares are controlled by management groupsand public sector investment institutions. High concentration of holdings iseased only marginally through floatation of mutual funds. Most companies rarelyissue marketable debt instruments; when companies do, the instruments tend to beprivately placed Government securities are placed with financial institutions bySBP which maint.- .s their value at or close to par, thus precluding trading.Given these constraints, stock exchanges mainly trade a relatively small number ofcommon shares. The regulatory framework for stock exchanges consists of legisLa-tive requirements in conjunction with a high degree of internal self-regulationimposed by the stock exchanges on members and listed companies. In practice,regulations are not strictly enforced and there is considerable scope for improv-ing the functioning of both exchanges. While there are 250 members in the KSE and120 in the Lahore Stock Exchange (LSE) only a small number are active; stockexchange members are both brokers and jobbers.

3.16 Performance. Despite increased activity in recent years, the stock marketremains thin, being characterized more by a lack of quality securities than insuf-

1/ For a detailed AnAlysis/description of The Capital Market, see Annex 4.

.

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ficient demand. As a result of the improved economic cLimate and governmentefforts to encourage the private sector, conditions have been relatively buoyantin recent years. Turnover and share values have increased (Table 2) and newissues, although small in number, are generally oversubscribed (by 17 times inFY84 and 3 times in FY85). However, due to the structure of share ownership, ofthe 353 listed companies on the KSE, only about 150 are traded, with active dailymarkets in about 30. The LSE has 247 listed companies, most ofwhich are alsolisted on the KSE; LSE's trading activity is insignificant. In general, multina-tionals are the best performers as they operate in more profitabLe sectors and payhigh dividends.

Table 2: Karachi Stock Exchange CompaniesPrices and Turnover

Aggregate General- Market VaLue Index of Turnover

Year Ended Number Paid-up of Ordinary Share Price ofDecember 31 of Comp4nies Capital Siares (1975176=100) Shares

(Rs million).. (No TO)

1981 311 8,078 8,554 128.7 35,2821982 324 9,439 11,267 163.8 50,2361983 327 9,995 15,201 207.6 76,0281984 346 11,496 17,770 232.1 115,6701985 353 11,P85 21,956 258.4 33,110 1/

1/ January-May 1985.

Source: Karachi Stock Exchange.

3.17 There is considerable potential for expanding the stock market inPakistan, as evidenced by the fact that at present there are more than 10,000operational private companies but only 353 listed companies. As part of thepreparation for this project the Bank Group initiated an active dialogue with GOPon measures to strengthen capital markets in Pakistan. The Government's reactionhas been positive; GOP announced a number of important measures in the FY86Budget. These include:

(i) reduction in the corporate tax for listed companies from 50% to 40%(privately held companies are taxed at 55Z);

(ii) income tax exemption on dividends paid by listed companies;

(iii) a decisien to allow private investment companies (local or foreignowned) to perform all banking functions except deposit taking;

(iv) disinvestment of shares valued at Rs 2 billion of shares in publicsector companies through secondary offerings in FY86; and

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(v) introduction of bearer bonds in foreign and local currency to attract"black money" and mobilize additional resources.

The tax concessions and the increase in the supply of shares should have a posi-tive impact on the stock market. The emergence of bearer bonds which can betraded in the stock exchange and new private sector investment companies alsoshould expand the range of financing sources for the corporate sector in Pakistan.

3.18 While by Pakistan standards the measures taken by GOP are significant,they need to be complemented by steps to encourage a smoother functioning of stockexchanges, promote more market-oriented corporate finance services in the pricingand distribution of securities, and develop a market for short-term corporatepaper. A number of additional measures have been discussed with GOP including:(i) issuing of bearer shares to attract "bLack money"; (ii) deregulation of under-writing activities; (iii) introduction of market pricing for new share issues;(iv) introduction of short-term corporate commercial paper; and (v) licensing ofprivate comuercial banking. The Government has referred these proposals to therecently established De-regulation Commissiorn and there are good prospects chatsome or alL of these measures will be implemented during FY86/FY87. At therequest of the KSE, GOP has agreed to provide technical assistance from the TAcomponent of the first IIC project to modernize KSE operations. IFC is coordinat-ing wich GOP/KSE and the LSE on the development of TORBand serection of consult-ants for the assignment.

3.19 At present, the corporate sector has no financial instruments to channel"black money" directly into productive investment. The issuing of bearer shares,a class of common stock in bearer form with the same dividend And residual assetentitlements as common stock, would direct "black money" toward equity investmentand would help correct the undercapitalized structure of Pakistan's corporatesector. Underwriting is carried out by a few syndicates of DFIs and banks, withfees determined by a rigid administrative schedule bearing no relation to marketconditions. Freeing underwriting should expand the number of underwriters andsubject fees to market competition. New issue pricing is determined not by themarket but by the Controller of Capital Issues (CCI) with new issues pricedthrough a formula whereby existing owners share one-half of the difference betweenthe company's net asset value and par value. This acts as a strong disincentivefor conversion of private to publicly-held companies since existing owners are notpermitted to set share prices in accordance with market perceptions of thecompany's prospects and risk pots.-tial. Short-term marketable commercial paperissued by established and profiL.. .le companies would provide an additional sourceof funding outside the banking system and lead to a secondary money market; thiswould add depth to the capital market and improve its allocative role. The intro-duction of private domestic banking would add a strong element of competition forNCBs and would expand the range and efficiency of financial services offered. Asan extension of GOP's decision to allow private investment companies, the settingup of venture capital companies aLso should be encouraged.

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IV. BANK'S INDUSTRIAL LENDINC STRATECY

A. Past Lending and Industrial Str&segy

4.01 As of December 31, 1984, Bank Group commitments to Pakistan amounted toabout US$3.2 billion, while IFC has made investments of US$179 million in 15enterprises and has assisted in setting up the National Development LeasingCorporation, a joint venture between a private sector group and NDFC. Of the BankGroup financing, public and private industry accounted about US$0.9 billion or28Z. Bank Group lending.through financial intermediaries for industrial projectshas been channeled through 16 loans and credits totalling US$534 million, of which11 loans and credits totalling US$244 million have been made to PICIC for onlend-ing to medium- and large-scale private sector projects, four loans and creditstotalling US$130 milLion have been made to IDBP to provide term loans directLy andthrough commercial banks to a large-number of small-scale industrial projects, oneline of credit of US$30 million was channeled through the NDFC for onlending topublic manufacturing enterprises and the first IIC for US$100 million was chan-neled through the DFIs and a major commercial bank (HBL). The Bank Group's directindustrial lending mainly for the public manufacturing sector amounted to aboutUS$430 million, consisting of industrial imports (US$220 million), fertilizer

-; 'loans (US$161 million), refinery engineering (US$12 million)-and industrialestates (US$6.5 million).

4.02 Prior to the first IIC project, Bank Group lending through financialintermediaries included loars to individual DFIs for ter= lending mainly to mediumand large private industry, and lending for smaLl-scale industry by commercialbanks, with refinance by IDBP. Lending to DFIs was aimed largely at the promotionand strengthening of a DFI as a vehicle for efficient intermediation of financiaLresources. Another major objective of the Bank's DFI lending was to provide theforeign exchange needed for industrial development, to support GOP's industrialdevelopment goals, particularly those aimed at encouraging the private sector,promoting regional development and labor intensive enterprise, and developingexports. The rationale for dealing with the DFIs individually was their clearlydefined roles in different market segments. IDBP concentrated on SSIs, NDFC dealtwith the public sector and PICIC focused on medium- and large-scale privateindustries. However by 1980 considerable overlap in the cLient base of the DFIshad developed with IDBP and PICIC lending to the same client groups and NDFC'sCharter had been amended to enable it to lend to the private sector. Because IDBPand PICIC had inadequate institutional and financial capabilities to respond tothe increasing credit demands from the private sector, GOP instructed the NCBs tofill the gap and they became a major source of term finance for industry. In1983, in view of these changes in the financial system, the Bank Group shifted thefocus of its lending strategy to focus on the industrial finance system as a wholewith the objectives of better positioning the Bank Group to discuss financialsector issues with GOP, influencing the roles and performance of major institu-tions and improving the industrial Lending capabilities of the comiercial bankswhich had become major financial intermediaries. The Bank Group's first IIC

* ~~~~~~~~~~~-15-

project was the vehicle to implement the strategy. Experience with the first IICproject was highly satisfactory (para. 4.04).

S. Impact of Past Operations

4.03 Past DFI Operations. 1/ Performance under past direct DFI operations hasbeen mixed, with institutional upgrading significantly constrained by politicaland economic developments, particularly from 1970 until 1980. The loss of assetson the independence of Bangladesh, combined with the devaluation of the rupee in1972, caused both IDBP and PICIC severe financial problems which impacted upontheir organization and staffing. A Project Performance Audit Report - PPAR -(SECM 79-494) on Cr. 177-PAK to IDBP issued in June 1979 focused upon the develop-ment impact of the project and on the institutional objectives. Operationally,the project impact was satisfactory. The financing of 65 subprojects in theprivate sector created 11,600 jobs at a job/cost ratio of US$3,400. The ex anteERR of the projects was between 16Z - 50Z. Institutionally the impact was limitedand the PPAR stressed the need for careful monitoring of IDBP's operations andcontinued efforts to revitalize it. Subsequeatly, the Bank Group and ADB workedclosely with GOP to revitalize IDBP, and by 1981 sufficient progress had been madeto enable the Bank Group to use IDBP as the administrating agency for two furtherlines of credit for SSI development (Cr. 1186-PAK and Cr. 1499-PAK) with IDBPproviding refinance to the cosmercial banks for small industry.loans. As withIDBP, PICIC experienced severe financial problems during the 1970s. The BankGroup worked closely with GOP to revitalize PICIC during this period and grantedthree loans and credits, each with significant technical assistance componentsfocussed on policies, procedures and standards. The PPAR on Ln. 590 (SECM78-537), issued in June 1978 focused on PICIC's serious portfolio problems and theneed for diversification and greater resource mobilization efforts. The ProjectCompLetion Reports for Loan 961-PAK and Loan 1326-PAK noted the beneficial impactof the credit components vhich financed 40 medium-/large-scale subprojects in theprivate sector, creating about 6,300 jobs at a job/cost ratio of US$25,500. Exante ERR on projects was between 102 - 40Z. Under the two loans, PICIC's newmanagement took up the institutional issues noted in the earlier PPAR, and madeconsiderable progress in resolving its operational difficulties, although furtherefforts are needed to sustain the improvements. In April 1984, several majororganizational changes were made in PICIC's top management and the structure ofPICIC's operational management was revised. Unlike IDBP and PICIC, NDFC did notsuffer from the events of the 1970s. The Project Completion Report on Cr. 546-PAMissued in October 1982 noted that the credit component of the project had beeneffective. Twenty-two subprojects, mainly in the private sector, were financedcreating 6,600 jobs at a job/cost ratio of US$36,000. The ex ante ERR on thesubprojects ranged from 15X - 50%. The PCR also noted that NDFC was well pLacedto contribute to industrial development notwithstanding its venture into the newarea of private sector financing. Since 1982, NDFC's operational and financialperformance has been satisfactory, although many of the subprojects financed byNDFC have yet to complete their repayment grace periods.

1/ For a detailed analysis of the operational performance of IDaP, NDFC andPICIC, see Chapter VI.

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4.04 First Industrial Investment Credit (IIC) Project. In 1983 the Bank Groupconcluded that while past Lending to individual DFIs had significantly achievedits institution-building objectives, there were serious deficiencies in theGovernment's industrial and financial poLicies which inhibiced appropriateindustrial growth. It was decided that, in addition to institution building,industrial and financial sector policy improvements should be an essential objec-tive of future Bank Group lending to the industrial seccor. Thus the first IICproject (Ln. 2380/Cr. 1439-PAK) expanded the Bank's involvement in the financialsystem, through the use of commercial banks as weil as vFIs as financial inter-mediaries for term lending to medium- and large-scale industries. Initially, fourfinancial institutions (IDBP, NDFC, PICIC and HBL) were eligible to participate inthe project. The UBL, the fifth PFI, became eligibLe in late November 1984. TheimpLementation of the project has been highly satisfactory. The use of a largernumber of efficient outlets has benefited private investors by reducing theproject processing time and increased the range of financiaL services investorscan obtain from a single financial institution. The competitive pressure, morestringent eligibility criteria, and implementation of action programs to improveoperating standards, has resulted in the PFIs becoming more efficient and marketoriented; competition between DFIs has developed rapidly in some areas. Overall,there has been improvement in the financial performance of all the DFIs, espe-ciaLly IDBP and PICIC, although their financial viability is still fragile andwill require careful monitoring. The DFIs which lacked domestic resources (IDBPand PICIC) have developed close working relationships with the commercial banks tooffset the deficiency. The first IIC project also has succeeded to a large extentin rationalizing regulations affecting DFIs. IDBP is now allowed to make workingcapital loans, mobilize deposits,.and offer export-import finance. PICIC has beengiven permission to participate in the interbank market, cake working capitalloans, and underwrite shares while NDFC now has the power to sanction projectswithout prior clearance of the Investment Promotion Bureau.

4.05 As of June 30, 1985, IIC I was fully committed a year ahead of theoriginal schedule. In addition, there were seven pending projects totalling US$20million which could not be accommodated because of the unavailability of funds.However, total disbursements to date (September 30, 1985) are only US$10.6 millionor liZ of the credit component, which is less than the rate of disbursement (45Z)anticipated at the time of appraisal. Of the US$94.7 million available forproject financing, PICIC utilized 33Z (US$31.6 milLion), HBL 28Z (US$26.3million), NDFC 22Z (US$21.1 million) and IDBP 17% (US$15.7 million). PICIC andNDFC initially concentrated their efforts in utiLizing a US$100.0 million creditline from ADB, which was fully committed in February 1985. Project funds wereused to finance 42 subprojects with satisfactory domestic resource costs andestimated average internal economic and financiaL rates of return of 15 or more.The sectoral distribution of project approvals was: textiles 25%, food and alliedindustries 22%, sugar 19%, paper products 11, engineering 11%, cabLe manufacture8% and other 4%.

4.06 From the US$2.0 million TA component, 10 technical assistance programsamounting to SDR 1.0 million have been approved. More than two-thirds of thesewere for training PFI staff while the balance was for sector work and organization

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studies. A major training program carried out under the sponsorship of the PBC inJune 1984 was very successful and has enhanced the NCB's capabilities in projectfinance. A second program wiLl be carried out later this year. The DevelopmentBanking Institute (DBI), which is owned jointly by PBC and the DFIs, is now fullyfunctional and has provided project appraisal training to the staff of DFIs andNCBs on an on-going basis. The Institute was supported under the first IICproject and will continue to be supported through NDFC under the proposed project.

C. Rationale and Strategy for Future Institutional Lending

4.07 The Bank Group's industry strategy in Pakistan encompasses sector work andlending operations geared to: accelerating structural adjustment in theindustrial sector, and supporting GOP's efforts to revitalize the private sector,improving public enterprise efficiency, strengthening the financial system, andincreasing exports in line with Pakistan's comparative advantage. An ExportDevelopment Loan (EDL) is being formulated with GOP to support further structuraladjustment in the sectoi. Issues which would be addressed include: reform intrade and industrial incentives, with a particular emphasis on removing barriersto export expansion; deregulation; public enterprise efficiency; and pricingdecontrol. The proposed EDL would build on past sector work including theanalysis of export and related import incentives, a comprehensive study of effec-tive protection, and development of a system for monitoring 8nd rewarding perfor-mance of public enterprises. The reforms complement those taken to address theissues affecting the financial system including the need to strengthen the capitalmarkets, which are being implemented in the context of the proposed Second IICProject. For the public manufacturing sector the Bank Croup's strategy is tofocus on selected subsectors for which there are good prospects for achievingmajor subsector reforms and improvements in the management and efficiency ofpublic sector units.

V. THE PROJECT

A. Project Objectives

5.01 The proposed second IIC project was identified by a supervision mission,which visited Pakistan in August 1984, to review progress of the first IICproject. The strong demand for credit under the first IIC project and investmentprojections indicated that PFIs needed further foreign exchange resources tomaintain their industrial project financing momentum. The proposed project willcontinue to support GOP's policy of promoting private industrial investment.Specific objectives of the proposed project are to:

(a) develop more efficient capital markets with the objectiveof increasing the sources of equity finance for industry(paras. 3.14 to 3.19).

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(b) ensure a stable flow of term finance to private industry byincreasing outlets and the range of services offered by them;

(c) continue institution building programs of PFIs, i.e., diversificationprograms, development of accounting and management informationsystems, organization studies, training, and resource planning; and

(d) stimulate further competition among PFIs as a means of improvingthe services offered to investors.

Under the proposed IIC II project, the coverage of the system will be expanded bythe inclusion of a third commercial bank, KCB, which will give the project sixoutlets which together finance about 70Z of industrial investment in Pakistan.

B. Project Description and Design

5.02 The basic concept of the proposed project is to complement, and expand thefocus of the first IIC by inclusion of new PFIs and through the development ofcapital and secondary securities markets. The proposed project would involve aloan of US$148 million, for onlending by the PFIs and a Credit of US$2 million fortechnical assistance to continue institutional upgrading programs, organizationand systems reviews and subsectoral studies. Subject to compliance witheligibility criteria, six PFrs will onlend Bank funds to viable industrial firmsin the private sector. They will be responsible for appraising projects inaccordance with Bank standards and all subproject appraisals,.as under the firstIIC project, will include calculation of internal economic rates of return (IE3R),internal financial rates of return (IFUR) and domestic resource costs (DRC).Although sectors such as agro-processing, construction, mining, shipping andutilities are eligible, the bulk of the loan is expected to go to manufacturing;with all industrial subsectors eligible for financing except the sugar industryw1here only balancing, modernization, and expansion of existing profitable millswill be considered. The project is intended to finance mainly mediumr and larger-scale enterprises and the asset size of enterprises financed under the project isexpected to range from US$2.0 million to US$10.0 million.

C. Policy and Procedural Changes

5.03 InstitutionaL Upgrading. The Project scope would enable the Bank Group tocontinue working with GOP to address the problems affecting the flow of industrialfinance. The capabilities of IDBP and PICIC would be reinforced further by intro-ducing operational and institutional improvements, and upgrading programs would beimplemented in the other institutions, as necessary, to enable their participationin the proposed project. Under the proposed Project, appraisal and supervisioncapabilities of the NCBs would continue to be strengthened and their participationwould enable them to provide their clients with a full range of banking servicesincluding foreign exchange term Loans.

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5.04 Regulations Affecting DFrs. Although IDBP, NDFC and PICIC lend to similartarget groups, each has been subjected to different regulatory controls. IDBP isa scheduled bank and falls under the supervision of the SBP. NDFC is anautonomous agency under the jurisdiction of the Ministry of Finance. PICIC is aprivate company and is supposed to operate independently, although 49X of itsshare capital is held by public sector institutions. With their different legalstructures and organizational arrangements, the DFIs operate under differentparameters which have created anomalies both in the services they can provide andin che fiscal treatment of their profits. These differences are summarized below:

IDBP NDFC PICIC

Term Loans yes yes yesDeposits /a yes yes noExport Finance and Foreign Exchange yes yes noCorporate Tax - yes no yesSanctioning Authority yes no yesWorking Capital Loans /b 'yes yes yes

/a IDBP, as a scheduled bank, can take deposits, but has only recentlybegun to do so. PICIC, as a private company, is prevented from takingdeposits by the Bank's Nationalization Act of 1974.

/b Until 1982, PICIC did not have adequate domestic resources to makeworking capital loans, while IDBP was restricted by its Charter.

5.05 The need to further rationalize regulations affecting the DFIs to enablethem to provide clients with more comprehensive financial services has been recog-nized by GOP. The conditions under which NDFC operates can be considered a modelfor IDBP and PICIC, to allow them to diversify and provide a full range of bankingservices. Under the first IIC, COP took a number of measures to rectify theoperating anomalies. An amendment to IDBP's Act in November 1983 expanded thescope of its operations; IDBP now is active in making working capital loans andplans to mobilize additional domestic resources through TFCs (para. 6.12). NDFCrecently has been allowed sanctioning authority, which was previously limited toIDBP and PICIC. PICIC now is allowed to mobilize local currency resources in theform of interbank deposits and credit lines from the SBP for onlending purposes.PICIC management has taken advantage of these facilities and has already made asubstantial volume of working capital loans. PICIC has also requested SBP toallow it to offer import-export finance to its clients and SBP is expected torespond favorably. With these changes, the three DFIs now operate under largelyconsistent competitive parameters. In the area of taxation where the DFIs aresubject to different treatment GOP is reluctant to exempt PICrC-a privatecorporation-from corporate tax, as it fears that this will create an undesirableprecedent. However, GOP is willing to allow IDBP and PICIC a higher spread tocompensate for the tax factor and has agreed that they be given a spread of 4%compared with 3Z for NDFC and the NCBs as a partial solution to the differences intax treatment.

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D. Technical Assistance

5.06 The proposed Project includes an IDA Credit of US$2 million to provideassistance to strengthen the institutional capabilities of the PFIs, improve theefficiency of the banking system and the operations of the capital market. The TAcomponent would supplement an approximate equivalent funded by *he PFIs to meetthe local currency costs of training programs and sectoraL studies. The technicalassistance is divided into three subcomponents: training (US$1.0 million);organization and systems studies (US$0.5 million); and subsector reviews (US$0.5million) A major part of-the training component will be used by the PFIs tostrengthen their project appraisal capabilities. Based upon the PFI TA programsdiscussed and agreed during negotiation, GOP would ensure that, by March 31, 1986,the DFIs, PBC and the Stock Exchanges jointly would provide a consolidatedprogram, satisfactory to IDA, for the use of consultants and overseas training.IDBP and PICIC would be major users of the funds allocated for organisation andsystems studies. IDBP has proposed a comprehensive review of its organisationstructure, while PICIC proposes to examine the benefits from diversification intoleasing, working capital financing, export/import financing and equity funding..GOP would allocate part of the TA funds to the PBC, for activities to improve theefficiency of the banking system. The KSE and LSE will also have access to the TAfunds to implement the findings of the consultants' review due in early 1986. Forall technical assistance subprojects, the Bank Group will approve the TORs, theselection of consultants and their terms of appointment.

E. Project Cost. Components and Financing Plan

5.07 As of June 30, 1985, the projected total funding requirements of fixedprivate industrial investment in medium- and large-scale industries by the PFIsduring FY86 - FY88 was about US$1.3 billion with a foreign exchange requirement ofabout US$0.6 billion (Annex 1). The project funds would meet part of the foreignexchange requirements of 40 to 45 subprojects (US$300 million) which form part ofthe PFrs total pipeline of about 100 projects. The proposed project will consistof two components: US$148.0 million of IBRD funds for onlending and US$2 millionof IDA funds for technical assistance (para. 5.06). The US$148 million projectcomponent will finance about 25X of the total foreign exchange costs with theremaining foreign exchange requirement filled by a US$150 million parallel ADBloan (with terms and conditions similar to the proposed project). 1/ The IBRDfunding would represent about 18.6% of the estimated foreign exchange requirementsof projected investments in the medium- and large-scale private industrial invest-ment over the next two to three years.

1/ ADB has scheduled the appraisal of its Xndustrial Investment Project inSeptember 1985, with Board approval expected by January 1986.

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VI. PARTICIPATINe FINANCIAL INSTITUTIONS

A. Participating NCBs 1/

General

6.01 Although all five NCBs are involved in term lending operations, the bulkof term lending to industry is made by EBL, JUBL National Bank& of Pakistan (NBP),the Muslim Commercial Bank (MCB) and with the Allied Bank Ltd. (ABL) involved to alesser extent. Under the first IIC project, HBL and UBL created separate projectsections for appraisal and end-use, recruited suitable staff, implemented trainingprograms in project appraisal and have developed satisfactory financial and tech-nical appraisal capabilities. In preparation for participation in the proposedproject MCB has set up a project finance division with staffing and proceduresacceptable to the Bank. While NBP has expressed strong interest in participating.in the project, it would need to establish a suitable project appraisal sectionand employ staff capable of carrying out project appraisals to Bank Groupstandards. NBP will have access to technical assistance funds under the projectand one year after the effectiveness of the loan, the Bank and GOP will jointlyreview NBP's eligibility to participate in the project as a PFI. In the meantime,it is proposed that, subject to fulfillment of conditions of eligibility, HBL, MCBand UBL participate in the Project. During negotiations, understandings would bereached with the NCBs on collection targets for the aggregate of subprojectsfinanced under SSI I, SSI II, IIC I and the proposed Project. To maintain asatisfactory level of portfolio infection, this collection rate should be not lessthan 701 of total dues of principal and interest.

Habib Bank Ltd. (HBL)

6.02 Background. BBL was established in 1942 by the Habib Group and expandedits operations with all facets of commercial banking activities. In 1972, HBL wasnationalized by GOP but unlike other NCBs, was able to retain the core of itsoriginal staff and has operited more on a commercial basis. Presently HBL isPakistan's largest NCB with about 1,900 local branches and 83 overseas branches.As of December 31, 1984, HBL's total assets were Rs 91 billion (US$6.0 billion).

6.03 Organization, Management and Staffing. BBL is managed by an executiveboard consisting of the president of the bank and three senior executive vicepresidents each responsible for a portfolio of departments. The Executive Boardis assisted by a Central Credit Committee (chaired by a senior member of theBoard) which can approve transactions of up to Rs 40 million when adequate funding

1/ Annex 2 gives a detailed coverage of the commercial banking system and therole in the system of the NCB's selected to participate in the proposedproject.

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is available, or Rs 20 million when funding is required. Lending over and abovethese limits must be sanctioned by the Executive Credit Committee, which ischaired by the president of the bank. All textile loans, loans to the publicsector and major loans to customers overseas are decided by the Executive Board.Both committees normalLy meet twice weekly and decisions are fairLy rapid.Applications for medium and long term loans are handled in the Syndicated LoanDivision (SLD) of HBL. Such loans are limited by amount to not, more than 20Z ofthe paid-up capital and general reserves of the bank, as stipulated in the offi-cial credit regulations for comercial banks, established by the PBC. The SLD issupervised by a Senior Executive Vice President, who is also a Member of theExecutive Board of the Bank. The SLD is headed by an experienced banker and wellstaffed. In addition to direct lending, SLD is also responsible for handlingconsortium proposals prepared by the development banks. HEBL has built up its termlending capability and its Industrial Credit Division (ICD) is well-staffed for

;I handling its present project finance activities in a systematic manner. HBL's --

management plans to centralize all large-scale industrial term lending includingsuppliers' credit in the SLD but to keep SSI operations separate from the SLD butcoordinating the SSI dctivities through the same board member. This is soundstrategy which should be fully supported. Although HEL appears centralized, th-eis significant delegation of authority to the regional and branch level managersto enable them to provide good services to their customers. Project supervisionreview shows that HBL's internal credit procedures, i*.e., fihancial evaluation,supervision, inspection, auditing are satisfactory even bj American standards.Overall, HEBL is very well managed.

6.04 Operations. Since 190 HBL's deposits have increased from Rs 28 billionto Rs 62 billion in FY84, or by 120Z. Advances have shown a simiLar rate ofgrowth increasing from Rs 16 billion in FY80 to Is 36 billion in FY84, or by 125%,part of which was in the form of increased medium- and long-term projectfinancing. HBL was an active participant in the first IIC project and, as ofJune 30, 1985, had committed US$26.3 million in 12 projects. Except for twoprojects, implementation is proceeding well.

6.05 Financial Aspects. HBL has performed well since 1980. Total assets haveincreased at an annual compounded rate of 22.0Z, deposits by 22.5%, and netprofits after tax by 32.9Z. With the profit growth return on equity has beensatisfactory ranging from 15% to 24Z. Given SBP's policy of requiring 35X reserverequirements in low yieLding assets and credit allocation to priority sectors atlower interest rates return on assets (ROA) has also been satisfactory at anannual average rate of about 0.4% p.a. Prior to 1981, all NCBs were required toremit net profit after tax to the Government. However, this policy was changed in1981 to allow the NCBs to improve their capital deposit ratios. Consequently,HBL's retained earnings increased significantly in 1982 and the tempo has beenmaintained. There is also notable improvement in efficiency as increased assetswere achieved without substantial increase in staff.

6.06 Future Prospects and Diversification. Given the projected growth in theeconomy, HBL is expected to maintain its satisfactory level of operations.However, to complement its activities in medium- and long-term financing there are

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a number of measures which could be taken by HBL including; greater use of equityfunding for bridge financing; use of SP8 suppLiers' credits and projectidentification/feasibility studies by external consultants. Appropriate implemen-cation of these measures would be discussed with HBL during negotiations.

Muslim Commercial Bank Limited (MCB)

6.07 Background. KCB was zet up in Calcutta in 1947 as a private bank; andupon the Partition of India and Pakistan in the same year. moved to Chitcagong inEast Pakistan. Later, in 1955 the headquarters moved to Karachi. Under theleadership of the Adamjee business group the bank expanded profitably, becomingthe third most important private bank in the country. In 1974, under the Banks'Nationalization Act, Premier Bank, a smaller institution, was merged into MCB.Today, MCB continues to be an important element among the country's financialinstitutions.

6.08 Organization, Management and Staffing. NCB has a relatively decentralizedorganizational structure. The chief executive officer is the President, who-isassisted by the four members of the Execucive Board who have specific managementresponsibilities; one in-the area of commercial operations and SBP relationships,another in the area of agricultural lending and overall business promotion, athird in overseas operations and industrial lending operations, and the fourth onadministration and personnel. In addition, all four have supervising respon-sibilities over a specified number of branches and districts.

6.09 Until 1984 MCB depended on the consortium leader's recommendations for theprojects in which it participated. It now has a well organize4 Industrial CreditDivision (ICD) consisting of appraisal, disbursement and end-use units, plus acell for small industry. The division has 15 professionals of which 8 have beentransferred from other departments while 7 have been recruited from industry orgraduate school programs. In addition, the Lahore regional office has twoofficers in charge of project finance. Recently, an experienced professional withseveral years of experience as a consultant, corporate manager and developmentbanker has been recruited to head che division. The division has data processingcapability for its operations, with access to MCB's computer center and a computerspecialist in the Division.

6.10 The ICD as currently organized is well-equipped to participate in theSecond IIC Project. It has developed sound strategy and policy statements as wellas procurement procedures for its operations. These documents will need to beapproved by MCB's Board. It also is developing internal procedures for processingproject proposals, presenting appraisal reports, coordination with other Bankdivisions, and supervision by senior management. To process project financingapplications the ICD has trained 10 of its officers in project finance techniquesand procedures, principally at the DBI. This type of training is scheduled tocontinue, with particular emphasis on end-use applications. However, it will beworthwhile to expand the program to training and practical exposure at overseaslocations as well. With more project financing ICD staff will gain experience inprojects that are financed.

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6.11 Operations. Since 1980 MCB's deposits have grown from Rs 10 billion toRs 17 billion in 1984 or by 70Z. This has provided an expanded resource base forthe increasing level of advances which have grown from Rs 6.5 billion in 1980 toRs 11.2 billion in 1984. Most of the advances have been for working capital/tradecredit although medium- and Long-term financing bas increased as an area of opera-tions and now accounts for 5X of MC8's total portfolio. So far, MCB's term lend-ing has been through consortia financing with MCB acting as the Lead bank in a fewcases where projects involved balancing, modernization. or equiRment replacement.schemes. MCB's industrial term lending commitments have expanded fromRs 146 million in 1982, to Rs 198 million in 1983, and Rs 349 miLlion in 1984, anincrease of 13OZ. Cement, hotel, and sugar projects account for about 50Z ofoutstanding loans, totall-ing Rs 500 milLion as of December 31, 1984. A potentialpipeline of about US$30 million has been developed and these couLd rapidlymaterialize into formal project finance proposals if foreign exchange term fundsare made available to MCB under the Second IIC Project.

6.12 The ICD has taken over the ieview of consortium proposals for rupee termfinancing of industrial projacts. MCB participates in these operations in aproportion of 15Z of total rupee financing. In addition, NCR has begun directterm financing operations and in 1985 sanctioned eight projects involving-totalassistance above Rs 40 million. These operations have provided valuable practicalappraisal experience to MCB's officers. As expertise in this area develops, ICDwill need to concentrate on supervision and develop expert cipabilities in thisrespect rather rapidly. Outside assistance for this purpose may be requiredsometime within the next two years.

6.13 Financial Aspects. Since 1980 NCB's net profit afeter tax has increasedfrom Rs 22 million (FY80) to Rs 89 million (FY84) or by an anuiual average of B0Z.Total assets have increased from Rs 14 billion in FY80 to Rs 23 billion in FY84 orby an annual average of 14%. ROA has moved in parallel with profit growthincreasing from 0.2% in FY80 to 0.42 in FY84. Return on equity (ROE) has beenless stable with ROE fluctuating from 20.5Z in FY80, to 11.81 in FY82, to 17.8Z inFY84. Although erratic the overall ROE is satisfactory.

6.14 Prospects. MC8 anticipates a continuation of its satisfactory operatingperformance with an increasing volume of medium- and long-term financing. Apotential pipeline of industrial projects has been developed at the level of NCR'stop management. This pipeline of about US$30 million could rapidly materializeinto formal project finance proposals if foreign exchange term funds are madeavailable to MCB under the Second IIC Project.

United Bank Ltd. (UBL)

6.15 Background. UBL was set up as a private bank in 1959 and expanded rapidlyduring the sixties to become the second largest private bank in Pakistan. It waswell-managed and had a cadre of highly qualified professional staff. However,following the nationaLization of commercial banks in 1974, a number of itsmanagers, including its president resigned. The situation was further exAcerbatedby the demand for experienced bank officers in the Middle East. As a result ofthe changes in top management and loss of experienced staff, UBL's performancefluctuated. In 1981, GOP appointed Mr. T. Hussain, a senior career banker at

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Habib Bank Ltd., as UBL's President. Under his leadership, UBL has performed verywell and UBL is now rated as the 451st largest bank in the world based an the sizeof its deposits. UBL has also closed over 100 unprofitable branches, whileretaining complete geographical coverage of the country (1,592 branches), and astrong presence abroad (31 branches and 4 subsidiary or affiliated banks).

6.16 Organization. Management and Staffing. UBL is a very decentralizedinstitution, refLecting the style of its founder. Top management,relies on acomprehensive management information system to control the bank's operations. Italso retains auchority over the larger credit decisions. An Executive CreditCommittee approves alL loans above Rs 40 million, while branch, zone, and regionalmanagers have varying degrees of delegated authority. The President and ExecutiveMembers of the Board provide additional control over a decentralized structurethrough their day-to-day contact with operations in their respective areas ofresponsibility, involving repeated travel through the country.

6.17 UBL became eligible to participate in the first IIC project in November1984, after signing a subsidiary loan agreement with GOP. Previously, it had beenincluded as a participadt for technical assistance to upgrade its term lendingcapability. In line with this objective, UBL established an Industrial CreditDivision to review consortium proposals and prepare projects for future participa-tion in the IIC project. This division is presently staffed with 14professionals, who have been recruited from within and outside UBL. At leasteight officers have received training at the DBI and/or courses organized by PBCwhile others have gained industrial term-lending experience in other institutions.As a result of these efforts appra.isal and end-use standards have improved con-siderably and qualify UBL for participation in the project. A proposal to sendstaff for overseas training has also been approved under the first IIC project andis expected to be implemented in 1986.

6.18 Operations. As with other NCBs, UBL's operations are concentrated onshort-term loans, seasonal advances and foreign trade financing. Medium- andLong-term industrial financing which accounts for about 6X of UBL's operations areusually carried out through participation in consortium financing arranged by theDFIs. UBL's growth from 1980 to 1984 has been consistent, deposits have increasedfrom Rs 21 billion (FY80) to Rs 45 billion (FY84) or an annual average growth of23Z p.a. Advances have also increased steadily from Rs 14 billion (FY80) to Rs 26biLlion (FY84) or at about 20% p.a. As of December 31, 1984, industrial termloans disbursed were Rs 418 million, a 175Z increase over disbursements of Rs 152miLlion in 1981. At present, UBL's portfolio of private sector industrial invest-ment loans is about Rs 1.1 million, with textile, chemical, hotel and cementsector loans accounting for about 50% of outstandings.

6.19 Financial Aspects. With the closure of unprofitable units during 1982,UBL's profits have increased significantly rising from Rs 17 million in FY80 toRs 35 million in FY82 to Rs 338 million in FY84. This has given a ROE of 30Zwhich is satisfactory. In turn the increased profitability has resulted in ahigher ROA which increased from 0.06Z in FY80, to about 0.6Z in FY84 on totalassets of Rs 60 billion.

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B. Part;cipating DFIs

Industrial Development Bank of Pakistan (IDBP) 1/

6.20 Background (1961-1980). IDBP was established in August 1961, to financesmall- and medium- sized enterprises through the reorganization of the PakistanIndustriaL Finance Corporation (PIFCO). In 1969, 'it was 581 owned by theGovernment and Government institutions, and 42Z by private institutional andindividual investors. In 1974, the private shareholdings were taken over by GOPunder the bank nationalization. The private sharehoLders received interest-bearing compensation bonas based on estimated break-up value. IDBP's initialshare capital of Rs 20 million was increased to Rs 50 million in 1970 and in FY81was doubled to Rs lQ0 million with GOP owning 90% directly, and the remainderbeing held by the four provincial governments and various government-ownedinstitutions.

6.21 ALthough initially profitable and financially sound, IDBP's overall posi-tion deteriorated significantly during 1970-1980 due to the costs of relocating -

from East Pakistan, the loss of assets in Bangladesh, the devaluat'ion of the rupeein 1972, and the default on repayment by subborrowers. Additionally, the sig-nificant downturn in economic activity particularly in the textile sector, whichaccounted for about 50Z of IDBP's portfolio added to IDBP's financial distress.Despite action by GOP and IDBP to improve IDBP's operations, the political andeconomic uncertainties which continued until 1979 negated any real improvements.This situation was exacerbated by the loss of many experienced staff to the KiddleEast and an acute shortage of engineers and financial analysts for projectappraisal/monitoring. By 1980 IDBP was considered uncreditworthy. UnderCr. 1186-PAK and the first IIC, a series of measures to address majorenvironmental, policy and procedural issues affecting IDBP's operations wereinitiated by GOP/IDBP. Progress has been satisfactory but further efforts areneeded to ensure that the improvements achieved are sustained.

6.22 Institutional Aspects. IDBP's Board of Directors consists of eightmembers, including the Managing Director of IDBP who is also Chairman of theBoard. All members of the current Board apart from the Managing Director andBEL's representative who are experienced development bankers, are high-rankingGovernment officials responsible for setting government industrial policy. Theoperations of IDBP's head office and four regionaL branches are presently groupedinto three functional areas: Operations, End-Use and Planning. Each headed by aDeputy Managing Director reporting to the Managing Director (Mr. Bashir Ahmad).The regional offices process and sanction loan applications of up to Rs 1.25million and process loan applications for Rs 1.25 million to Rs 2.5 million forsanctioning at the head office. Considerable end-use activities are carried out

1/ A detailed analysis of IDBP's operations from 1981-1985 is available on theProject File. See also Annex 5 and SAR Report No. 4637-PAK dated December 30,1983.

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by the regional offices where about 702 of the staff is Located. To support itsoperations, IDBP has a staff of about 800, with recent recruitment restricted toprofessionals with experience in commercial banking, large-scale project appraisaland computer systems applications. To prepare staff for planned diversificationof activities IDBP has developed a well balanced program of internal and externaltraining which will be discussed and agreed during negotiations. With diver-sification of IDBP's operations there is a need to review IDBP's present organiza-tion and staffing structure. TA funding for such a review would be made availableunder IIC I. Given the significant expansion of IDBP's operations, there is aneed for the continued presence of a competent Chief Executive to administer itsoperations. GOP agrees with this need and has given assurances that any appointeeto the position of Chief Executive would have qualifications and experienceappropriate for the position.

6.23 Strategy, Policy and Procedures. Earlier this year, IDBP revised itsStrategy Statement to focus an diversification, emphasis on priority subsectors,increased resource mobilization, and arrears recovery. Its policy statement wasalso modified to highlight financial objectives related to the revised strategy.These objectives which include ROE, ROA, DSCR and D:E ratios will be discussed andagreed during negotiations. As part of its present and previous strategy, IDBPutilized technical assistance to improve the scope and quality of its appraisalswhich now include calculations of internal financial and economic rates of returnand domestic resource cost ratios. It has also carried out a number of subsectorstudies and prepared project profiles as aids to portfolio diversification andlending expansion. IDBP's appraisal standards are satisfactory although still inneed of strengthening, given the increasing complexity of.subproject proposals.To monitor project implementation, IDBP has developed an integrated system of sitevisits and project reporting which gives an up-to-date picture of projectprogress. To achieve better arrears control, IDBP proposes to reorganize itsend-use operations to give greater emphasis to project implementation and opera-tional monitoring. Problem projects, rescheduling proposals and litigationactivities are concentrated at IDBP's head office.

6.24 Operational Performance and Impact. Since its inception, IDBP has mobi-lized about US$0.5 billion in foreign exchange mainly from bilateral credits andborrowings from ADB, and the Bank Group. About Es 0.6 billion in rupee resourceshave been provided by the SBP. Since FY80 loans to new projects have averagedabout 75% of approvals while BHRE projects accounted for about 25%. Thirty-fourpercent of approvals have been above Rs 20 million while 9Z have been below Rs1.25 million. The sectoral distribution which had been biased heavily towardscotton and the textile sectors has shifted towards greater diversification inaccordance with IDBP's strategy statement and the priorities agreed under thefirst IIC project. During FY84 IDBP sanctioned loans of Rs 1.1 billion (more thandouble that of FY83) with about US$35 million in foreign currency. During FY85the same level of approvals was achieved. Loan commitments and disbursement3 havealso improved considerably rising from Rs 374 million in FY83 to Rs 423 million inFY84 and Rs 540 million equivalent in FY85. In line with GOP policies, IDBP hasdirected lending operations to the less developed provinces; 46Z of totalapprovals were for projects in Punjab Province, 31Z in Sind Province, 12Z inNorthwest Frontier Province (NWFP) and 8% in Baluchistan Province. While thispattern is consistent with population distribution, IDBP plans to expand its

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lending operations in NWFP and Baluchistan. Since the mid-1970s, IDBP has playeda positive role in the development of small- antd medium-scale industry (SSI),although more recently in line with the changes in the financial sector, whereby alarge part of SSI requirements are financed by the NCBs through IDA credits, ithas tended to concentrate more of its lending operations on medium- to large-scalecapital intensive projects. From FY82 to FY84, IDBP's completed projects gener-ated about 4,800 new jobs, at an average cost per-job of Rs 260000, and earnedlsaved gross foreign exchange of about Rs 53 million.

6.25 Financial Performance. Although IDBP's financial position has improveddue to GOP's arrears recovery program, which included credit curtailment,rescheduling, investment sanctioning, it is still suspect and will require carefulmonitoring. Particular care will be needed to ensure that the level of collec-tions on arrears is considerabLy improved (particularly collections of currentdues). As a result of the GOP arrears recovery program, IDBP's total arrears(principai and interest) have fallen from Rs 1.8 billion (FY81) to Rs 0.9 billion(FY85) or by 50Z, and arrears as a percentage of the portfolio have fallen from46Z (FY81) to 21X (FYg5). Recoveries of loans disbursed after FY80 were 66Z(FY84) and 63% (FY85). While this is an improvement over past collectionperformance, collections on current dues must increase to 75Z to contain anyincrease in the overall level of arrears and to maintain the DSCR of at least 1.1which is necessary if IDBP is to break even on its operations and remain finan-cially viable. Since FY81, IDBP's profitability has improved, with net profitsafter tax increasing from Rs. 5 million (FY81) to Rs. 45 million (FY85).- DuringFY81-FY85 total assets increased from Rs. 2.1 billion to Rs. 4.3 billion, anannual average growth of 20X p.a. in nominal terms. With the improvedprofitability, ROE increased from 3Z (FY81) to 162 (FY85), while IDBP'sdebt:equity ratio dropped from 5.6 to 4.2, within the prescribed limit of 5:1.IDBP's DSCR is presently 1.2, which is satisfactory.

6.26 Prospects. The general business prospects in Pakistan are likely to begood due to the continued improvement in the investment climate and GOP's policyof providing incentives to promote private industrial investment. Over the lastthree years IDBP has improved its operations and with determined efforts, shouldbe able to perform even better over the next two to three years. Barring anymajor political upheavals and economic downturns, IDBP's prospects aresatisfactory, particularly as its present strategy provides Ear further diver-sification of operations including: underwriting of new public issue of shares,-intensifying deposit mobilization; providing export-import and leasing finance;and issuing of TFCs. To streamline its operations and increase efficiency, IDBPwill install in-house computers for operational monitoring and control. Based onits present pipeline of projects and contributions from new activities, lendingoperations are projected to increase from Rs. 1.4 billion (FY86) to Rs. 2.7 bil-lion (FY90).

6.27 Because of GOP's measures (para. 4.03), projected increases in activities,and anticipated improvement in recoveries, IDBP's net profit is projected to growfrom Rs. 45 million (FY85) to Rs. 70 million (FY87) and then decline toRs. 55 million (FY88), when interest rate subsidies are expected to be withdrawn,

.

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and to recover to Rs. 82 million (FY90) when the impact of higher levels of opera-tion would be felt. Net profit as a percentage of networth is projected to reach18Z in FY87 and to average about 13% thereafter. With higher operating volume andincrease in loan portfolio, administrative expenses as a percentage of totalassets are expected to decline to 1.0 in FY90. IDBP's total assets are projectedto grow at an annual rate of 20Z from Rs. 4.3 billion (FY85) to Rs. 11 billion(FY90), with 20Z of the projected growth expected to come from wqrking capitalloans. If IDBP can implement its stated strategy, its working caDital Loan port-foLio will account for a substantial portion of its total portfolio. which wilL bea healthy mix enabling it co carry our its developmental activicies and remainfinancially sound. The expansion will be financed largely by an increase inforeign currency borrowings, deposits, retained earnings and TFC issues. However,to maintain its liquidity position, IDBP will need to collect at least 75Z of theamount falling due on all new loans, i.e., loans made from FY81 onward and alsoachieve significant collection rates on pre-FY81 loans. IDBP will thus have topay much closer attention to recent new loans, which are the direct responsibilityof the present management. Total arrears in nominal terms would decline if thecash collection of current amount falling due reaches 75%. Based on the assump-tion that IDBP can meet its recovery targets, the DSCR would remain around 1.1,which will enable IDUP to remain eligible for participation under the proposedproject. Debt:equity ratio would not exceed 5:1 throughout the period.

NationaL Development Finance Corporation tNDFC) 1/

6.28 Background. NDFC was established by GOP in January 1973, as a whollyowned government financial institution to provide financial and technical assis-tance to public sector industrial enterprises. As GOP's industrial policy shiftedin favor of private sector undertakings, NDFC was authorized to finance privatesector ventures with some restrictions. Subsequently, in January 1983 GOP allowedNDFC to finance the private sector without any limitation. NDFC also receivedpermission to set up financial subsidiaries and has since established twosubsidiaries: National Development Leasing Corporation (NDLC) and the RegionalDevelopment Finance Corporation (RDFC).

6.29 With an initial authorized and paid up capital of Rs 100 million NDFCquickly expanded and developed into a "mixed bank," raising deposits and borrowingfrom international multilateral and bilateral sources as well as from the SBP.With the availability of blended funds, NDFC acquired a mixed portfolio, following.a prudent practice of maturity matching. Aside from flexibility in lending, andfunding; NDFC benefited from an exemption of reserve requirements and interestrate ceilings imposed on commercial banks in Pakistan. Although NDFC operates ona self-imposed reserve ratio of 25Z, with tax exemption and retention of most ofits profit, it has built up a strong capital base. During 1981-1983, NDFC raised

1/ A detailed analysis of NDFC's operations during 1980-1985 (YTD) is held inthe Project File. See also Annex 6.

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Rs 200 million in long-term resources by issuing bonds eligible for reserverequirements to the commercial banks.

6.30 WhiLe NDFC falls under the general supervision of the Ministry of Finance,it has considerable operating autonomy under its Board of Directors which meetsregularly to establish NDFC's overall policies and approve all direct lendingproposals above Rs 5 million. Mr. Zafar lqbaL is Chairman and Chief ExecutireOfficer. The other five members of the GOP appointed Board repr'esent the SBP, theMinistry of Finance, the Ministry of Production, Bankers' Equity Ltd. and theInvestment Corporation of Pakistan.

6.31 NDFC's organization and staffing structure presently reflects significantchanges made over the past two years to keep pace with the expansion in the volumeand range of the Corporation's activities. NDFC has appointed a Managing Directorwith day-to-day responsibility for direct project operations reducing from 12 to 7(including the Chief Executives of three subsidiaries) the number of executivesreporting directly to the Chairman. However, the Managing Director has no bankingexperience, and wiLL need considerable suppott from senior managers to beeffective. Thus, for the time being the Chairman continues to be responsible forall major banking and administrative decisions. Since NDFC is now going through aconsolidation period, it is important that it is managed by a professional andexperienced banker. GOP supports this view and has given assurances that, aspresently, any appointee to the position of Chairman and Chief Executive Officer,would have the quaLifications and experience appropriate for the position. Totalstaff have increased from 300 (FY83) to 528, of which 238 were professionals and290 were support staff, while the number of SVP positions has expanded from 11 inFY82 to 15 in 1985, with only one of the additional positions-being in the opera-tional units. This expansion includes some inappropriate changes resulting in aduplication of effort or responsibilities, particularly by Pakistan ConsultingServices (PCS) whose services overlap with those of the Economics and MarketingDepartments. Some of these weaknesses are temporary, as a number of units are newor have been entrusted with enlarged responsibilities only recently.Nevertheless, this is an important area for senior management's attention and somedegree of decentralization and a more systematic approach to assigning respon-sibilities and accountability should be considered. At present PCS accounts forabout 8Z of NDFC's administrative budget, but has yet to contribute significantly

- to NDFC's profits. As part of the review of NDFC's strategy, the future role ofPCS would be discussed and agreed.

6.32 Strategy Policies and Procedures. NDFC's PoLicy Statement, approved byits Board in January 1981, established clear guidelines for direct projectfinancing, financial exposure limits and other appropriate financial policies. Tosupplement the policy statement, NDFC has prepared a detailed Corporate StrategyStatement for FY85-FY87 which sets out general objectives, sectoral priorities,major operational plans and resource mobilization goals. The Strategy Statementdoes not however specify financial objectives, i.e., return on equity, return onassets, debt:equity ratio, debt service coverage ratio recovery targets andspecific targets for administrative expenses as a percentage of the average loanportfolio. During appraisal of the second IIC project, modifications to thestatement were discussed with NDFC, with respect to operational objectives, profit

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margins, and expenditures and adoption of a revised Strategy Statement by NDFC'sBoard would be a condition for NDFC's participation in the project. Subsequentchanges in the Policy Statement or Strategy Statement would require prior consult-ation with the Bank and in the case of the Policy Statement, the Bank's priorapproval. In addition, NDFC will need to implement an action program to containthe growth of personnel, rationalize its service functions, correct some organiza-tional flaws, and reduce expenditures relative to the volume of operations.

6.33 In the initiaL period of its operations, NDFC placed considerable emphasisupon the preparation of appraisals of high quality, providing adequate coverage oftechnical, market and financial aspects although recently there has been somegeneral reduction in appraisal quality. For projects receiving direct assistance,NDFC calculates the internal financial and economic rates of return, debt servic-ing ratio and DRC ratio. While most projects have substantially higher economicrates of return, 15% is used as a normal minimum cut-off point. Supervisionresponsibility for short-term working capital loans has been decentralized toNDFC's branches, while supervision of long-term loans is carried out by headoffice staff with prior-ity given to projects which are behind schedule or operat-ing below the expected leveL of performance. Projects which have been operationalfor three years are subject to a detailed analysis to verify economic and otherbenefits vis-a-vis the appraisal data. With respect to short-term working capitalLoans, there is a need for clear guidelines for the clearing of these accounts ona seasonal basis or their partial renewal according to the characteristics of theenterprise concerned so that they become self-liquidating operations againststocks and/or receivables. NDFC's procurement procedures are generally sound andconform to local commercial practice. Three competitive quotations are requiredfor both domestic and foreign procurement. To comply with requirements of thefirst and second IIC projects, NDFC has prepared detailed procurement guidelinesfor Limited International Bidding and ICB for large projects. These are consis-tent with the Bank's guidelines. NDFC's auditing and accounting procedures andstandards are also satisfactory. NDFC is introducing computer facilities tostrengthen its operations through the use of a Data Management System (DNS).

6.34 Operational Performance and Impact. In FY81 and FY83, NDFC successfullyfloated two long-term 10% bond issues of Rs 100 million which were quickly takenup by commercial banks, because they were eligible for reserve requirements. MDFCalso generated short-term foreign currency resources for specific clients throughits correspondent banks, in connection with its import financing activities.While these facilities were provided to clients rather than to NDFC itself, theinitiatives were taken by NDFC for which it received either a finder's fee ormanagement fee depending on its involvement. In 1983, NDFC's short-term depositsexpanded by more than 60%, while in FY84 growth was less than 10%. Term deposits,on the other hand, have been relatively stable for the past three years. Withinthis overall pattern, NDFC has actively developed different deposit schemes, somewith very satisfactory results. Bearer Deposit Certificates increased fromRs 177 million in FY83 to Rs 639 million in FY84 and Rs 677 million as ofMarch 31, 1985. With its strong resource base during FY80-FY84, NDFC has approvedabout Rs 12 billion in working capital and term loans to a wide range ofsubsectors. Projects were well distributed by sector, with agro-based industries

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accounting for 18Z, steel and engineering 17Z, energy 15Z, cement 13Z, automobiles9Z, chemicals 8Z and other industries 20%. About 56Z of the projects approvedwere in Sind, 39Z in the Punjab and 5% in Baluchistan and NWFP. Since its invol-vement in private sector lending in FY82, NDFC has disbursed 107 loans totallingRs 2.2 million. Between FY82 and FY84 the level of annual disbursements increasedby 302, resulting in an increase in portfolio of practically 5O% during the sameperiod. The quality of this enlarged portfolio is satisfactory, with projectsfinanced having considerable developmental impact.

6.35 Financial Performance. As of December 31, 1984, NDFC's assets totaLledRs 6.8 billion consisting of Loans (76Z), investments (9Z) and other assets (15Z).These were financed by deposits (50Z), borrowings (34%), networth (11%) and cur-rent liabilities (7Z). During FY8O-FY84, NDFC's assets increased at an averageannual rate of 27Z; loans at 28Z p.a. The growth was financed mainly by depositswhich grew from Rs 1.3 billion in FY80 to Rs 3.4 billion in FY84, or at 26% p.a.NDFC's long-term debt:equity ratio ranged from 3.4-4.0 during the period and was3.8 at the end of 1984 which was below NDFC's limit of 5:1. NDFC's profitincreased from Rs. 88.million (FY80) to Rs.-188 million (FY84), giving NDFC a ROEaveraging 23Z during the period, making it one of the more profitabLe DFIsassociated with the Bank Group. On an adjusted after tax basis, NDFC's averageROE during the period was 11X p.a., which is satisfactory. NDFC has been able tooperate profitably and maintain its sound financial position by careful portfoliomanagement and by maintaining an average interest rate spread of about 3.0Z.Although NDFC's end-use activities are sound and collections have consistentlyexceeded 80% of amounts due, there has been a gradual increase in the level ofarrears and portfolio infection: Arrears now account for 72 of NDFC's totalportfolio and infected projects 21% of the portfolio. This i8s partially balancedby a Rs 100 million provision for bad debts and a general policy of non-accrual ofinterest on doubtful accounts. Nevertheless, arrears is an important area formanagement's attention if NDFC is to avoid more significant levels of arrears andinfection of its portfolio. While NDFC's financial position is satisfactory,planned growth and diversification of operations in recent years have increasedoverheads and operating costs somewhat faster than revenues and assets. DuringFY83-FY84, NDFC's total assets increased by 14%, while salaries increased by 63%and other administrative expenses rose by 73%, which incr4:sed the administrationexpense/average loan portfolio ratio from 0.7 (FY82) to 1.4 (FY84). The trend isexpected to continue for 1985 when administrative expenses are expected to rise by25Z. Thereafter the ratio should decrease with growth of the portfolio.

6.36 Prospects. NDFC's business prospects are satisfactory, assuming that theoverall investment climate remains favocable and it continues to be managed byprofessional and experienced bankers. NDFC plans to increase its lending opera-tions at an annual compounded rate of 20% with loan approvals projected toincrease from Rs 3.5 billion in FY8S to Rs 8.5 billion in FY89. Since investmentin public manufacturing sector is likely to 4ecline further, the bulk of thegrowth is expected to come from the private sector. Nonetheless, the projectedreal growth rate of about 12% is achievable given NDFC's past records and itsability to provide complete financiaL services. In terms of business mix, theshare of term lending as a percentage of total loans is projected to increase from

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38X in FY84 to 52Z in FY89. As the spread on term Loans is generally lover thanthe working capital loans, NDFC's profit margin is likely to be squeezed. Thechange in the mix appears to be due to the difficulty in mobilizing short-termdeposits and the availability of term resources both domestically from the SBP andinternationally. Foreign exchange lending is estimated to increase from Rs 452million in FY84 to Rs 1.7 billion in FY89. Although this appears ratheroptimistic, it is feasible given NDFC's strong pipeline of 70 projects requiringforeign exchange loans of US$180 million. NDFC plans to finance about 20Z of itsgrowth by increasing local currency deposits which are projected to increase fromRs 3.4 billion in FY84 to Rs 6.1 billion by FY89, or at annual growth rate of 12Z,which is below the past growth rate of 152. Foreign borrowings are projected toincrease sharply from Rs l billion in FY84 to Rs 4.6 billion by FY89. whichdomestic currency borrowings mainly from the SB:' and bond issues, are projected toincrease by Rs 3.5 billion. The remaining gap is expected to be financed byprofit. To meet its foreign currency requirement lending of US$160 million, NDFCwill borrow about US$50 million from -the second IIC project, US$75 million fromthe second ADB Development Finance Loan and about US$35-US$40 million, from theinternational commercial markets. -

6.37 NDFC's total assets are projected to increase at an annual rate of 22Zfrom Rs 6.8 billion in FY84 to Rs 18.4 billion at the end of FY89 with the loan -

portfolio increasing from Rs 5.2 billion in FY84 to Rs 15.6 billion in FY89. Thebulk of the growth is expected by borrowings overseas and locally. As NDFC is nothighly leveraged, the increase in debt will not result in sharp increase indebt:equity ratio which is projected to increase from 3.7:1 in FY84 to 5:1 inFY89, which is within the agreed limit. Total debt:equity ratio is projected toincrease to 8.8:1 by end FY89, which is acceptable. The quality of NDFC's port-folio is expected to remain sound. Assuming that NDFC maintains a balance betweenterm loans and working capital loans, its profits after provision for losses areprojected to increase from Rs 148 million in FY84 to Rs 429 million in F789. Thereturn on equity is projected to remain well above 20S. Administrative expensesare projected to decline from 1.4Z of the average loan portfolio in 1984 to 1.0 bythe end of 1988 assuming that NDFC vigorously implements agreed cost controlmeasures. Given careful monitoring of its portfolio and expansion of operations,NDFC should remain a sound financial institution.

Pakistan Industrial Credit and Investment Corporation (PICIC) 11

6.38 Background. PICIC was established in 1957, with Bank Group assistance toprovide term finance, in local and foreign currencies, to private industry and toplay a key role in capital market development through direct purchase and under-writing of shares and debentures. During the 1960s PICIC was well-managed andbecame the major source of foreign exchange term finance for private industrial

1/ A detailed analysis of PICIC's operations during FY80-FY84 is held on theProject File. See also Annex 7 and SAR Report No. 4637-PAK dated December 30,1985.

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investment in the cement, sugar, and textile sectors, which today are importantsubsectors of Pakistan's economy. However, the 1970s proved to be an exception-ally difficult period for PICIC. The separation of Bangladesh, the 1972 devalua-tion of the rupee by 131Z and the nationalization of major private industries inthe first half of the decade, contributed to a drastic reduction in privateindustrial investment and a generaL disruption of the economy. The worldwiderecessions affected Pakistan's textile export industry, which in the 1970saccounted for more than 40X of PICIC's portfolio. Consequentl;, by 1980, PICICwas faced with serious portfolio and institutional problems. shared also by IDBP.To address these issues GOP introduced a number of measures including: introduc-tion of new senior management, establishment of the GOP Comittee for Sick Units,World BankJADB Collection Review Meetings, and the passing of a PresidentialOrdinance on Foreign Exchange Risk. Subsequently the Bank Croup and ADB workedclosely with GOP and PICIC to bring these measures to fruition and since 1981,PICIC has been able to reduce its arrears, substantially improve its liquidityposition, increase its business, and improve its financial condition while takingadditional measures to reorganize the institution to enable it to function effec-tively in a more completitive financial envi7ronment.

6.39 Institutional Aspects. PICIC's initial paid-in capitaL of Rs 20 millionwas contributed by private institutions and individuals, many of them foreignbanks. The initial equity base was increased progressively to Rs. 109.9 millionas a result of stock dividends distributed in 1977, 1978, and 1981. At the end of1984, the public sector shareholding acquired under the Bank nationalization in1972 represented about 56Z of PICIC's shares and although PICIC is technically aprivate institution, it is now very much a government institution.

6.40 PICIC's Board of Directors, including the Chairman and Managing Director,consists of 15 Pakistan and 7 foreign directors. Of the Pakistan directors, onerepresents the Federal Government, one the Provincial Governments on a rotationalbasis, two the govarnment institutional shareholders (SLIC and MIT), and the restare prominent industrialists and businessmen. The size of the Board has oftenresulted in awkward situations for the Managing Director, as administrative mat-ters and organizational changes require full Board apprzral. Some Board membershave held their positions for more than 20 years, making their views prevalentover other members. However, in some cases, this accumulated experience is alsoresistant to change and innovation. Relations between Management and the Boardcontinue to be problematic due to the personalities invr.ved. Ideally, a smallerand more professional Board with a mandAte to operate P1_IC would be moredesirable.

6.41 From 1981 - 1983, PICIC's management focussed on the operational difficul-ties of PICIC, addressing problems of operational standards and portfolioinfection. In 1984 PICIC reorganized its operations into three groups. Appraisalfunctions, including Engineering and Economic Analysis were grouped under anExecutive Vice President. Portfolio recovery, Loan and Special Projects wereplaced under a Senior Executive Vice President, and supporting functions such asAccounting and Administration were grouped under another Senior Executive VicePresident. An experienced computer specialist was also hired to develop a much

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needed management information system and put an automated accounting system intooperation and to coordinate the administrative and procedural changes that thissystem will require. The LegaL Department is being reorganized to make moreeffective PICIC's proceedings against defaulting debtors. WhiLe these measuresare steps in the right direction, much more needs to be done to equip PICIC tosurvive in the competitive financial environment that is developing in Pakistan.For this purpose, PICIC's Management proposes to utilise TA funds under IIC I toengage consultants to carry out a Strategy Study. Terms of reference for theconsultants have been reviewed by IDA, and the selected consultants should startwork by March 1986, although commencement of the study has been set as a conditionof effectiveness for PICIC's Loan Agreement with GOP. As part of its proposeddiversification, PICIC is discussing with IFC the possibility of a line of equityfinAncing. Establishment of an equity financing function would be consideredunder the proposed Strategy Study. Inasmuch as PICIC will need to addressoperational, organizational and staffing issues very carefully in defining itsrole in industrial finance, there is A need for the continued presence of anexperienced banker as PICIC's Managing Director. GOP concurs with the assessmentand has given assurances that any appointee to the position of Managing Directorwould have the qualifications and experience appropriate for the position.

6.42 As of December 1984, PICIC employed 137 professional staff of which manyhave been with PICIC for more than 10 years. While this could, point to a satis-factory staffing situation, in terms of professional ezperience, it mostlyreflects the routine application of work patterns adopted many years back. Thisis particularly true because of the no-growth situation of the late 1970s andbecause of the specialized character of some departments. The proposed diversify-ing operations would include a revision of exi-ting operations to make them moreeffective and to reassign tasks where necessary. These changes should beinstituted under leadership provided by second and third tier managers, whichneeds to be developed. As new systems are established, cianges at these levels -

may also be required which will test Management's ability to deal with PICIC'sfundamental problems. This should be complemented by a more systematic approachto training of both staff and managers.

6.43 Operational Performance and Impact. PICIC's operations have grown con-siderably since FY80. Total approvals have increased from Rs 340 million (FY80)to Rs 1.0 billion (FY84). This is due to the availability of foreign exchangeresources form the Bank and ADB, a more dynamic management, and buoyant investmentclimate. Additionally, during FY83-FY84, PICIC ventured successfully in theinter-bank money market as a net borrower to partially address it lack of rupeeresources and to offer working capital financing to its clients. Resources raisedin this manner enabled PICIC to reduce SBP cash credits (which were provided forliquidity support in the past) and build-up a Rs 617 million portfolio of sbortters loans as of December 31, 1984. In total PICIC has provided aboutRs 7.7 billion for over 800 industrial projects. About 12Z of this reflectsPICIC's catalytic function resulting in direct foreign loans and/or foreigninvestment to Pakistani projects exclusive of its own loans. The textile sectoraccounted for 34Z of total cumulative sanctions followed by food products 20Z,cement and ceramics 15Z, engineering goods 10%, paper products 82 and miscel-

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laneous sectors 13%. However, the importance of the textile sector has declinedsubstantially as new loans are made to the engineering, chemical and food process-ing industries.

6.44 While PICIC's contributLon to industrial development has been creditable,its role in industrial financing has lately been diminished mainly due to thechanges in the financiaL and industrial environment. Since 1980 the importance offoreign exchange Einancing has been reduced because of increased availabili:y offree foreign exchanges and the types and sources of financial services required byindustry have changed significantly. As a result, PICIC's share of industrialfinancing declined from about 20% in 1970 to about 3% in 1985. Since then, PICIChas made renewed efforts to maintain its market share with some success. Underthe First IIC Project PICIC's performance was encouraging; it submitted16 projects with foreign exchange requirement of about US$32.0 million, and totalinvestment requirement of about Rs 920 million. These projects were mostly innon-traditional, high technology, and high value added industries. The quality ofthese projects, in terms of appraisal, financial soundness and managementcapability, is also perceptibly better than before.

6.45 Financial Performance. PICIC's financial performance during FY8O-FY84 wassatisfactory and its financial position has improved from the low point of the1970s and early 1980s although the quality of PICIC's portfolio still requirescareful monitoring. PICIC's low point in history was probably 1981, with collec-tions of 35% of current dues, and arrears of Rs 1.5 billion, representing 67% ofthe portfolio. However, with the strong support of GOP, the Bank and ADB and theappointment of a more pragmatic'management, PICIC has improved on this situation;by settling legal cases out of court and through the ruling of the Committee forSick Projects and credit squeeze through ECBs, PICIC's collection reached 73Z ofcurrent dues in 1984. With this recovery and the restructuring and reschedulingloans of Rs 0.5 billion in the past three years, arrears were reduced toRs 1.1 billion as of December 31, 1984, cr 35% of portfolio. In spite of thisimprovement, its portfolio remains significantly affected by arrears which couldadversely affect coLlections for many years. Some of the recently restructuredprojects could become problematic, particularly if the economy slows down andworking capital credit is tightened. PICIC needs to take more determined steps toaddress the arrears problem with the aim of leaving the arrears problem behind asa thing of the past within the next two years. Collection efforts on overdueaccounts, particularly re-1980s, should be stepped up, targeting accounts fcrrecovery on a quarter:, basis and liquidation proceedings should be pursuedagainst unviable firms. To cover potential write-offs PICIC has provided Rs 227million and has accrued about Rs 660 million of interest on overdue accounts.With the improvement in collections, expanded operations and tighter operatingcontrol, PICIC's net profits after tax have increased from Rs 38 million (FY80) toRs 62 (FY84) or by 10% p.a. Total assets have increased from Rs 2.4 billion(FY80) to Rs 3.9 billion (FY84) and with the improved profitability ROA increasedirom 1.3% (FY80) to 1.7% (FY84) which is satisfactory. PICIC's return on equityimproved from 92 to 12Z (FY84) and dividend payments were restored with the resultthat PICIC's share prices have increased from Rs 6 per share (FY80) to Rs 10 pershare or par (FY84). PICIC's DSCR of 1.2, and D:E ratio of 6:3 are satisfactory.

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6.46 Prospects. During FY8S - FY88 PICIC expects to stabilize its term lendingat Rs. 1.0 billion p.a. and to increase working capital loans Rs. 617 million inFY84 to Rs. 2.0 billion in FY88 which is expected to enhance its profitability.In terms of foreign exchange, PICIC plans to lend about US$60 million p.a. duringFY86 - FY87, meeting its requirements from the proposed project and the second ADSloan for DFIs, to be processed in parallel with the second IIC project. With cheincreased lending and a diversification of activities, P'CIC's financial resultsand conditions are likely to improve further unless there is a dramatic downturnin the economy. Total assets are projected to increase from Rs. 3.9 bilLion(FY84) to Rs. 8.2 billion (FY88), an increase of 20% p.a. in nominal terms. TheLoan portfolio is projected. to increase from Rs. 2.9 billion (FY84) toRs. 6.3 billion (FY88) with net profit after tax projected tc increase Erom Rs 62million (FY84) to Rs 147 million (FY88). Return on equity is estimated toincrease from 12.6Z in 1984 to 17.6Z in 1988. Administrative expenses areprojected to decline to 0.5% of average total assets in (FY88) reflecting tightercost control. Because of the ezpectedt improvement in earnings, PICIC's debtservice coverage ratio should remain well above 1.1, which is the threshold forparticipation under the proposed project. Degt:equity ratio is projected toremain well below the agreed level of 7:1. However, PICIC's operations (and IDBP)are sensitive to any significant changes in the credit environment and investmentdemand, which could negate the improvements that have been achieved to date.

C. Conditions for Participation

6.47 During negotiations, understandings were reached with GIP and the PFIs on:

NCBs IDBP NDFC PICIC

Appraisal/Supervision Staffing (AM)1/ xFinancial Covenants (AM) x x xReporting Requirements (LA and AM) x x x xProcurement PoliciesiGuidelines (AM) xPolicy Statement (LA and AM) x x x xStrategy Statement (LA and AM) x x x xOrganizational Review/Strategy Study (LA and AM) x xTraining Programs FY86-FY88 (LA and AM) x x x xCollection Targets FY86-FY88 (AN) x x x x

Also during negotiations, GOP gave assurances that any appointees to the positionsof Chief Executive Officers of the DFIs would have the qualifications andexperience appropriate for the positions.

1/ Specific agreements and understandings are noted in the Loan Agreement (LA)or the Agreed Minutes (AM), including Minutes of Technical Discussion).

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6.48 Access to Loan Funds. During negotiations agreement was reached with GOPand the PFIs that effectiveness of the Subsidiary Loan Agreement between GOP andthe PFIs and the PFIs' access to the Loan funds would depend upon compliance withthe following conditions:l/

ECBs IDBP NDFC PICIC

Implementation of an AdministrativeExpense Control Program

Commencement of Organization/Strategy Study s xBoard Approval-Policy Statement x x x xBoard Approval-Strategy Statqrent x x x xBoard Approval-Collection Targets x x sCommencement of Training Program x x x x --

Maintain Agreed Debt:Equity Ratio x x xMaintain Debt Service Coverage Ratin x x xAchievement of Collection Targets x x x sEstablishment of Project Financing Departmefts 2/ x

Additionally, it was agreed that the eligibility of an institution to participatein the project be withdrawn if within six months after the signing of the LoanAgreement between GOP and the Bank Group, the PFI has not fulfilled its conditionsof participation and signed a subsidiary loan agreement with GOP (para. 6.49).Also, continued access to the Second IIC funds would depend on each PFI continuingto comply with their respective conditions of participation.

6.49 Conditions of Board Presentation and Loan Effectiveness. Prior to Boardpresentation, at least two eFIs, of which one shall be a DFI and one an NCB,should have established their eligibility to participate in the project, by ful-filling the conditions of participation set out in paragraph 6.48. Additionally,signing of subsidiary loan agreements, satisfactory to the Bank Group, by at leasttwo PFIs, of which one shall be a DFI and one an NCB, would be a condition ofeffectiveness of the Loan.

1/ Detailed in Schedule 4 of the Loan Agreement.

2/ For KCB and NBP access to the Loan funds depends upon the establishment ofProject Financing Departments with staffing and procedures acceptable to theBank.

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VII. THE PROPOSED LOAN

A. Amounc and Allocation of Funds

7.01 The Loan. The financial package for the proposed Project would consist ofa Bank Loan of US$148 million for project financing, and an IDA Credit ofUS$2 million for technical assistance made available to GOP on standard Bank termsand conditions. GOP would onlend the loan funds to the PFIs, with subsidiary loanagreements with each institution. The technical assistance funds would be passedto the PFIs as grants.

7.02 Subloan Size, Free Limits and Review. Under the first IIC project, theBank Group agreed to an initiaL allocation of about 45Z of the project funds to.the three DFIs. The balance of funds were placed in a pool of funds available toall PFIs which subsequently met eLigibility criteria. This formula was used toencourage competition among PFIs; allow for the strengthening of each PFI withoutadversely affecting the flow of investment funds to the private sector; andsafeguard the interest of the DFIs during this transitional period. -Given theprojected availability of resources from the Bank Group-and ADB, there is nojustification for making specific allocation to DFIs and funds would be madeavailable to PFIs on a first-come first-served basis. -Prior Bank review andapproval would be required for all DFI and Habib Bank subloans above US$2 million.The aggregate of free limit subloans would not, however, exceed US$40 million ofthe total project funds. There will be no free limit for UBL and MCB, and theBank will review all their subprojects. About 35Z by number and about 75Z byamount of all subprojects would receive prior Bank review and approval. Allsubproject proposals above the free limit would be required to include calcula-tions of economic and financial rates of return and domestic resource cost ratios.The cut-off for acceptance would be ERR of at least 15x. As noted above, theproposed project will include special eligibility criteria for the DFIs to ensurethat they continue to carry out agreed action programs and make steady progress inaddressing their financial and organizational problems.

B. Financial Package

7.03 As noted in paragraph 5.07, the proposed loan of US$148 million wouldfinance part (25Z) of a total foreign exchange financing requirement ofUS$600 million needed by the PFIs. ADS would provide 25Z (paragraph 7.04) whilethe sponsors would provide a minimum of 22.5Z in equity financing, with thebalance provided by the PFIs. Any foreign exchange requirement not covered by theBank or ADB funds would be met from the foreign exchange pool of the SBP undergeneral open license 1/ or from resource mobilization by the NCBs with overseas

1/ For projects involving a total investment not exceeding Rs 60 million andneeding foreign exchange less than Rs 30 million, the investor can raiseforeign exchange directly from SBP under general license scheme.

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branches. The necessary local currency requirement,will be provided by the spon-sors and the PFIs. In most cases IDBP and PICIC would co-finance their sub-projects with the NCBs. Based on the existing pipeline of projects and the maxi-mum and minimum size limits of US$6.0 million and US$500,000 respectively foreligible subprojects, about 45 projects would be financed under the proposedproject. The loan funds are expected to be fully committed within 3 years ofBoard approval of the Project (i.e. by December 31, 1988).

7.04 Co-Financing - ADB. In December 1983 ADB, as co-financing with IDA'sfirst IIC, made a loan of US$110 million to BEL, NDFC and PICIC together with anequity line of US$2 million to BEL. The Loan is expected to be fully comitted byDecember 1985. ADB is presently processing a US$150 million line of credit forindustrial financing and expects to submit the loan for Board approval in early1986. The Bank and ADB are working closely together to ensure a consistentapproach to the conditionality being proposed for the common participating finan-cial institutions and for financial poLicy reform.

Onlending Terms -

7.05 Project funds will be onlent by PFIs at 14Z p.a. which, given inflation ofabout 6Z to 7% in FY85, is substantially positive in real terms. The proposedonlending rate is consistent with both the opportunity cost of capital in Pakistanand market lending rntes of 14% - 15Z (para. 3.11). .Inflation rates are expectedto remain below 10X over the commitment period of the loan. However, to preventthe onlending rate from becoming negative in the event of accelerated inflation,agreement was reached during negotiations that onlending rates would be reviewedperiodically with GOP and that GOP would take corrective measures to ensure thatonlending rates remain mutually satisfactory to the Bank and GOP. The firstreview would take place six months after effectiveness ani annually thereafter,with appropriate adjustment of the onLending rates to reflect (a) the trend ofinflation and the need to ensure that the lending rates remain positive in realterms; (b) prevailing borrowing and lending rates in Pakistan; (c) the adequacy ofthe spread for (i) the Government to cover the foreign exchange and interest raterisks and (ii) the PFIs to cover their costs in making the subloans; and (d) therate of commitment and disbursement of subloans. The proposed loan would be lentto GOP which would onlend to IDBP and PICIC at fixed spreads of 4Z, and 3% toother PFIs. As under the first IIC project, the higher spread is proposed forIDBP and PICIC since they are subject to income tax. Under the proposed project,GOP would bear the foreign exchange and interest rate risks. This policy approachwas adopted in 1980 when GOP decided to bear the exchange risk for all foreigncredit which it onlends to intermediary financial institutions. Given that thereare strict foreign exchange controls and no long-term forward market to coverexchange risks, it is not feasible to pass on the foreign exchange risk to PFIs orfinal borrowers.

7.06 Beneficiaries. Although the proposed '.IC Project is aimed at financingprivate sector projects, NDFC is involved in public sector financing, and wishesto have some flexibility in financing projects or public sector enterprises.Thus, during negotiations it was agreed that NDFC would be allowed to submit

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public sector projects up to a total of US$10 million, for financing BMR projects,although no specific allocation would be shown in the Loan Agreement. Allindustrial subsectors will be eligible for financing under the project, except forthe sugar industry where only BMR and expansion of by-product processing ofexisting, profitable mills will be considered. Sectoral distribution of sub-projects is expected to follow the pattern established under the First IrC Project(para. 4.05) with less emphasis upon textiles and food processing industries.

7.07 Amortization Schedule. The proposed loan will be made to GOP on standardBank Group terms and conditions - presently an- interest rate of 8.82X and a20-year repayment for the IBRD Loan. Although considerable progress has been madeunder the First IIC Project in permitting the DFIs to mobilise local currencyresources, they have yet to achieve self sufficiency in this area and be graduatedfrom supplementary assistance from GOP and the SBP. IDBP's and PICIC's rupeeresources are currently restricted to refinancing credit lines to cover purchasesof locally fabricated machinery, although during the period of the Project, bothDFIs propose to fund their operations, in part, by (i) diversifying into depositoperations; (ii) securing suppliers' credits from the SBP; (iii) issuing subor-dinated debentures; and (iv) retaining earnings. While these sources would meet alarge part of their needs, there would still be-x considerable funding gap whichan extended amortization schedule would help bridge. Unlike IDBP and PICIC, NDFChas successfully mobilized considerable local currency resources through depositsand debenture issues. To meet its lending targets for-FY86 - FY90, NDFC expectsto raise resources by increasing local currency deposits, issuing debentures, andobtaining SBP credit lines. However, the amounts to be mobilized will not coverNDFC's requirements, although the resource gap is proportionately less than forIDBP and PICIC. To augment the local currency resources of the L. s, it is recom-mended that as under the first IIC project, GOP onlentd the funds to the DFIs for aperiod of 15 years, including a grace period of 3 years. The DFIs would onlendthe funds to industrial projects based on their cash flow requirements. However,the maximum maturity normally will be limited to 10 years including the graceperiod, which would provide a rollover of funds to augment the local currencyresources of the DFIs and enable them to provide working capital finance to theirclients. Since NCBs do not need local currency, they would repay GOP on the basisof a composite aortization schedule of subloans.

C. Administration

7.08 Procurement. The procurement procedures of the PFrs are satisfactory.As under the first IIC project, Limited International Bidding (LIB) procedures 1/wouLd be required for individual contracts for equipment and civil works aboveUS$2 million. Project sponsors would be required to advertise the procurement in

1/ Section 3.2 of IBRD's "Guidelines for Procurement Under IBRD Loans and IDACredits."

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the local press and seek bids from a list of potential suppliers broad enough toassure competitive prices. Sponsors would be required to notify embassies andtrade representatives of Bank Group member countries and Switzerland representedin Pakistan; however, they would not be required to advertise in internationalpublications. The PFIs would be required to confirm directly with the suppliers,the validity of the lowest evaluated bid. For smaller contracts, PFIs wouldemploy their existing procurement procedures which generally conform to the BankGroup's standard practices. In most cases, machinery and equipment would beprocured by obtaining at least three competitive quotations from establishedsources. The PFIs would be expected to maintain records of the method of procure-ment and to monitor utilization of subloans through regular supervisionactivities. For technical assistance projects the PFIs would follow the Bank -

Group's guidelines for the selection of consultants.

7.09 Disbursement Procedures. The estimated disbursement period is seven years(Annex 8), although actual disbursement may be faster because of the large numberof institutions participating in the Project. The proceeds of the Loan would bedisbursed at the rate of 10OZ of the foreign exchange costs for machinery andequipment of eligible subloans and 60X of local expenditures (corresponding to theestimated average foreign exchange content of -these items). The proceeds of theCredit would be disbursed at the rate of 10OZ. As in prior Bank Group loans andcredits to DFIs, full documentation of ezpenditures would be submit;:ed to the BankGroup. For the technical assistance component, the loan proceeds would be dis-bursed at the rate of 100% for consultants' services and overseas training.

7.10 Reporting, Accounts and Auditing. PFIs would be required to submitquarterly progress reports acceptable to the Bank Group covering their operationsunder the Project. Financial statements, submitted annually by the NCBs and theDFIs, would be required to conform with the Bank Group standard reportingrequirements, with submission of audited financial statements, prepared by inde-pendent auditors acceptable to the Bank, within six months after the end of eachfiscal year.

VIII. PROJECT BENEFITS AND RISKS

8.01 Benefits. The project would assist GOP in maintaining the growth ofprivate industrial investment, developing the capital market, and reorienting -

development finance institutions from purely term lending activities to becomemore dynamic financial intermediaries. If successful, the project would open nevavenues for financing industrial investment by the private sector and release thepressure on the banking system. IIC II also should be helpful in stimulatingprivate savings. The project would finance 40 to 45 subprojects creating about30,000 new direct jobs at an average investment cost per job of about US$20,000.The average IERR and IFRR of the subprojects to be financed under the project areestimated at 15X - 20%. The proposed project would allov the Bank to continue itsassistance to GOP in addressing broader financial and banking sector issues andproviding institutional building assistance to commercial banks. Also, IFC willbe assisting GOP in strengthening the operations of the KSE and LSE, with TAfinancing under IIC II.

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8.02 Risks. While the DFIs have considerable project appraisal experience, theNCBs only recently have embarked on independent term lending operations based onproject viability rather than purely collateral considerations. Thus, there is arisk that MCB and UBL will move slowly from collateral to appraisal-based lendingand that their participation in the project wiLl be limited, reducing the impactof the rationalization of the term financing system. However, this risk should beminimized, as both institutions have moved rapidly to estabLish effective termlending policies, procedures and appraisal capabilities. For the DFIs success ofthe action programs to continue the improvement in the operational and financialviability of IDBP and PICIC will require strong commitment by GOP and theirmanagements. This has been given and eviden,a indicates that GOP will translatethese comfitments into effective action. If however, the actions taken do notprove effective, there could be some weakening in the financial viability of theseinstitutions with subsequent delays in utilizing project funds. The proposedaction programs, technical assistance and conditions of participation should

0--- minimize these risks.

8.03 A risk of the Lending component of the proposed Project is that an ade-quate number of eligible subprojects might not materialize due to political uncer-tainties and the absence of the continued improvements needed to support a stronginvestment cLimace. GOP has taken a number of steps to remove controls inhibitingindustrial development; more needs to be done. If progress in liberalizingindustrial policy is slow, industrial investment will Also be constrained. Thisis unlikely in view of COP's recent policy moves over the last three years, recentimportant liberalizations in industrial and financial sector policies andindustrial policy reform measures currently being discussed in the context ofother proposed Bank Group operations. However, projects 'on hand and in thepipelines of the PFIs indicate credit demand in excess of the amount proposed forthe Project and full comoitment of the US$148 million subloan component shouldbe achieved within the three years provided under the Projecte

IX. RECOMMENDATIONS

9.01 During negotiations, understandings between the Bank Group and GOP werereached on:

(a) contents of Statements of Strategy and Operating Policiesfor PFIs (para. 6.47);

(b) collection ratios (para. 6.47);

(c) free limits and subproject reviews (para. 7.02);

(d) periodic review and appropriate adjustment of onlending rates(paras. 7.05);

(e) onlending terms, conditions and spreads (para. 7.05);

46,-

(f) limit on financing public sector projects (para. 7.06); and

(g) procedures for procurement, disbursement reporting, accountingand auditing (paras. 7.08-7.10).

9.02 It is recowAended that the eligibility of an institution to participate inthe Project be withdrawn if six months after signing of the Loa'n and Development;Credit Agreements between GOP and the Bank Group, it has not fulfilled its condi-tions of participation and signed a subsidiary Loan agreement with GOP(para. 6.48).

9.03 It is recommended that, as a condition of Board Presentation, at least twoPFIs, including one NCB and one DPI, should have established their eligibility toparticipate in the project by meeting all of the conditions of participation notedin paragraph 6.48.

9.04 It is recommended that the signing bf a subsidiary loan agreement by atleast two PFIs, including one NCB and one DFI,, should be a condition of effective-ness of the project (para. 6.49).

9.05 The proposed Project constitutes a suitable basis for a Bank loan ofUS$150 million equivalent to GOP.

* ANNEX 1

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Projected Private Industrial Investment (FY85-FY88)

A. Projected InvestmentFY85 FY86 FY87 FY88 FY86-FY88

(actual) - (current Rs. billion)---

Investment in Medium- andLarge-scale IncAustries (MILSI) /a 6.1 7.3 8.7 10.5 26.5

B. Projected Financing (PFI Projects)FY86-FY88

(US$ million)

Foreign Local TotalTotal Requirement: 600 650 1,250

Less Available Financing:

Sponsors /b - 295 295Bilateral Sources 50 - 50DFIs 119 119Commercial Banks /c - 236 236Existing Lines of Credit /d 125 125

175 650 825

Gap: 425 - 425

To be Financed:ADS 150 150IBRD 150 - 150Conmercial borrowing (NDFC) 50 - 50GAP (GOP/NCBs) 75 75

425 - 425

/a FY85 is based on YTD actuals and projected investment. Thereafter nominalgrowth of 20Z p.a. is assumed.

/b Including non-repatriable foreign investment and internally generated funds.T7 Direct term loans and tending through consortia by NCBs.7- Existing lines of credit from ADS and IBRD to DFIs to be utilized by

December 31, 1985.

Exchange rate - US$1 = Rs 15.4

Source: Kission estimates.

-46-

ANNEX 2Page 1

PAKISTAN

SECOND INDUSTRIAL INvESTKMENT cREDIT (IIC) PROJECT

The Commercial Banking System

Background

1. Overview. The financial system in Pakistan consists of: (i) five nation-alized commercial banks (NCBs); (ii) seventeen foreign commercial banks (FCBs);(iii) four specialized commercial banks; (iv) nine development finance institu-tions (DFIs); (v) several insurance companies; (vi) two Leasing companies; (vii)two stock exchanges; and (viii) a housing finance corporacion. The State Bank ofPakistan (SBP), the central bank, directs and regulates the financial systemwithin overall policies set by GOP. The Pakistan Banking Council (PBC) overseesand coordinates the activities of NCBs and fulfills many of the functions pre--viously discharged by NCB shareholders. The Ministry of Finance monitors the -

operations of the other financial institutions.

2. The commercial banking system in Pakistan predates the country'sindependence. The oldest Pakistani bank was established in 1942 by the Habibgroup of entrepreneurs. The Australasia Bank (now forming the Allied Bank) wasestablished in Lahore early in 1947. Most banking functions before theIndependence, however, were carried out by numerous branches of foreign and Indianbanks having their main offices in Bombay, Calcutta, and Delhi. Most of themclosed their offices upon partition, so that Pakistan had to rebuild its bankingsystem. In July 1948, the State Bank of Pakistan (SBP) was established as thecentral bank of the country. One of its first functions was the issuance ofcurrency to replace Indian currency notes in circulation as a transition measure.The second important function was the promotion of banking companies. A BankingCompanies Act was passed in 1948, and the first new bank to be established, withgovernment participation, was the National Bank of Pakistan in November 1949. Theexisting Pakistani banks also were encouraged to expand and the branches of for-eign banks allowed to continue their activities undisturbed. In the 1950s, com-mercial banking expanded rapidly and important new private banking institutions,such as the National Commercial Bank in 1957 and the United Bank Ltd. (UBL) in1959, were created. In the 1960s, two other important banks were established-Commerce Bank and Standard Bank. During this time SBP carried out its traditionalcentral banking functions by inspecting banking institutions. It also contributedto the formation of professional bankers through a centralized training scheme.

3. As banking grew, GOP felt the need to review the effectiveness of banks inpromoting economic development. In 1959 a Credit Enquiry Commission was appointedto examine the provision of credit to agriculture, business and industry, withparticuLar emphasis on primary producers and small establishments. The Commissionfound a tendency for credit to gravitate towards established groups ofentrepreneurs and to be unavailable to small industrial and agriculturalproducers, and recomiended that measures be taken to redistribute financingresources. Acting on these general recomnendations, during the sixties, GOP

-47- ANNEX 2Page 2

sought to channel credit to targeted sectors mainly through specialized institu-tions and other schemes financed by SBP. However, within the commercial bankingsystem little was changed; in 1972 GOP saw the need to enact a Banking Reforms Actwhich expanded significantly SBP's control authority over the banks, to the extentof removing directors and management if necessary. Capital and reserve require-ments were raised and reinvestment of a percentage of profits made compulsory.GOP felt that the banks were failing to play an effective part in ensuring a widerand more equitable dispersaL of the benefits of economic growth., Together withbanking reforms, SBP introduced more specialized credit schemes for smallproducers in agriculture and industry, this time enjoining greater commercial bankparticipation. These measures proved to be a prelude to the Nationalization ofBanks Act of 1974, whereby the SBP and all the commercial banks incorporated inPakistan were brought under direct government ownership. The directors andmanagement of the banks were removed and replaced by government appointees. ThePakistan Banking Council (PBC) was established to coordinate the activities of thenationalized banks, which were merged to form five banks. Since nationalization,the banking system has continued to expand its operations and geographicalpresence, under more direct government control. Since then, GOP has continued topermit the establishment of foreign banks. As recenLly as in 1982, three addi-tional foreign banks entered the Pakistani banking industry.

Present Structure

4. Commercial Banking System. With total assets of Rs 254 billion, or aboutBOZ of the assets of the financial system as of June 30, 1983, and a network of7,000 branches, commercial banks play a dominAnt role in Pakistan's financialsystem. The five NCBs accounted for about 94Z of deposits, 90Z of advances and87Z of commercial banks' net profits.

Table 1: The Commercial Banking System,Key Indicators, 1978-1984 /a

NCBs FCBs1978 1983 1984 1978 1983 1984

Deposits (Rs billion) 63.2 159.7 175.1 3.6 10.3 n.a.Advances (Rs billion) 37.0 91.6 100.4 ,.3 10.2 n.a.Total Assets (Rs billion) 95.0 225.3 246.7 9.6 28.6 n.a.Advances/Deposits (Z) 58.5 57.4 57.3 92.0 99.0 n.a.Capital and Reserves (Rs billion) 1.0 4.5 5.3 0.2 0.8 n.a.Capital/Deposit (Z) 1.6 2.8 3.0 4.9 4.7 n.a.Net Profits (Rs billion) 0.15 0.74 0.97 0.06 0.11 n.a.Return on Total Assets Z 0.14 0.30 0.64 0.62 0.52 n.a.Operating Costs as Z of AverageTotal Deposits 3.8 3.0 3.1 5.2 5.2 n.a.

Number of Branches /b 7,038 6,931 6,777 39 59 n.a.

/a As of December 31.7i As of June 30.

Source: Grindlays Bank, June 30, 1983 and staff estimates.

-48- ANNE 2Page 3

5. Traditionally, Pakistani banks also have had a branch system abroad.Branches were first established in the United Kingdom. More recently, the branchsystem abroad has expanded as Pakistan's foreign trade diversified and as increas-ing numbers of Pakistani laborers migrated to Europe, the Middle East, Europe,and Africa. By 1983, NCBs had 200 branches abroad (Table 2) which contributesignificantly to deposits via workers' remittances and to profits through foreignexchange and trade operations.

Table 2: Foreign Branches of NCBs

Continental OtherUSA UK Europe Culf Places Total1982 1982 1982 1982 1982 1982

HBL 1 22 32 3 15 73NBP 4 _10 2 2 7 25UBL 1 26 20 - - 47MCB - 20 - - - 20ABL - 3 - - - 3Bank Al Jazira (JointVenture of NBP) - - 16 - - 16

Middle East Bank (JointVenture of MCB) 1 1 10. 4 16

Total 7 82 80 5 26 200

Source: Pakistan and Gulf Economist.

6. The NCBs' boards and chief executives are nomuinated by GOP. In recentyears, care has been taken to maintain continuity of direction where possible andjustified. Overall the banks are well managed. Internally, banks have adopteddifferent administrative structures. Some are quite centrally managed whileothers are significantly decentralized. Some emphasize foreign trade activities,others domestic operations. These different management styles, freedom ofoperation, and traditional different clientele have made for diversity and healthycompetition within the system. Three of the five banks--Habib, National, andUnited--are much more important in terms of the volume of their operations andtheir impact on the economy. Of the remaining two-Allied and Muslim-the latteris more aggressive and efficient. Allied is the smallest accounting for about 5Zof the operations of the NCBs. Table 3 presents the situation in 1983 and 1984.

-49 ANNEX 2Page 4

Table 3: Comparative Position of the NCBs

Capital Netand Reserves Deposits Advances Profit---- (Rs billion)- - (Rs million)

1983 1984 1983 1984 1983 1984 1983 1984

Habib Bank 1.9 2.2 55.0 62.0 31.6 35.7 351 328United Bank 1.0 1.3 41.5 44.6 25.0 26.4 149 338National Bank 1.0 1.1 40.6 44.4 19.0 21.5 143 196Muslim Bank 0.5 G.5 15.7 16.9 10.9 11.2 88 88Allied Bank 0.2 0.2 6.9 7.2 5.1 5.5 12 12Total 4.6 5.3 159.7 175.1 91.6 100.3 743 962

= -- -= = =-=

Source: Grindlays Bank, June 30, 1983.

7. The PBC plays an important coordinating role in the NCB system. It is alsothe communications link with the Covernment, enabling the banks to put before theGovernment proposals on banking Legislations and- regulations. Additionally, thePBC formulates policy guidelines for the banks, reviews.their performance anddetermines areas where corrections or greater coordination is needed. The PBC,however, has no legislative or regulatory functions. The first remain with GOPauthorities and are essentially contained in the Banking Companies Ordinance of1962. The latter is the jurisdiction of the SBP which establishes reserverequirements, credit controls ard.allocations, interest rate levels and structure,and commission charge guidelines.

Recent Performance

8. Deposits. The comparative deposit figures for the commercial bankingsystem for the years 1979-1984 are shown in Table 4.

Table 4: Commercial Banks - Deposits(Rs billion)

z(March) (March)

1980 1981 1982 1983 1984 1984

Demand Deposits 22.8 27.2 28.3 34.0 30.0 24.9Savings Deposits 26.8 30.0 33.1 42.8 52.1 43.3Fixed Deposits underOne Year 8.2 8.4 10.3 13.8 16.0 13.3Fixed Deposits overOne Year 8.2 9.7 12.4 18.1 22.2 18.5Total Deposits 66.0 75.3 84.1 108.7 120.3 100.0

Source: SBP 1983/1984 Annual Report.

-.50- ANNEX 2Page 5

Overall deposits have doubled from Rs 66.0 billion in 1980 to Rs 120.3 bilLion in1984. Traditionally the banks have tapped personal savings, and have expanded thebase of personal deposits from 64% of the total in 1978 to 72% in 1983. Theimportance of government deposits has been reduced Erom 7.5% to 5%. Corporatesavings have remained relatively constant at about 17%. Other deposits fromforeign and domestic constitutents have reduced importance, down from 10.5% to 6%.

9. The second important development is the savings promotion effort of thecommercial banks in recent years to reach larger numbers of depositors, even inthe most remote areas of the country. Between 1980 and 1984 the number ofdepositors increased from 15.4 million to 20.2 million while the average size ofaccount rose from Rs 4,550 to Rs 6,100. The growth in deposits was achievedwithout significant increases in average interest rates, still around 6.25%, butrather through branching and marketing efforts.

10. The third important development is the growing importance of fixed longterm deposits, which have tripled by between 1980 and 1984. Noteworthy is thedevelopment of time deposits of over five years maturity, which since their intro-duction in the third quarter of 1981 have grown to Rs 10.4 billion or 8.6% oftotal deposits at March 31, 1984.

11. With respect to other resources, the noticeable variations are inincreased borrowings from the SBP representing greater use of specialized creditLines, particularly for export financing. In 1978, borrowings from SBP repre-sented 8.3% of total resources while in 1984 they stand around 13%. The otherimportant change in the rcsource base of the commercial banking system is thecontinuous growth of the capital and reserve accounts, and the important equitycontribution to the NCBs by GOP during 1981. While in 1978 capital and reservesof the system stood at only Rs 1.9 billion, in 1983 this increased to Rs 5.3 --billion due to an increase in paid-in capital subscribed by GOP and SBP and shouldincrease profits. The NCBs have been allowed to strengthen their capital byretaining net profit after tax; in the past they were required to remit all profitto the Government. An important improvement has taken place in the capitaldeposit ratio, increasing the stability of the system and of individual banks. Asa result, the combined profits of five NCBs increased from Rs 150 million in 1975to Rs 962 million in 1984 (Table 1).

12. Advances. In the period bank credit grew at an even faster rate thandeposits, reflecting greater use of SBP's refinance credit lines, and some relaxa-tion of credit ceilings by the State Bank. In 1978, total credit was 69.7% )fbank deposits, while in 1982 it constituted 78.4%. Under the credit allocationguidelines issued by tke SBP, the expansion of credit was directed to differentsectors of the economy in about the same proportion as in previous years. Thefollowing table compares the commercial banks' portfolio by sector between 1978and 1982.

ANNEX 2Page 6

Table 5: Commercial Banks Advances by Economic Sector(Rs billion)

For June 30 1978 1979 1980 1981 1982 XAgriculture, forestry,hunting and fishing 2.7 2.6 3.5 4.3 3.7 6.3

Mining and quarrying 0.2 0.3 0.5 0.7 0.1 0.9Manufactu ing 13.0 16.1 16.9 20.6 21.1 36.8Construction 1.0 0.9 1.1 1.2 1.2 1.9Elect.1city, gas, water,and sanitary services 0.3 0.2 0.4 0.5 0.5 0.9

Commerce 9.0 11.0 12.9 13.9 16.1 28.1Transport, storage andcommunication 0.5 0.5 1.1 0.7 0.7 1.2

Services 2.9 3.9 6.3 7.5 8.5 14.8Others 2.5- 3.7 4.2 4.8 5.1 9.1Total 32.1 38.7. 46.7 54.3 57.4 100.0

.0= ! = =Source: SBP 1983/1984 Annual- Report.

13. These figures show the continued predominance of the mAnufacturing sectorwith 37Z of bank credit. The second most important sector is commerce, absorbing28Z of bank advances. Given the marked improvement in industrial investment since1982, the proportion of credit of the manufacturing sector is estimated to haveincreased to around 40%. The figures show some uneven treatment of the manufac-turing sector and an expansion rate slightly below the overall expansion ofcredit. This is explained by the reduction of government investment in manufac-turing in the past three years because of its policy of limiting public sectorinvestment to BMR projects and promoting private investment in the sector. Theslack was picked up by the private sector only gradually, and even then the creditdemands from p.ivate industrialists will not match in the short run the very largedemands made for public industrial enterprises in the past.

Profitability

14. With the measures taken by GOP and PBC since 1979, the overall performanceand profitability of NCBs has improved considerably. The combined net profitafter ta. of the NCBs increased from Rs 150 miLlion in 1978 to Rs 970 million, anannual compound growth rate of 36%. However, profitability remains relatively lowand the performance among MCBs is mixed. As of December 31, 1984, Habib Bank'sprofits before taxes were Rs 828 million, or 52.31 of the combined profits of theNCBs although its total assets were 37% of the NCBs. In 1984, return on totalassets ranged from 0.91Z for HBL to 0.28% for Allied Bank, the smallest NCB. AllNCBs, to a certain extent, continue to suffer from the problem of overstaffing dueto strong labor unions. In 1984, personnel cost as a percentage of deposits ofNCBs averaged 1.89Z ranging from a low of 1.63% for HBL to 3.03% for Allied Bank.The relatively low profitability of NCBs is caused mainly by: GOP's monetarypolicy of maintaining very high reserve requirements (35% of deposits); the creditallocation policy, which directs NCBs to finance priority sectors at low interestrates; a large network of low profit branches in rural areas; non-payment of

-52- ANNEX 2Page 7

interest on loans to the public sector; and general overstaffing. FCBs, however,are able to increase profitability by catering to selected corporate clients andcarrying out a larger proportion of fee-based business for which profit marginsare greater.

Table 6: Earnings of NCBsN.s million)

* 1984Share Z Z Increase

1981 1982 1983 1984 All over 1981

-NBP 31 99 143 196 20.4 632HBL 122 273 351 328 34.1 269UBL 43 29 149 338 35.1 786MCB 33 44 88 88 9.2 267ABL 6 5 12 k2 1.2 100Total 235 450 743 962 100.0 409

Source: Grindlays Bank, June 30, 1983 and mission's estimates.

15. RoLe in Industrial Financing. Since 1979, the SP has aLlocated a termindustrial financing role to the NCBs by assigning them specific allocations.These allocations, if not utilized, cannot be channeled to other credit purposesby the banks. Initially there was some reluctance by the banks to participate inthe scheme. This reluctance was based on the low interest spread obtained. Byregulation these loans could only earn 112 p.a. while working capital loans nor-mally earn 14Z. However, the disincentive was removed partially through the useof Participation Term Certificates. Also, the more efficient banks found ways tomake these operations more profitable by insisting on other banking business suchas letters of credit, working capital, collections and foreign exchange.

16. Term lending by NCBs has increased sharply since FY83 (Table 7). WithIslamization of the banking system and the use of Term Finance Certificates, thebanks do not have the problem of crossed rates and term lending has become moreattractive. In 1985, it is expected that actual disbursements of term loans toindustry during the year will increase further to Rs 2.0 billion. The rapidgrowth of this portfolio also was aided by the partial liberalization of interestrates through the adoption of Participation Term Certificates. In parallel, thebanks have sought and SEP has allowed the reception of time deposits with fixedmaturities of five and more years, which have gained acceptance rapidly withoutsignificant cost increases. This factor has reduced the risk of conversion ofshort term deposits into longer term loans.

-53- ANNEX 2Page 8

Table 7: NCBs, Fixed Industrial Investment Allocationsand Utilization, 1978/1979-1983/1984

(Rs million)

Allocation Utilization /a Percent

FY81 576 387 67FY82 1,736 1,374 79FY83 1,579 1,387 88FY84 1,837 1,604 87FY85 2,195 1,716 /b 78

7a Net of repayments.Th As of June 13, 1985.

Source: SBP.

Prospects

17. Prospects for the development of the commercial banking sector in Pakistanwill be shaped by at least four major factors. The first will be the overallperformance of the Pakistan economy and the demands that the different sectorswill make on the banks for funds -and services. At present, the prospects are forcontinued growth and a widening of services demanded. The second factor has to. dowith the future savings rate; Pakistan presently has A relatively low rate ofdomestic savings at 7% of national income. There is scope for increased savingsparticularly as income increases, becomes more widely distributed and inflation ischecked. The third factor is the introduction of Islamic concepts into theeconomy, particularly in the financial sector, and the related issue of freeinginterest rates as a result of participation schemes. Preliminary analysis showsthat Islamization has thus far resulted in gradual deregulation of the financialsystem. Under the Islamic banking system, scope exists for increased bankdeposits attracted by higher yields and there is the possibility for the banks tomatch these resources with credit demands maintaining adequate spreads. Thefourth factor which will influence tihe development of the commercial banks isconstituted by the policies that the SBP will pursue, particularly with respect toreserve requirements, credit ceilings, credit allocation, and other regulatoryfunctions.

18. Recent experience and statements point to the likelihood of relativelyflexible and judicious management of the system with a tendency to free up regula-tions as needed. An example is the recent freeing up of service charges, on whichbanks can now compete freely. The ceiling on term loans has been removed whilethe rate ceiling on short term working capital loan has been increased from 15% to20%. This attitude and actions will alLow the system to develop in accordancewith the needs of the economy and permit it greater internal efficiency. The lastfactor is the continuing role of the PBC in guiding and coordinating the UCBs'activities. In spite of the banks' improving performance which would seem tojustify a greater degree of independence and competition, this is not likelyparticularly in new areas of banks' involvement such as Islamic instruments,

ANNEX 2-541 Page 9

leasing, or industrial term financing. However, it is felt that continued PBCaction should not mean a departure from the soft-glove approach utilized until novwith much success. The relationship between the PBC and the banks will continueto depend much on personaLities involved.

19. The two important policy issues relevant to the comercial banking systemare: the levels and structure interest rates, and the credit allocation system.SBP is charged with regulating both. In the past, the levels and structure of theinterest rate have been utilized by SBP to pursue two contradictory objectives:increase the rate of savings through attractive deposit interest rates and promoteinvestment in certain sectors and activities by offering low cost financing forthem through ch.- commercial banks. The result has been a crossed interest rate

- 1.. structure which had to be subsidized either by GOP, the non-preferred sectors orthe banks. The financial authorities had recognized the problem but were never-theless reluctant to address this issue directly and publicly in view of GOP'scomitment to Islamization of the economy. With the adoption of Islamic instru-ments both for deposits and loans, the lid has been taken off interest rate levelsand the crossing effect eliminated. As long as the result is that of rationaLiz-ing interest rates to reflect current price movements and market interplay betweensavers and users, GOP'zs. < ^rvach can be considered adequate. This, however, is anaspect to be mcaitored carefully in the future.

20. The banking system in Pakistan has traditionally been subject to quantita-tive credit controls. These have taken the form of credit ceilings and creditallocation measures. GOP has maintained these controls because of the interestrate distortions of the recent past and the policy of moving away from interestrates, it has no alternative but to manage credit on the basis of quantitative-assignments. COP argues that this policy is in keeping with the needs of adeveloping economy with limited resources and the need of maintaining fiscalstability. SBP monitors credit limits and allocations closely and re-adjustsamounts assigned periodically. While the system appears rigid and cumbersome, sofar no convincing arguments have been made for inefficiency or distortions inmaking credit available as demanded, in the industrial sector.

-55-

ANNEX 3Page 1

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Islamization of Pakistan's Financial System: - A Preliminary Assessment

Introduction

1. Under Islam, it is considered an injustice if the party providing finan-cial capital is guaranteed a fixed and pre-determined interest rate while theparty providing enterprise alone is made to bear the investment risk. A fixedinterest also is considered unjust to the lender if the borrower earns a profitquite out of proportion to what he pays in interest. Capital is not considered aseparate factor of production but should be inextricably linked with enterprise ina profit and loss sharing arrangement. Since interest rates are considered amajor source of injustice and contrary to Islam's objective of social equity,their abolition becomes the driving force of the financial Islamization process.Although there is some disagreement among Islamic scholars, the Government hasadopted the view that interest, defined as a predetermined fiied return for theuse of money, is inconsistent with an Islamic system. The focus of reforms is toreplace interest rates them with financial mechanisms acceptable to Islam in theshort run, and by a more fundamental readjustment of all basic social and economicrelations in the long run.

2. Pakistan's 1973 constitution required that all existing laws conform withthe injunctions of IsLam but only after 1977, when the present Government tookoffice, has the creation of an Islamic economic system become a major governmentobjective. In 1980, following a number of reports and considerable publicdebate, 1/ the Government began implementing a gradual and cautious program offinancial Islamization. Beginning July 1, 1979, the House Building FinanceCorporation (HBFC), the Investment Corporation of Pakistan (ICP), and the NationalInvestment Trust (NIT) began to reorient their financial activities toward non-interest bearing operations. NCBs and cooperative credit societies were requiredto provide interest-free loans in kind up to Rs 5,000 to farmers cultivatingsubsistence holdings. Bankers Equity Limited (BEL) was established to financeprivate industrial investment through the provision of new financing modes. OnJune 26, 1980, legal changes were introduced to permit the issue of ParticipationTerm Certificates to replace debentures and the establishment and issue ofModaraba companies and certificates. BEL was registered as the first Modarabacompany in Pakistan. On July 1, 1980, the Small Business Finance Corporation(SBFC) converted to non-interest operations. On January 1, 1981, commercial banks

1/ See An Agenda for Islamic Economic Reform. The Report of the Committee onIslamization Appointed by the Finance Minister, Pakistan Institute ofDevelopment Economics, Islamabad, May 1980; and Report of the Council ofIslamic Ideology on the Elimination of Interest from the Economy, June 1980.

-56- ANNEX 3Page 2

were directed to begin accepting profit and loss sharing (PLS) savings and termdeposit accounts. To facilitate the operation of these accounts, the State Bankof Pakistan converted a number of transactions previously conducted on a non-interest basis. On July 1, 1982, Musharikas were introduced to provide workingcapital financing on a PLS basis, together with hire-purchase and leasing forfixed investment.

3. The Government has used the transition period during which conventionalfinancing modes and new IsLamic instruments functioned in parallel to test the newfinancing arrangements and their effects on intermediaries and investors. GOP hasapproached this process pragmatically and has made a number of adjustments toprevent major disruptions to the system. Six years aEter the first measures wereadopted, the FY85 Budget announced that the financial system would be fully con-verted by July 1985, with the following timetable: 1/

(a) From January 1, 1985, all transactions of banks with the Federal andProvincial Governments, public sector corporations, private and jointstock companies will be based on Islamic (non-interest) financing;

(b) Effective April 1, 1985, all new financing by financial institutions toall entities including individuals shall be on the basis of (a);

[c) From July 1, 1985, banks will not accept: interest-beiring deposits. Allsavings and term deposits will be on a PLS basis;

(d) Islamic financing modes will be extended to the agricultural sector; and

(e) Foreign loans and deposits will continue on an interest basis.

Islamization of the Financial System

4. PLS Deposits. Commercial banks have operated voluntary PLS accounts sincei981 but with full Islamization, time and savings deposits in all financialinstitutions will be on a PLS basis. Under the PLS system, financial institutionsdeclare a return on deposits every six months based on profits earned with PLSfunds. A reserve fund will be set up with 5X-1OZ of profits to offset futurelosses and equalize rates of return over time. Since the banks' more profitableoperations were earmarked for PLS funds, returns have been consistently higherthan for comparable fixed interest deposits, although there has been considerablevariation among banks. As Table 1 shows, PLS deposits recorded strong growth andby December 1984 accounted for 26Z of total deposits and almost one-third ofinterest-bearing deposits.

1/ All existing interest-based obligations will be honored until discharged.

-57- ANNEX 3Page 3

Table 1: Deposits in Nationalized Commercial Banks, 1981-1984 /a(Rs billion)

1981 1982 1983 1984

Total Deposits 70.6 82.8 106.9 111.7Interest-bearing - (54.7) (66.4) (86.3) (91.0)PLS ( 6.5) (12.9) (19.9) (29.4)

Memorandum Item:PLS as Z of Total Deposits 9.2 15.4 18.6 26.3PLS as X of Interest Deposits 11.9 19.4 23.1 32.3

/a As of end-December.

Source: State Bank of Pakistan.

5. Government Finances. Government savings schemes, which together withprize bonds finance a large proportion of public, development expenditures, L/ willcontinue to operate on the basis of fixed interest. Prize bonds which do not payinterest but distribute prizes at random, will remain unchanged. Governmentborrowing through treasury bills and bonds will also cqntinue on an interestbasis. Financial arrangements between the Federal Government, provincial govern-ments and government corporations will remain unchanged since the Governmentconsiders these as merely accounting adjustments which do not give rise toinjustice.

6. Hark-Ups. Among trade financing modes, the most commonly used is themark-up, which is applied to the financing of inputs for agriculture and industryas welL as for domestic and international trade. Instead of lending, the finan-cial institution makes a fictitious purchase of a portion of the company's assetsor inputs which is sold back to the company when the loan falls due at a priceincLuding a mark-up. Instead of a penalty for late payments, timely repayments ofthe loan command rebates in the agreed mark-up. A mark-down is also possible bywhich assets are sold and re-bought by the borrower at a lower price. Mark-downsalso can be used as discount rates for the purchase of trade bills and notes ofcredit. The mark-up or mark-down is negotiated freely between the parties but SBPhas set minimum and maximum rates of 10 and 20%. Although mark-ups were intro-duced to provide short-term financing, in 1985 SBP extended the concept to termfinancing. In this case, SBP only specified a 10% minimum but no maximum rate.Mark-ups entail a predetermined fixed rate of return, security of principal andare not governed by the principles of profit and loss sharing, they are a lesspreferred, but nonetheless acceptable, financing mode under Islam. Hark-upfinancing is expected to be used extensively by financial institutions, despitecriticism in some quarters that it is tantamount to charging interest.

1/ The net flow of resources into these schemes was equivalent to 45% ofdevelopment expenditures in FY84.

-58- ~~~~~ANNEX 3Page 4

7. Participation Term Certificates (PTCs). Similar to redeemable equity,PTCs are transferable instruments based on the PLS principle and were intended toreplace bonds and debentures for medium and long term local financing. PTCs are aform of redeemable equity whereby instead of receiving interest, PTC holders sharein the profits and losses of the issuing company. PTCs can be issued for up toten years, are secured by a fixed mortgage on company assets, and the claim oncompany profits is based on pretax profits and is a tax deductible expense.Although technically the PTC share of profits should be based gn the ratio of PTCsto the company's paid-up capital plus reserves, FTC agreements have specified anexpected rate of return of 15X. Most PTCs are being issued at 17% with a 2Zrebate if the company makes payments within 30 days of closing its annualaccounts. Specific agreements may provide that in the event of losses a portionof PTCs can be turned into convertible shares, similar to preference shares interms of rights and privileges. If the company returns to profitability theseshares can be reconverted into PTCs.

8. During the initial stages of Islamization, the Government expected PTCs tobecome the main term lending instrument fog both development finance institutionsand commercial banks. However, because of its PLS features, PTCs met with con-siderable resistance from the private sector and the commercial banks. Theprivate sector voiced strong reservations about the potential involvement offinancial institutions in the management of coLpanies and the possible dilution ofownership in the event of losses. More importantly,.because of their deposit basethe commercial banks were concerned with the excessive transformation of short-term demand liabilities into venture capital-type investment. The commercialbanks were concerned that given their already high involvement in term financing,a complete switch to PLS-based instruments would have an adverse effect on theirinternational credit rating.

9. Modifications were introduced to make PTCs more attractive. Instead ofaccounting on an annual basis, PTC holders can, over the period of the PTC issue,adjust shortfalls in lean years with surpluses in more profitable years in accord-ance with the pro-rata share of profits attributable to the PTC issue. Any excessprofit over the agreed rate of return will be held in a special reserve to adjustfor profit shortfalls or loss of principal until redemption. PTC holders canagree with the issuing company on a profit definition that is different fromaccounting profits (e.g., different depreciation rates) and interim annual redemp-tions can take place out of cash flows regardless of profitability. Althoughthese refinements reduced the risk inherent in PTCs they did not meet the commer-cial banks' concerns regarding safety of principal and regularity of income, andtheir desire to avoid PLS-based instrument for term-lending. As a result, theGovernment introduced a new term financing mode based on mark-ups.

10. Term Finance Certificates (TFCs). The recently introduced TFCs areexpected to take the place of PTCs and will become the major financing instrumentfor fixed investment. Commercial banks still have the option of using PTCs in thecase of established companies with proven profitability and dividend records. TheTFC involves application of the mark-up principle, initially designed as a short-term financing instrument to long-term investment financing. The provider offunds (TFC holder) acquires assets from the investor which are sold back at apredetermined mark-up. The purchase price plus the mark-up is paid back in annual

ANNEX 3Page 5

or semL-annual installments over an agreed period of time. Installments arecovered by TFCs which are equivalent to promissory notes issued by the borrower inrespect of equivalent installments oE principal and interest. Bridge (medium-term) finance will be provided on the same basis, to be retired out of publicflotation of shares, cash flows or new funds injected by owners from their ownresources. SBP has determined that the actual mark-up or rate of profit will befreely negotiated between the parties but has set a minimum of 10% p.a.

11. Hire Purchase. To finance acquisition of machinery and equipment, as wellas durable consumer goods, a hire-purchase is an interest-free agreement in whichthe lender shares ownership with the borrower. As the borrnwer repays ininstallments, he gradually gains ownership of the asset. In addition to periodicrepayment of principal, the lender receives a share of the imputed rental value,net of depreciation, of the item purchased in proportion to its outstanding sharein the total outlay.

12. Leasing. A saLe under which the price of the item procured includingprofit is payable on a deferred basis in installments or lump sum. The lessor(financial institution) retains ownership of the asset and the lessee has posses-sion and use of it against payment of rentaL over a specified period. Althoughhire-purchase and leasing arrangements are common in many. countries, they are newdevelopments in Pakistan's financial system.

13. Modaraba. The Modaraba Ordinance of 1980 defines a Modaraba as a businessin which one party participates with his money and another with his efforts andskills, and a Modaraba Company as a, company engaged in the business of floatingand managing Modarabas. A Modaraba is an investment fund for which resources areobtained through the sale of Modaraba certificates by a Modaraba Company. Banksand financial institutions can register themselves as Modaraba Companies and inthat capacity, provide risk capitaL to Modarabas in the form of equity and creditwith equity (PLS) features. An important advantage of Modarabas is that itenables project sponsors to mobilize funds directly from the public withoutrecourse to finarcial intermediaries. In this way, funds raised through Modarabasfall outside the credit ceilings imposed by SBP.

14. Modarabas can be malti- or uni-purpose. Initially, a company registeredunder the existing Companies Act was eligibLe for registration as a ModarabaCompany provided that it had paid-up capitaL of Rs 5 million, of which a minimumof Rs 2.5 million is allocated to its Modaraba operations; or solely engaged inModaraba activities with a paid-up capital of Rs 6 million. In order to encouragethe use of Modarabas, the Government subsequently towered the limit on paid-upcapital to Rs 2.5 million. The Modaraba Company must invest in at least 10% ofthe capital it offers to subscribers. The income of Modaraba Company is taxexempt if at least 90% of its annual profits are distributed to certificateholders. Profits are distributed only after the Board decides what share ofprofits should be retained in reserve for meeting contingencies or for equalizingprofit distribution. Losses are shared among certificate holders after recourseto reserves and unappropriated profits. If accumulated losses exceed 50% ofsubscribed capital, the Modaraba Company must cease operations.

-60_ ANNEX 3Page 6

15. Musharikas. Based on the PLS principle, the parties contribute capitaland/or effort in a specified venture. Profits are shared according to a pre-agreed formula but losses, if any, are shared in proportion to the funds con-tributed by each party. A proportion of profits is set aside for the promoter asa management bonus for having managed the venture. Although in principle aMusharika is a form of partnership, an amendment to the Partnership Act of 1932has excluded Musharika as a legal partnership in Pakistan. Some Musharika agree-ments expressly specify that the relationship between the banking company and itscustomer is that of debt and credit or, allowing the payment of "reasonablecompensation" or liquidated damages, in addition to principal in the event ofdefault. A Musharika financing scheme was Launched by NCBs on June 1, 1982,designed to meet the working capitaL requirements of trade and industry. However,the scheme has not proved popular and most working capital financing is beingprovided on a mark-up basis.

16. Other financing modes introduced as part of the Islamization processinclude: (i) interest-free production loans to subsistence farmers and fishermenfor the purchase of seasonal inputs and to cover maintenance costs(ii) Qard-e-Hasana, or interest-free loans given on compassionate grounds andrepayable when the borrower is able to repay. A large proportion of these loansgo to deserving students who must repay when they complete their studies and findemployment; (iii) interest-free loans with a service charge through which bankscan recover their costs of operations; and (iv) rent-sharing which allows thebanks to form partnerships with their clients in the purchase of property bysharing in the rental value or any other income from the property.

Evaluation

17. The Government is treading a careful path between the need to introducenew financial practices consistent with Islamic tenets and the need to avoid adisruption of the financial flows required by a modern industrial economy. Forinstitutions dealing with foreign loans, the Government has given an assurancethat they will continue to function on the basis of interest. The Government hasemphasized that while it is committed to the process of Islamization it needs toproceed gradually and cautiously. As a result, Pakistan's financial system isundergoing a process of change which will continue as experience with the newsystem grows. Islamization has been in operation for too short a period to permita full evaluation, but some emerging trends can be discerned. Although someuncertainties remain about evolution of the system it appears that, on the whole,IsLamization is having a beneficial impact on the financial system.

18. The most important effect of Islamization has been the freeing of finan-cial rates of return particularly for term-lending and a more market-orientedapproach to the pricing of capital. By allowing financial institutions to nego-tiate rates of return and mark-ups within a range of 10% to 0Z0 for short-termfinancing and setting only a minimum of 10% for term lending, the term imbalancewhich existed under the interest-based system has been corrected. Returns on PTCsand TFCs are being set at 15X compared to 11% for industrial rupee term-lendingunder the previous system. Working capital and trade financing through Musharikasand mark-ups will remain 14%. Moreover, if Government continues to aLlowflexibility in the setting of rates, mark-ups and rates of return on new financing

ANNEX 3Page 7

modes will have a stronger alLocative function than was previously the case inPakistan. By making returns more responsive to market conditions, financialinstitutions can react more readily to changing economic circumstances and adjustrates in the event of higher infLation.

19. Because of its emphasis on equity or quasi-equity investment modes and theneed to develop alternative financing mechanisms, Ibtamization is encouraging thediversification of financial instruments and a stronger role for the privatesector. Two Leasing companies with majority private sector ownership are alreadyin operation. It is expected that once TFCs become widely used, NBCs will bepermitted to selL certificates in the stock exchange, encouraging the developmentof secondary markets in Pakistan. Modarabas enable private investors to mobilizefunds directly from the public and thus provide an additional source of financeoutside credit ceilings. Hire-purchase is a new development in Pakistan whichwill expand financing options for the private sector. The Government is evaluat-ing a proposed foreign private investment company sponsored by USAID and in theFY86 Budget Speech announced it will encourage the setting up of private invest-ment companies. The FY86 Budget also introduced a number of new financial instru-ments designed to attract "black money" from Pakistan's extensive undergroundeconomy. Although these resources will be used to finance public expenditure,upon redemption the funds will be legitimized and thus will be available forreinvestment in the formal sector. The Government has decided.to divest Rs 2billion in shares of profitable public sector manufacturing units which isexpected to increase by about 10% the supply of securities in the stock exchange.To encourage the development of the stock market, the Government has decided toprovide a tax exemption on dividetrd income from publicly traded companies and hasreduced the corporate tax for publicly listed companies from 55.% to 40%. Animportant outcome of Islamization has been the abolition of stamp duty for allfinancial transactions. This was a major constraint to the issuance of short-termcorporate paper in Pakistan.

20. During the initial stages of Islamization, the Government sought toreplace most interest-based lending with financial instruments based on the PLSconcept, while mark-ups were to be used largely for trade finance. However, asthe system evolved it became clear that there was considerable resistance to theuse of PLS-based instruments, especially from commercial banks. NCBs opted todirect most of their lending through mark-up instruments. As of end-1984, 83% ofbank lending from PLS deposits was for mark-up (and mark-down) financing. WhilePLS-type lending (Musharikas and equity participation) accounted for less than l10of PLS funds (Table 2). The Government appears to have accepted the need to avoida major switch to PLS lending instruments and has extended the mark-up conceptto term and working capital financing so that the majority of bank lending willcontinue to be through non-PLS instruments. Although PTCs and other types of PLSinstruments will continue to operate, it is likely that they will be restricted tosituations where both financial institutions and investors see advantages inopting for equity-type financing. To the extent that most financing takes placethrough mark-ups, which offer security of principal and regular income flows, mostof the uncertainty and risk inherent in a PLS-based Islamic system are removed.Thus, concerns over the possible adverse effects are diminished substantially.These included: the impact on risk-averse investors, the potential bias againstcyclicaL industries and long-gestation projects; legal uncertainties regarding

-62- ANNEX 3Page 8

profit and loss statements, the potential involvement of government-controLledfinancial institutions in operations or ownership of loss-making companies, andthe impact on the risk portfolio and international credit rating of comercialbanks.

Table 2: Nationalized CommerciaL Banks, Investment of PLS Funds /a

-Amount X ShareFinancing Mode (Rs million) (Z)

Mark-up and Mark-down 16,263 83.0.Commodity Operations (11,426) (58.3).Trading Operations (2,755) (14.1).Documentary Inland Bills (377) (1.9).Export Bills (953) (4.9).Import Bills (613) (3.1).Others (139) (0.7)

PTCs . 1,094 5.6Musharika 777 4.0Hire-purchase 130 0.7Rent sharing 198 1.0Others 1,125 5.7

Total 19,587 100.0

la As of December 31, 1984.

Source: Pakistan Banking Council.

21. A difficulty in mark-up lending is that penalty rates or compounding ofmark-up in the event of delayed payment is not possible. This is being resolvedby financial institutions through higher expected rates of return or mark-ups thanwouLd be charged ordinarily, combined with rebates for timely payments. Thus,PTCs generally carry a 17% annual return which is reduced to 15% when payments aremade within 30 days of the closing of company accounts. Minimum and maximum ratesspecified by SBP offer ample scope for this approach. In addition to providing anincentive for timely payments the Government has set up Banking Tribunals whichare required to adjudicate disputes within 90 days. If the proceedings continuebeyond this period, the defaulter is required to either deposit in cash the amountof any installment in default or furnish an acceptable security covering theclaim. If the borrower does not comply, the Banking Tribunal will decide in favorof the financial institution. The Banking Tribunals appear to provide financialinstitutions with needed protection against possible customer default under aninterest-free financing system although the expediency and effectiveness of theTribunals remains to be seen. To date, no Banking Tribunals have been appointed.Provided the new Banking Tribunals operate efficiently, the legal framework ofPakistan's financial system would be improved considerably. In the past, civilcourts in Pakistan have been ineffective in dealing with defaults with cases oftendragging for more than ten years.

22. The effect of Islamization on deposits and the level of savings is lesscertain. Returns on deposits in financial institutions will be based entirelj onPLS principles. As there is no guaranteed return on deposits, this could lead tothe withdrawal from the formal financial system of risk-averse depositors. Since

a -63- ANNEX 3Page 9

government savings schemes will continue to operate on an interest basis, somefunds could be diverted into these schemes. On the other hand, non-interestbearing deposits could also attract new depositors who previously declined tomaintain fixed interest deposits for religious reasons. Moreover, since PLSreturns will be determined by the proficability of each financial institution,commercial banks and other deposit taking institutions are Likely to compete moreaggressively for funds, leading to improved service and, possibly, increasedmobilization of term and savings deposits. In recent years commercial banks inPakistan have improved considerably their overalL profitabiLity while somewhatreducing operating costs. Net profits of NCBs increased from Rs 150 million in1978 to Rs 740 million in 1983. Operating costs as a percentage of averagedeposits decreased frem 3.8% to 3.2% over the same period. It is unlikely thatshort run PLS returns would fall below interest rates offered prior toIslamization. Over the long run, to the extent that the system can accommodateminimum expected rates of return on PLS deposits (e.g., through reserve funds ordeposit insurance schemes) mcst of the uncertainty and increased risk would beremoved.

23. PLS deposits mAy cause some problems for FCBs. Since rates of return aredetermined ex post, FCBs are not able to use rates in advance to regulate thelevel and structure of their deposit base. This is more of a problem for FCBsbecause their deposit base is less stabLe than that of NCBs and, given a largeproportion of corporace depositors, more sensitive to variatibns in rates ofreturn. Thus, a low rate of return in one period could lead to a run on depositsduring the next. However, since all proposed PLS returns must first be approvedby SBP, it is likely that SBP will attempt to keep variations among banks within asmall range to minimize volatiLity in deposits.

24. Under IsLamization, Pakistan's monetary policy is not likely to be con-ducted differently. Direct and selective controls are the primary instruments forregulating the growth and distribution f domestic credit. The Annual Credit Plansets specific overall monetary and credit growth targets as well as credit ceil-ings for each lending institution and minimum credit targets for priority sectors.Although SBP has indirect instruments available to regulate credit expansion-suchas a 5% minimum cash reserve requirement, a 30% liquidity ratio, and its redis-count rate-these are not used. Under the new system bank liquidity will continueto be determined through credit ceilings and SBP will set detailed credit alloca-tion targets. Priority lending targets imposed on commercial banks also willcontinue. SBP's rediscount rate will not be abolished but will be tied to anindex of Government treasury bills and will continue to be used mainly forliquidity support to DFIs.

-64-

ANNEX 4Page 1

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

The Capital Market

Background

1. Previously stock exchanges had operated in Karachi and Lahore, but thesewere closed at independence. The Karachi Stock Exchange (KSE) reopened in 1949with 13 listed companies and in 1970 the Lahore Stock Exchange was established.Substantial private investment and rapid growth of private enterprise in the 1950screated buoyant conditions on the Karachi Stock Exchange as reflected in aggregatemarket capitalization and also in the number of new issues. However, lack ofproper regulation resulted in substantial losses for some smaller investors. TheSecurities and Exchange Ordinance was enacted in 1969 to protect investors -.ncorporate securities. Increased powers were thus acquired by the regulatoryauthorities over listed companies and the Stock Exchange, especially with respectto disclosure of information relating to corporate affairs.- Constraints onprivate sector profitability in the late 1960s,- folldwed by the loss of EastPakistan, the devaluation in 1972, and the Government's nationalization programdepressed the stock mirket which continued to stagnate throughout the 1970s.Although, as a result of the improved economic climate and government measures toencourage the private sector since 1977, the stock market has revived somewhat, itremAins a relatively marginal source of funds for industrial investment.

The Stock Market

2. Structure. Stock exchanges in Pakistan principally trade only thecommon 17 shares of companies registered in Pakistan. £here is hardly any tradingin corporate debentures, preferred shares, and Government securities. Debenturesare a little used source of corporate finance and have been nearly aLwaysprivately placed, while Government securities are predominantly held by banks tosatisfy liquidity requiremencs. 2/

3. Stock exchanges regulations consists of requirements imposed bylegislation, and those imposed by the stock exchanges on their own members and onlisted companies. Legislation consists of the new Companies Ordinance (1984), theSecurities and Exchange Ordinance ('969), and Rules (1971). The Corporate LawAuthority, effectively a branch of the Ministry of Finance, and the Registrar ofJoint Stock Companies are responsible for ensuring compliance with these Acts.

1/ Termed "ordinary" shares in Pakistan.

2/ The current 35% statutory liquidity requirement consists of 30% investedin approved securities and a minimum reserve requirement of 5% in cash.

ANNEX 4Page 2

New issues are governed by the requirements of the Monopolies and RestrictiveTrade Practices Ordinance (1970) and the Capital Issues Act (1947). The lattergives full authority to approve all public issues to the Controller of CapitalIssues (CCt) who is a Joint Secretary in the Ministry of Finance. Listing on astock exchange in Pakistan is, in general, not the outcome of an independentinitiative by a company. Rather, it reflects the requirements of eitherregulatory authorities or financial institutions, which impose the requirement asa condition for the provision of credit. A company is required to secure publicstatus when its issued capital exceeds Rs 10 million (or Rs 5 mitlion in the caseof non-industrial companies). A public company is obliged to offer 5OX of itsshares to the pubLic. This requirement is relaxed in the case of subsidiaries ofmultinational companies, so that the sponsors can retain 60X of the shares. Allpublic companies require a minimum of 250 individual sharehoLders. It is notknown to what extent nominees are used to circumvent this requirement.

4. Single capacity for both jobbing and braking prevail on both stockexchanges. Membership of the Exchange is on an individual or partnership basiswith each partner a member in his own right, with the exception that a father mayintroduce his son. The KSE has a fixed membership of 200, of whom about 80 areactive, but trading is dominated by about 30 members. The Lahore Stock Exchangehas 120 members of-which only a handful are active. Admission is controlled bythe Board of each stock exchange within the framework of the 1971 Securities andsExchange Rules. Members must be citizens of Pakistan, and have some previousexperience of the securities business. It has become a matter of practice thatmembers of KSE would satisfy a minimum networth criterion of Rs 500,000. Outgoingmembers usually trade their membership. The going rate has appreciated in recentyears and at present, is understobd to be around Rs 300,000. While the Securitiesand Exchange Ordinance provides the Federal Government with powers whizh couldoverride the Board of a stock exchange, the Board carries responsibility forregulation and control of matters relating to dealing, registration and settlementin addition to admission, disciplining and suspension of members. The stockexchanges have requirements relating to disclosure of, and the procedures for "ownaccount" dealing by members. In practice, disclosure is substantially overlookedand regulations are not rigorously enforced. Commission rates are fixed accordingto a schedule set by the stock exchanges, varying inversely with the value of atransaction; in practice the commission amounts to an average of about 0.3% pertransaction. While the members feeL strongly about the low commission level, amuch greater source of concern expressed by the members is the low volume ofbusiness.

Incentives for Investment in Equity

5. The main incentives for investment in shares in Pakistan at preser.t are:

(i) Up to June 1985, profits earned from PLS banking accounts,income from NIT 1/ units and dividend income from listedcompanies was free from income tax up to a maximum of Rs 15,000.Since the dividend yield on the listed stocks have ranged from9% to 12X, the return on shares was substantially lower thantax-free yields of 15Z to 17X available under the ITational SavingsSchemes (NSS). Budgetary measures for FY86 (para. 16) have

ANNEX 4Page 3

effectively removed this disadvantage by exempting from taxdividends paid by listed companies as well as income from NITunits. This measure is probably one of the most powerfulincentives, which could accelerate the growth of the stockmarket.

(ii) A tax credit in the form of an investment allowance (butlimited to one-third of total income and a maximum ofRs 50,000) is available on acquisition of shares of newissues declared qualified for this purpose but not forsecondary purchases of existing shares on the exchanges.

(iii) Overseas Pakistanis are allowed repatriation in foreignexchange of original capital invested in listed sharesafter these are held for one year. Dividend on sharesacquired by overseas Pakistanis is aLso repatriable.However, NIT units and NSS-Khas Deposit Certificatespurchased abroad in foreign currency need not be heldfor one year and are fully repatridble as to both capitaland income. Foreign investors, though not excluded frompurchasing Pakistan equities, have not done so becauseexchange regulations prevent repatriation.

Capital Market Institutions

6. Two most active participants in the stock market are the NationalInvestment Trust (NIT) and the 'Investment Corporation of Pakistan (ICP). ICPunderwrites new issues, operates 16 close-end mutuaL funds including the StateEnterprise Mutual Fund and also manages an "Investors Scheme" comprising about9,800 discretionary or non-discretionary investment accounts with aggregateinvestment of about Rs 378.6 million as of June 30, 1984. In operating its ownportfolio (valued at as 355.4 million as on June 30, 1984) ICP attempts marketstabilization through countercyclical action. Transactions by ICP constitutearound 16Z of the total trading on KSE. Shares valued at around Rs 3 billion areheld by NIT and ICP inclusive of the latter's mutual funds and Investor's Scheme.NIT has managed to ensure a fair return to its unit-holders (currently around 13Zagainst a sale price of Rs 11.50). The ICP mutual funds have performed well withdividends of from 11% to 28Z. Average earnings of investors under the Investor'sScheme have generally exceeded the rates of dividend payment on its mutual funds.This compares favorably with the dividend performance of the stock market as awhole as reflected by the fact that since FY81, dividends paid have ranged between12% to 131 of total listed capital.

7. Companies listed on the KSE as of June 30, 1985, cover a wide spectrum ofcommercial activity with cotton textiles accounting for 291, engineering 10%,chemicals and pharmaceuticals 8%. Of the 353 listed companies, 258 companies werewholly owned by private investors, and 63 were joint sector companies, the balance

1/ The National Investment (Unit) Trust, a government controlled open-endmutual fund.

-67- ANNe 4Page 4

32 muLtinational companies. Multinational companies have been consistentlyamongst the best performers on the stock exchange. This is partly due to con-fidence in their management and partly because they operate in sectors (forexamplev chemicals and pharmaceuticals) which are more profitable and in whichcost barriers to new entrants are higher. They have also been relatively promptin their dividend payments, perhaps because dividends to overseas shareholders canonly be released after the local shareholders have been paid.

Recent Performance

8. As a result of improvement in the economy and in the overall investmentclimate, the turnover of shares on the KSE accelerated rapidly in the four yearssince 1980, corresponding in some degree to the rapid increase in the same periodin the market value of listed shares (Table 1).

Table 1: Karachi Stock Exchange 1/

Companies, Prices and Turnover

Aggregate General IndexMarket Value of Turnover

Number of Paid-up of Ordinary Share Prices ofDecember 31 Companies Capital Shares (1975.-1976=rOO) Shares

--;Rs mitlion) - (million)

1977 282 4,973 6,008 130.6 24.61978 287 5,623 6,187 141.9 28.61979 305 6,645 7,608 &181.0 42.71980 314 7,630 6,404 167.5 25.81981 311 2/ 8,078 6,859 200.6 35.31982 324 9,439 11,267 163.8 50.21983 327 10,035 15,201 207.6 76.01984 346 11,496 17,770 232.1 115.71985 3/ 353 11,885 21,935 258.4 33.1

1/ The Lahore Stock Exchange has 247 listed companies all of which are listed- on the Karachi Stock Exchange as well. Its trading activity is marginal.

2/ Eight companies delisted.* 3/ Provisional figures up to June 27, 1985. Turnover given is for the period

January-May 1985.

Source: Karachi Stock Exchange.

Of the listed shares about 150 are regularly traded and there is an active daiLymarket in only 30. Of these, most are blue chip companies, amongst which multina-tionals and selected engineering enterprises feature prominently. Reasons for therelatively thin market in shares is in large measure explained by the structure ofshare ownership. Since 1980, paid capital of listed companies ha.. increased about80% (from Rs 6.6 billion to Rs 11.9 billion), and the market value has almosttripled (from Rs 7.6 billion to Rs 21.9 billion). The rapid increase in stockprices reflects some underlying improvements in important segments of industry(including cotton textiles, which account for nearly one-third of the listedcompanies), revival of basic business confidence, recognition of political

-68- ANNEX 4Page 5

stability, and cLarification of the Government's policies in respect of the rela-tive roles of the private and public sectors. Another material factor has beenreturning wealthy Pakistanis from the Middle East.

9. Dividend Performance. Generally, most investors in Pakistan bothindividual and institutional tend to be income oriented. Cash dividend and highpayout ratio weigh more heavily in their investment decisions than potentialcapital gains. Most listed companies therefore are required to,declare dividends(Table 2).

Table 2: Dividend Performance

No. of Listed No. of CompaniesYear Companies Paying Dividends Z

1979 305 151 501980 314 163 521981 311 e 164 531982 324 167 521983 327 183 561984 346 165 1. 48

l/ This is an interim position with results of onLy 300 companies.

Source: Karachi Stock Exchange.

New Issues

10. Since FY78 their have been about 13 new issues a year with an average issuevalue of Rs 165 million which were oversubscribed by 350%. In FY84, the value ofnew issues accelerated sharply to Rs 1.1 billion from Rs 564 million in FY83reflecting a general buoyancy in the stock market. The new issue activities inthe past were sluggish (Table 3). This could probably be attributed to:

Ci) Relatively high cost of equity finance as compared to thecost of debt from both DFIs and NCBs. Apart from dilutionof control which equity issues entail high dividend paymentsrelative to the cost of long-term local currency debt finance,which was reduced further because interest was tax deductible.Also, dividend received by shareholders, who also tend to bethe owners and managers, was subject to individual income tax.This disincentive has been adequately offset by the measurestaken in the FY86 budget (para. 16). These include loweringthe corporate tax rate for the listed companies from 50% to 40%and full tax exemption on dividends received by individuals fromthe listed companies. Previously, the exemption was limited toa maximum of Rs 15,000 in the case of private companies; and

(ii) Concentration of considerable private investment activityin recent years in small and medium-sized industries, whoseissued capital amounted to less than Rs 10 milLion.

ANUEX 4-69- Page 6

Table 3: New Issues Floated on Karachi Stock Exchange 1/

Amount Offered Subscription MultipleNo. of for Total (Subscription received

Year Issues Subscription Subscription times offer)(Rs million) (Rs million)

FY78 9 41 .342 8.3FY79 16 *91 485 5.3FY80 12 378 2/ 649 1.7FY81 7 49 198 4.1FY82 12 109. 321. 3.0FY83 12 77 564 7.3FY84 20 297 1,056 17.0FY85 16 280 806 3.5 31

1/ Excludes Rights and Bonds Issues.-2/ Includes State Enterprise Mutual Fund of Rs 280 million.3/ Provisional figures;

Source: KSE and SBP.

Underwriting

11. Underwriting activities in Pakistan are carried out mainly by BEL, ICP,NDFC, Pak-Kuwait, Pak-Libya, and Pak-Saudi. NIT maintains a preemptive option totake up 20% of all public issues and a small reserve quota is kept for employees.Although they can form underwriting consortia, NCBs have been rfluctant to do so.They are increasingly seen as an alternative source of longer-term debt finance.There have been very few situations where the underwriters have sought the supportof stockbroker partnerships. Underwriting commissions are fixed by CCI and do notvary with size or risk of the issue. The present rate is set at 2-1/2Z with afurther 2-1/2% payable on actual take-up by the underwriters. The level of over-subscription for new issues, shown in para. 10 above, masks one under-subscriptionin FY83 two in FY84, and four in FY85. Apart from the paucity of new issues,another possible explanation for over-subscription in the case of existing com-panies is that the issue price set by CCI provides for an almost certain capitalgain, whereas shares of new companies are always priced at par with CCI employinga formula to set the issue price for established companies at half-way between thepar value and asset break-up value. Reserves may, however, be capitalized byallotment of bonus shares, although public companies are required to maintainminimum 25Z free reserves.

Role of Capital Market in Financing Industry

12. Table 4 shows that during FY83-FY85 the stock market was a marginal sourceof funds for industry. While FY84 was an exceptional year with a surge in newissues, particularly right issues, the stock market financed about 4.5Z of privateindustrial investment during FY83-FY85. However, there is scope for greatermobilization of resources through equity issues. GOP's recently introduced taxconcessions for companies listed on the stock exchange should have a positive

-70- ANNEX 4-70- Page 7

impact and appreciably increase the proportion of private industrial investmentfinanced through new issues; estimated to rise to around 7Z during the next twoyears (a 50X increase). As the stock market broadens in range and size, andbecomes more efficient, there should be greater awareness of listed shares as aninvestment avenue leading to increased financing of industry through equityissues.

13. On the basis of industrial term lending by- DFIs and BCBs during FY81-FY83(Rs 9 million) and debt:equity financing of 60:40, it is estimated that Rs 1.5billion in new equity will be offered for public subscription during FY86-FY87.=This excludes rights issues, shares to be disinvested by the government and sharesto be offered as a consequence of conversions of private companies to publicstatus.

TabLe 4

FY83 FY84 FY85e -- Rs million-

Right Shares 202 509 75Public Offers 77 297 230Direct Investment in Listed 279 806 305Shares (A) = . =

Sponsors Equity Listed 60 358 345Bonus Shares 218 298 177Debt Converted to Equity 18 15 9Indirect Investment in Listed 296 671 531Shares =

Gross Addition to Listed Equity 575 1,477 836=:

Gross Private Industrial 5,264 6,540 7,848 1/Investment (B) - - -

Direct Investment in ListedShares as Z of Gross PrivateIndustrial Investment (AIB) 5.3Z 12.3Z 3.9Z

1/ Mission's estimate.

New Corporate Law

14. In 1984, GOP passed "The Companies Ordinance, 1984" to replace the 1913Companies Act, that had constituted the core of Pakistani corporate legislationsupported by an assortment of other enactments, most of which were also substan-tially repealed. The stated objectives of the new Act seeks the achievement ofhealthy growth of corporate enterprises, protection of investors and creditors,promotion of investment, development of the economy, and matters arising out of orconnected therewith. Greater shareholder control has been attempted throughprovisions for more open management, making it obligatory for managements tosupply more detailed information on the Company's working and accounts, limits onmanagement authority in sensitive areas, protection of minority shareholders and

ANNEX 4-71- Page 8

creditors and more effective supervision and control. Stringent provisions havebeen made to prevent abuse of power by the directors through the holding of morefrequent company meetings, and prescription of quorum requirements for company andboard meetings. Criminal liability of the directors and relevant corporateofficers has been stipulated for non-compliance with a variety of provisions.Shareholder(s) having an aggregate 20X equity interest or creditors with an equiv-alent exposure to a company can seek judiciaL reorganization of the company'saffairs, including transfer of shares between shareholders and termination of thecompany's contracts with directors or its chief executive officee.

15. Among its controversial provisions is the power acquired by the Governmentunder Section 296 to declare a company facing financial or operational problems "asick company" and to cause a plan for rehabilitation to be prepared. Onceapproved by the Government the plan would be implemented as enforceable, final,and binding. The plan could include capital reorganization, loan restructuring,acquisition of shares of the management group, alterations in the Memorandum andArticles of Association, and appointment/removal of Directors. Corporate manage-ments are viewing this as an arrogation of arbitrary power since "financial oroperational problems" that could give rise to, this action has not been defined.There is considerable apprehension in corporate circles by the power conferred onthe Corporate Law Authority under Section 295 to replace the management with anAdministrator if more than 60% of its creditors represent inter alia that:creditors or shareholders are being defrauded; or the shareholders are beingdeprived of a reasonable return; or the market value of its shares falls below 75Zof par value; or its debt:equity deteriorates beyond 9:1 and current ratio slipsbelow 0.5:1; or if any industrial unit owned by the Company operates onlypartially/intermittently over twb years; or that accumuLated losses have wipedout more than 60Z paid-up capital. At the same time, powever, it is clear that*unless the Companies Ordinance is implemented fairly and pragmatically withrespect to areas where the Government has assumed discretionary powers, a climateof uncertainty could Lead to lower levels of investment activity, and closercorporate control instead of broadbasing of corporate ownership. Up to now, allindications are that GOP would administer the Ordinance flexible to ensure con-tinued growth of the private sector.

Proposals for Capital Market Development

16. There is considerable potential for expanding the stock market inPakistan, as evidenced by the fact that at present there are more than 10,000private companies but only 353 listed companies. As part of the preparation forthe second IIC project, the Bank Group discussed with GOP measures to strengthencapital markets in Pakistan. The Government's reaction has been positive and itannounced a number of important measures in the FY86 Budget. These include:

(i) reduction in the corporate tax for listed companies from 50% to 40%(privately held companies are taxed at 55%);

(ii) income taz exemption on dividends paid by listed companies;

(iii) a decision to allow private investment companies (local or foreignowned) to perform all banking functions except deposit taking;

-72- uANNE 4Page 9

(iv) disinvestment of shares valued at Rs 2 billion of shares in publicsector companies through secondary offerings in FY86; and

(v) introduction of bearer bonds in foreign and local currency to attract"black money" and mobilize additional resources.

The tax concessions and the increase in the supply of shares should have a posi-tive impact on the stock market. Bearer bonds which can be traded in the stockexchange and new private sector investment companies should also expand the rangeof financing sources for the corporate sector in Pakistan. The supply of newshares is aLso expected to increase sharply as most bridge loans are now ripe forconversion into equity (para. 13).

17. While the measures taken by GOP are significant, they need to be comple-mented by steps to encourage a smoother functioning of the stock exchanges,promote more market-oriented corporate finance services in the pricing and dis-tribution of securities, and develop a market for short-term corporate papers.There are a number of -additional measures which GOP should consider to improve theefficiency and expand the range of capital markets in Pakistan. These include:(i) issuing of bearer shares to attract "black money"; (ii) freeing of underwrit-ing activities; (iii) introduction of market pricing for new share issues;(iv) introduction of short-term corporate commercial papers;-and (v) licensing ofprivate commercial banking. The Government has referred these proposals to therecently established Deregulation Commission and there are good prospects thatsome or all of these measures will be implemented during FY86-FY87. GOP has alsoagreed to KSE's request to IFC for technical assistance to modernize itsoperations, which will be financed from the technical assistance component of thefirst IIC project.

18. At present, the corporate sector has no financial instruments to channel"black money" directly into productive investment. The issuing of bearer shares,a class of common stock in bearer form with the same dividend and residual assetentitlements as common stock, would direct "black money" toward equity investmentand serve to help correct the undercapitalized structure of Pakistan's corporatesector. Underwriting is presently carried out by a few syndicates of DFIs andbanks, with fees determined by a rigid administrative schedule bearing no relationto market conditions. Freeing underwriting should expand the number of under-writers and subject fees to market competition. New issue pricing is not deter-mined by the market but by the CCI. New issues are priced through a formulawhereby existing owners share one-half of the difference between the company's netasset value and par value. This acts as a strong disincentive for conversion ofprivate to public companies since existing owners perceive new floatations asexpensive giveaways and are not permitted to set share prices in accordance withmarket perceptions of the company's prospects and risk potential. Short-termmarketable commercial papers issued by established and profitable companies wouldprovide an additional source of funding outside banking systems and lead to asecondary money market which would add depth to the capital market and improve itsallocative role. The introduction of private domestic banking would add a strongelement of competition for NCBs and would expand the range and efficiency offinancial services offered. As an extension of GOP's decision to allow privateinvestment companies, the setting up of venture capital companies should also beencouraged.

-73- ANNEX 5Page 1 of 7

PAKISTAN

SECOND INDUSTLXAL INVIESTHNT CREDIT (tIC) PROJECT

Industrial Develvetmnt Bank of Pakistan (IDMP)

Income Statesomts (FYMl-MYSS)(Rs mi'.ion)

FY81 FY82 FY83 FY84 FY85(Prov.)

INCOME

Interest income 190 204 229 285 346Other income 20 23 32 45 81Total income 210 Z27 261 330 427

EXPENSES

Interest on borrowings 142 157 153 190 285Administrative expenses 29 34 37 49 53Other expenses includingprovisions for doubtful debt 25 19 -30 41 60Total expenses 196 210 220 280 371

scm = =

PROFIT BEFORE TAX 14 17 41 50 56

Less: Provision for taz 9 11 7 10 11Net income 5 6 34 40 45

FINANCIAL RATIOS(Z average total assets)

Total income 10.3 10.3 10.3 11.0 11.2Financial ezpenses 6.9 7.1 6.1 6.3 6.8Spread 3.4 3.2 4.3 4.7 4.4Administrative expenses 1.4 1.5 1.5 1.6 1.4NET INCOME 0.2 0.3 1.3 1.3 1.2

Yet profit/Average total networth 3.0 3.1 16.0 16.2 16.0

Source: IDBP.

-74- ANNEX 5Page 2 of 7

PAKISTAN

SECOND INDUSTRIAL INVESTKMENT CREDIT (IIC) PROJECT

Industrial Development Bank of Pakistan (IDBP)

Balance Sheets (FYS1-FY85)(Rs million)

FY81 FY82 FY83 FY84 FY85ASSETS (Prov.)

Liquid assets 31 44 32 33 44Investments 75 75 91 107 187Loan portfoLio 2,058 2,304 2,658 3,214 4,136Less: Provisions (178) (194) (178) (151) (203)

Loan portfolio (net) 1,880 2,110 2,480 3,203 4,164Other assets 90 115 92 100 156Total assets a/ 2,076 2,344 2,695 3,303 4,320

LIABILITIES AND NETWORTH

Current liabilities b/ 143 107 142 102 154Deposits 125 125 115 215 534

Borrowings

Foreign currency 512 554 652 758 914Foreign currency loans

repayable in rupees 89 84 81 81 80State Bank - industrial loans 325 479 653 821 1,032State Bank - cash credits 511 617 509 499 470Federal government loans 151 151 252 310 403Others 3 3 15 206 381

1,591 1,888 2,162 2,675 3,280Other liabilities 25 28 48 47 47Paid-in capital 100 100 100 100 157-Reserves 92 96 128 164 148Total networth 192 196 228 264 305

Total liabilities and networtb 2,076 2,344 2,695 3,303 4,320=__ ==

Debt:equity ratio cJ 4.5 5.6 4.1 4.2 4.2

a/ Net of assets and liabilities in Bangladesh.b/ Excluding current maturity.c/ Including subordinated debts.

Source: IDBP.

UA.AEX 5-75- Page 3 of 7

-PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Industrial Development Bank of Pakistan (IDIP)

Projected Income Statements (FY85-FY90)(Re million).

FY86 FY87 FY88 FY89 FY90INCOME

Interest on loans 453 587 723 869 1005Interest on short-term investment 36 59 80 95 120Fees & other income 62 68 75 83 91Total income 551 714 178 1,047 1,216

EXPENSES

Interest on F.C. loans 80 182Other financial expenses 256 334 447 536 629Administrative expenses 61 70. 81 93 107Provision for doubtful debt 74 94 96 108 106Total expenses 471 598 750 893 -1024

Profit before tax 80 116 128 154 192Taxation 24 46 73 88 110Net profit 56 70 55 66 7

_- = -

FTNANCIAL RATIOS(Z average total assets)

Gross income 11.8 11.5 11.7 11.8 11.8Financial expenses 6.9 '7.0 7.6 7.8 7.9Spread 4.4 4.5 4.1 4.0 4.0Administrative expenses 1.2 1.1 1.1 1.0 1.0Net profit 1.2 1.1 0.7 1.7 0.8

Provisions/Year-end portfolio 6.2 6.7 7.2 7.7 8.2Net profit/Average total networth 16.9 17.9 12.3 13.2 14.4

Source: IDBP.

ANNEX 5-76- Page 4 of 7

PAKISTAN

SECOND INDUSTRIAL INVESTHENT CREDIT (IIC) PROJECT

Industrial Dmvelopient Bank of Pakistan (IDBP)

Projected BaLance Sheets (FY86-PY90)(as million.)

FY86 FY87 FY88 FY89 FY90ASSETSCash & bank balances 50 59 67 74 82Accrued interest & other assets 127 127 127 127 127Investments 548 763 894 1,205 1,544

Local currency loans 2,755 3,502 4,000 4,523 4,990Foreign currency loan* & guarantees 1,718 2,046 2,492 2,941 3,317Working capital loans 550 750 1,000 1,300 1,500Total loan portfolio 5,023 6,298 7,492 8,764 9,807

Less: Provisions for doubtfuldebts (277) (371) (467) (575) (681)

Net loan portfolio 4,746 . 5,927. 7,025 8,189 9,126

Fixed assets (net) 22 26 30 34- 38Amount recoverable from Govt. 1 1 1 1 1Contingent rupee assets 2 2 2 2 2Total assets 5,496 6,905 8,146 9,632 10,920

- - -= =2

LIABILITIES & NETWORTHCommercial deposits 684 959 1,259 1,584 1,934Accounts payables 140 126 151 177 200Provision for income tax (9) (9) (9) 899 (9)

Rupee borrowings 2,706 3,413 3,886 4,428 4,965Rescheduled borrowings 300 401 401 401 401Foreign currency borrowing andguarantees 1,168 1,443 1,836 2,218 2,519

P.T.C. 150 150 150 300 300Total L.T. borrowings 4,324 5,407 6,273 7,347 8,185

Share capital 157 157 157 157 157Reserves 190 249 293 348 413Special development assistance fund 9 9 9 9 9P.T.C. redemption fund - 6 12 18 30Networth 356 421 471 532 609

Contingent rupee liabilities 1 1 1 1 1Total liabilities & networth 5,496 6,905 8,146 9,632 10,920

l -= zS=== - _

Debt:equity ratio 3.8 4.1 4.7 4.7 5.0

ANNEX 5-77- Page 5 of 7

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Industrial Development Bank of Pakistan (IDBP)

Projected Cash Flow Statements (FY86-FY90)(Rs million)

FY86 FY87 FY88 FY89 FY90SOURCESNet profit 80 116 128 150 192Add: Non-cash transaction

-- Depreciation 2 2 2 2 2Provision for losses 74 94 96 108 106

Less: Income :redited to profitand loss account but notreceived (102) (105) (124) (130) (123)

Add: Expenditure debitqc to ,profit & loss accountbut not paid 57 *62 39 40 40

CoLlection of advances (Prin.) 235 260 294 363 440Income tax paid (24) (46) (73). (88) (110)Interest expenses 336 434 573 692 811Available for debt servicing (A) 658 817 953 1,141 1,356

Drawn down on borrowings.cal currency 339 482 600 664 658

- Foreign currency 364 402 514 546 503- IDA credit for SIRD 288 346 - - -Increase in comm. deposits 150 275 300 325 350Increase in industriaL deposits 20 20 20 20 20Recovery of working capital loan 289 550 750 1,000 1,300P.T.C. issues 150 - - 150 -Total 2,258 2,892 3,119 3,841 4,189

APPLICATIONSRepayment of borrowing

-- Local currency 85 121 127 122 122Foreign currency 70 88 121 159 203

Interest expenses 336 434 573 692 811Required for debt servicing (B) 491 643 821 973 1,136

Disbursement of loans-- Local currency 339 482 600 664 658-- Foreign currency 364 402 514 541 503-- Working capital loan 550 750 1,000 1,300 1,500-- IDA credit for SIRD 288 346 - - --ayment of other liabilities 39 39 39 39 39Increase in fixed assets 6 6 6 6 6Increase in investment 175 215 131 311 339Total uses 2,252 2,883 3,111 3,834 4,181

jurpLus/(Deficit) 6 9 8 1 8Opening cash & bank balance 44 50 59 39 74Closing cash & bank balance 50 59 67 41 82

Debt Service Coverage Ratio (A/B) 1.3 1 .2 1.1 1.2 1.2

ANNEX 5-78- Page 6 of 7

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Industrial Development Bank of Pakistan (IDBP)

Analysis of Amounts Due and Recoveries (FY81-FY85)(Rs million)

FY81 FY82 FY83 FY84 FY85

A. Opening Balance 1,811 863 1,097 993 864

B. Amount Fallen Due:i) Against past dues 150 73 93 85 91ii) Current 207 314 372 455 431iii) Total Fallen Due 357 387 465 539 573

C. Foreign Exchange Adjustment (150) 119 53 1 44

D. Total Dues (A+B+C) 2,018 1,369 1,615 1,533 1,485

Ew Cash Collection:i) Arrears 115 89 98 89 64ii) Current 97 159 216 272 361iii) Total 212 248 314 361 425

F. Rescheduling/Adjustment 943 24 262 303 200

C. Closing Balance (D-E-F) 863 1,097 1,039 869 860

RATIOS {Z):

i. Cash collection-current 27 41 47 50 63to total Fallen dueE(ii) as Z to B

ii. Cash collection arrears 6 10 9 9 7to opening balanceE(i) as Z to A

iii. Cash collection as Z to 11 18 20 24 29total dues (E as X to D)

iv. Rescheduling and adjustment 47 2 16 20 13as X to total dues(F as Z to D)

v. Total collection rescheduling 58 20 36 43 42and adjustment as Z to totaldues (E+F as Z to D)

vi. Cash collection current 47 51 59 60 75as X to amount fallen duecurrent E(ii) as Z to B(ii)

ANNEX 5Page 7 of 7-79-

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Industrial Development Bank of Pakistan (IDBP)

Analysis of Amounts Due and Recoveries (FY86-FY9O)(Rs million)

FY86 FY87 FY88 FY89 FY90

A. Opening Balance 883 848 861 846 819

B. Amount Fallen Due:i) Against past dues 93 108 135 166 197ii) Current 572 655 793 953 1109iii) Total fallen due 665 763 928 1,119 1,306

C. Foreign Exchange Adjustment - - - - -

D. Total Dues (A+B+C) 1,548 1,611 1,789 1,965 2,125

E. Cash Collection:i) Arrears 79 109 148 181 233

ii) Current 421 491 595 715 832iii) Total 500 600 743 896 1065

F. Rescheduling/Adjustment 200 150 200' 250 300

C. Closing Balance (D-E-F) 848 861 846 819 760

RATIOS (Z):

i. Cash collection-current 63 64 64 64 64to total fallen dueE(ii) as Z to B.

ii. Cash collection as Z to 32 37 42 46 50total dues (E as Z to D)

iii. Cash collection arrears 9 13 17 21 28to opening balance(E(i) as Z to Al

iv. Rescheduling and adjustment 13 9 11 13 14as X to total dues(F as Z to D).

v. Total collection rescheduling 45 47 53 58 64and adjustment as Z to totaldues (E+F as Z D)

vi. Cash collection current 74 75 75 75 75as Z to amount fallen duecurrent [E(ii) as Z to B(ii)]

-80-

A^RM 6Page 1 o1 4

ISCOND DDSTXIAL INVSm UTC CEDMIT tIIC) PiOJECT

National Develomment Finance Corporation MMDP)

Coouar atLs aleenee Sbeets (1980-1984)(1 mllion)

Current AssetsLiquid asset. &/ 305 252 211 377 540Acerued interemt on inveaetnt 9 12 17 75 50Accrued interest and charge on loan 68 67 117 125 209Depoeit and prepaymant -A 6 i6 113.

Iuvesuutnt (at cost)Equity , 53 56 56 60 103Goverment bonds and loans, treasury

deposit and debentures 15 512 5Z4 1 394 h49* - L 568 580 ~~nL1.454 6

Principal 1,904 2,303 3,276 3,741 5,156aterest in arrears 26 57 63 129 123kMa Prowi ion for doubtful lon (16) (21 6 cM)o4g 11)

1914 2.239 3,2.5 3 804 5,173Fixed assets (net of depreciation) I 4 __0 381 8.2TOTAL ASSZTS 2.571 3.148 4,251 5.939 6,767

Liabilities and BcmitvCrent LiabilitieJ i-

Accrued interest and expenes Ill 120 170 235 290Sundry creditors a 9 10 16 12Provision for dividends 13 13 26 36 43Others 6, -a 40 35 -

ii 15_2 246 m 3aTim deposits Si

Less than 12 months maturity 992 1.134 1,640 2,722 3,011more than 12 months maturity 335 434 368 379 _63

1,327 1-568 08 30 aO 337*Borrowings

Foreign curr&en 347 394 624 834 978Local currenc 409 522 785 880 1,131Boads - _ -0 ..0 20 200

NetworthPaid-ia capital 132 132 132 132 132Statutory reserve 126 169 229 310 405Continency reserve 92 96 91 102 100Rend redinption resrve --- 15 29- 58 87

30 411 498 602 __MTOTAL LxIxLTTE AMD NEIO7RU 2.751 3.148 4,251 5,939 6.767

CGuarantees 6. 100 136 99 81

Debt:equity ratio 3.3 3.8 4.1 4.0 3.6

SI Liquid asets corises cash on hand and in bank.h z eludes ecrent saturity of deposits and borrois.pqi Deposits with fixed mturities.

(

ANNEX 6Page 2 of 4

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

National Development Finance Corporation (NDFC)

Comparative Income Statements (1980-1984)(Rs million)

1980 2.981 1982 1983 1984Income

Interest on loans 187 221 302 378 484Other loan charges 9 16 20 30 50investment income and intereston bank deposits - 47 47 88 192 177

Profit on sale of investment 10 6 6 7 -Dividend income 2 - 3 4 12 14Total income 255 293 420 619 725

Expenses

Interest 157 189 270 414 464Comitment fees and other charges 2 1 5 5 7Provision for doubtful loans 6 11 23 22 42Salaries 5 7 10 16 26Other administrative expenses 5 8 13 22 38Total ezpenses 175 216 321 479 577

Net profit 80 77 99 140 148

Financial Ratios (Z)

Net profit/average total assets 3.4 2.7 2.7 2.7 2.3Net profit/average netuorth 25.3 20.2 22.0 25.7 22.3Admin. exp./avg. loan portfolio 0.5 0.7 0.8 1.1 1.4Admin. exp./avg. total assets 0.4 0.5 0.6 0.7 1.0

-82-

AM= LPage 3 of 4

SlCORD NDDUITL INVTI1 CREDI? (TIC) PROJCT

National Daveloument Finance Cornoration (UDPC)

Proigeted Balanee Sbcet (198O1989)(as million)

(Actual)Assets~ ~ ~~ Vel

Currenlt AmetILLiqid assets j/ 540 55 62 58 133 59Aecrid intereit on invesbant 50 50 S0 50 S0 SOAccrud interest and charges oan loan 218 247 323 416 512 609Deposit and prepaymnt 113 124 1 130 m. 14

IZnestme (at cost)Equity 103 130 1S0 10 205 230Goverent bonds and lons. treasurydeposit and debentures 497 lQ 1 000 1-325L 1,525

600 1.130 .75 1-380 1-30 1-5loon PortfolioPrincipal - 5,158 6,781 8,936 11,17 13,415 15,840Interest in arrears 114 151 - 148 164 157 186

T.: Provision for doubtful lona (flO8 (149 _JL) (19j) (4f376) (47)5.164 683 8.870 -11,060 13.196 -1-. 55

Fixed asets (net of depreciation) 82 152 173 190 196 197TOTAL ASSM 6.767 8,482 10,778 13,284 15,752 18,361

Liabilities and EloitvCurrent LIabilities k/

Accrued interest and zpenaee 290 350 400 . 400 S00 550Sundry creditors 12 S0 60 70 80 90Proision for dividends 43 43 53 63 73 73Others _S 30 5 60 _a 70Z

ui~~~ ~~ A1foit SJMI fl Less than 12 months mturity 36011 3,145 3,US 3,910 4,497 5,171Moe tha 12 months mturity 36 S5 615.l~ 690.2R 793.fl 9..12

3374 3.710 4.100 4.60 5.Z90 6.083Borrow

Foreign eurreacy 978 1,446 2.151 2,943 3,775 4,635Local currency 1,131 1,532 2.030 2,618 3,143 3.795Donds 200 S00 841 1A 1.110 976

2.309 3.478 5-0Z 6,677 8.028 9.406Netvorth

Paid-in capital 132 132 182 232 282 282Statutory reserve 405 514 645 820 1,041 1.305Contingency reserve 100 115 113 141 208 303Bond redemption reserve . 7 1L5 1U. __IL 18S 199

724 876 1JS$ J.67 17 1.6 2.089TOTAL LIA3JLXTIS AND UITPOIR 6,767 8,537 10,778 13,284 15,752 18,361

Guarantees 81 100 120 130 140 150

Debt:eqnity ratio 3.8 4.7:1 5.2:1 5.4:1 5.2:1 5:1

u Liquid assets cmprises cseh oon band and in bank.Ei Excludes current matrity of deposits and borrowings.

£ Deposits with fied mturities.

-83- ANNEX 6Page 4 of 4

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

National Development Finance Corporation (NDFC)

Projected Income Statements (1985-1986)(Rs million)- S

1984 1985 1986 1987 1988 1989Income (Actual)

Interest on loans 484 742 969 1,249 1,538 1,829Other loan charges 50 42 46 49 54 58Investment income and intereston bank deposits i77 144 130 142 163 184

Profit on sale of investment - - - - - -Dividend income 14 21 26 30 35 39Total income 725 949 1,171 1,470 1,790 2,110

Expenses

Interest 464 643 809 1,008 1,218 1,434Commitment fees and other charges 7 5 5 5 5 5Provision for doubtful loans 42 41 65 77 85 99Salaries 26 35 40 46 53 61.Other administrative expenses 38 47 54 62 71 82Total expenses 577 771 973 1,198 1,432 1,681

Net profit 148 178 198 272 358 429

Cash dividend 26 26 36 46 56 56

Financial Ratios (Z)

Net profit/average total assets 2.3 2.3 2.1 2.3 2.5 2.5Net profit/average networth 22.3. 22.3 20.2 22.2 23.2 22.5Admin. exp./avg. loan portfolio 1.4 1.4 1.2 1.1 1.0 1.0Admin. exp./avg. total assets 1.0 1.1 1.0 0.9 0.9 0.8

-84- m cAN 7Page 1 of 4

PAKISTAN

SECOND INDUSTRIAL INVESTMET CREDIT (IIC) PROJECT

Pakistan Industrial Credit and Investment Corporation (PICIC)

Income Statements (1980-1984)

(Ru million)

1980 1981 1982 1983 1984Incou -

Interest income 190 174 205 258 316Commitment fees 9 25 25 48 23Income - short-term investments 12 12 10 10 10

- Income - equity investments 9 15 20 22 43Total income 220 226 260 338 392

Expenses

Interest on borrovings 151 155 183 222 254Comitment fees - - - - -Administrative expenses 21 19 21 25 22Depreciation - - - 1 1Provision for doubtful debts 4 2 9 20 16Portfolio write-offs - - - 11 20

Total expenses 176 176 ,213 279 313

Net income s4 50 47 59 79Less: income taxes (6) (12) (15) (16) (17)

Net income (after taxes) 38 38 32 43 62

Dividend - - 11 14 16

RatiosMet profit/avg. networth (X) 9.0 10.0 '.3 9.0 12.6Net profit/avg. total assets (Z) 1.1 1.3 1.0 1.3 1.7Long term debt/equity ratio 5.4 5.1 5.1 5.9 6.3Admin. ezp./avg. total assets 0.7 0.7 0.7 0.7 0.6Admin. ezp.lavg. loan portfolio (Z) 1.2 1.1 1.0 1.1 0.8

Source: PICIC.

-85- ~~~~~~ANNME 7-85- Page 2 of 4

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Pakistan Industrial Credit and Investment Corporation (PICIC)

Balance Sheets.(1980-1984) 1/(Rs million)

1980 1981 1982 1983 1984Assets

Cash and short term deposits 97 80 115 120 123Securities 19 14 7 20 21Sundry current assets 25 23 70 103 115Accrued interest 507 535 570 645 637Loan portfolio (gross) 1,793 1,811 2,425 2,639 3,167Less: reserves (94) (99) (104) (224) (238)

Loan portfolio (net) 1,699 1,712 2,321 2,415 2,929Equity investments 98 97 104 105 110Fixed assets (net) 1 1* 1 4 5

Total assets 2,446 2,462 3,188 3,412 3,940

Liabilities and NetWorth

Current liabilities 74 87 221 164 172Long term borrowings 2,001 1,985 2,484 2,780 3,255Total Liabilities 2,075 2,072 2,705 2,944 3,427

Paid-up capital 92 92 110 110 110Reserves-retained earnings 279 298 373 358 403Networth 371 390 483 468 513

Total liabilities and networth 2,446 2,462 3,188 3,412 3,940

Long term debt:equity ratio 5.4 5.1 5.1 5.9 6.3

1/ Assets and liabili.ties in East Pakistan are excluded.

Source: PICIC.

-86- ANNEX 7

Page 3 of'4

PAKISTAN

SECOND INDUSTRIAL INVESTHENT CREDIT (IIC) PROJECT

Pakistan Indlistrial Credit and Investment Corporation (PICIC)

Projected Income Statements (1985-1988)(Rs million)

1985 1986 1987 1988Income

Interest income 400 487 642 783Commitment fees 43 55 58 59Income-equity investments 18 19 20 22

Total income 461 561 720 864

Expenses

Interest-short term borrowings 91 99 131 189Interest-Long term borrowings 176 ,211 261 313Commitment fees 5 6 6 7Administrative expenses and depreciation 32 34 37 .40Provision for doubtful debts 15 21 28 30Portfolio write-offs 5 .6 7 8

Total expenses 324 377 470 587

Net income 13- 184 250 277Less: income taxes (60) (84) (116) (130)

Net income (after taxes) 77 100 134 147

Dividend 17 17 17 17

Ratios

Net profit/average net worth (Z) 14.3 16.5 18.9 17.6Net profit/average total assets (Z) 1.8 2.0 2.1 1.9Admin. exp./avg. total assets 0.8 0.7 0.7 0.5Admin. exp./avg. loan portfolio (Z) 1.0 0.9 0.8 0.7

Source: PICIC.

-87- ANNEX 7Page 4 of 4

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Pakistan Industrial Credit and Investment Corporation (PICIC)

Projected Balance Sheets (1985-1988)(Rs million)

1985 1986 1987 1988Assets

Cash 216 319 371 505Securities 24 - 25 -Sundry current assets 35 1 36 1Accrued interest 808 938 1,076 1,278Loan portfolio (gross) 3,490 4,268 5,543 6,574

Less: reserves (147) (173) (208) (246)Loan portfolio (net) 3,343 *4,095 5,335 6,328Equity investments 105 105 10' 105Fixed assets (net) 14 21 .21 21

Total assets 4,545 5,479 6,969 8,238

Liabilities and Networth

Current liabilities 226 388 859 1,110Foreign borrowings 2,058 2,517 3,141 3,705Local borrowings 1,695 1,925 2,205 2,532

Total liabilities 3,979 4,830 6,205 7,347

Paid-up capital 110 110 110 110Reserves and retained earnings 456 539 654 781

Networth 566 649 764 891TotaL liabilities and networth 4,545 5,479 6,969 8,238

Ratios

Long-term debt:equity ratio 6.6 7.0 7.0 7.0Debt service coverage ratio

1/ Assets and liabilities in East Pakistan are excluded.

Source: PICIC.

-88- ANNEX 8

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT 1/

Projected Disbursements 2/(USs million)

Credit T.A. Total Z 3/FY87Si 7.3 0.2 7.5 5S2 14.8 0.2 15.0 15

22.1- 0.4 22.5 15FY88S1 10.0 0.2 10.2 22S2 11.9 0.4 12.3 30

21.9 0.6 22.5 30FY89Si 14.5 0.4 14.9 40S2 14.5 0.6 15.1 50

29.0 1.0 * 30.0 50FY90Si 18.5 - 18.5 63S2 19.0 19.0' 75

37.5_- 37.0 75FY91

Si 7.5 7.5 80S2 7.5 .7.5 85

15.0 * 15.0' 85FY92Si 7.5 - 7.5 90S2 7.5 - 7.5 95

15.0 - 15.0 95FY93Si 7.5 - 7.5 100S2 -_ ___

7.5 - 7.5 100

TOTAL 148.0 2.0 150.0

1/ Assuming that the loan becomes effective on May 1, 1986.

2/ The regional profile for Pakistan indicates a 7- to 9-year disbursementperiod. However, with six PFIs, disbursement is anticipated to beconsiderably faster.

3/ Percentages are cumulative.

-89- AN 9

PAKISTAN

SECOND INDUSTRIAL INVESTMENT CREDIT (IIC) PROJECT

Selected Documents and Data Available in Project File

A. The Manufacturing and FinanciaL Sector

1. Sixth Five Year Plan (FY83 - FY87)

2. Pakistan - Industrial Sector Strategy Paper (November 1, 1983)

3. Review of Pakistan's Financial System and Impact on InudstrialInvestment, IBRD Working Paper, July 1982

4. State Bank of Pakistan, Annual Report (1983-1984)

5. A Comparative Analysis of the Nationalized Commercial Banks and ForeignBanks Operating.in Pakistan, June 1984

6. The Islamization of Pakistan's Financial Sector, P. Popiel and I. Dalla,December 1984.

7. Capital Markets, Khalid Mirza, IFC.

B. Project Related Reports and Documnts

8. Agreed Minutes of Negotiations

9. HBL's Annual Report (1984)

10. EBL's Policy and Strategy Statement

11. MCB's Annual Report (1984)

12. MCB's Policy and Strategy Statenent

13. UBL's Annual Report (1984)

14. UBL's Policy and Strategy Statement

15. IDBP - Analysis of Operations and Pinancial Position

16. IDBP's Annual Report (1983-1984)

17. IDBP's Policy and Strategy Statements

18. NDFC - Analysis of Operations and Financial Position

19. NDFC's Annual Report (1984)

20. NDFC's Policy and Strategy Statement

21. PICIC - Analysis of Operations and Financial Position

22. PICIC's Annual Report (1984)

23. PICIC's Policy and Strategy Statements

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