Economy: rent-seeking through revolving doors

In Pakistan, the risk reward mechanism on investment is lopsided, and that is one of the reasons for the low productivity and lack of ingenuity in entrepreneurship in Pakistan. There are abnormal returns on equity in low-risk businesses where either return is guaranteed (power sector), or demand is ensured – such as fertilizer companies.

In other industries, import protection is enough to have returns for inefficiencies – for example automobiles, where price is regulated – such as oil and gas marketing companies. And in the competitive exports market, the only darling is textile, which traditionally has relied on subsidies and its inefficiencies are washed out by periodic currency devaluation.

The banks don’t lend to those who take risks in the private sector, and for the last decade or so, the banking model is simple – run bank branches as deposits shop to sell zero-cost current accounts (and so-called innovative products such as bancassurance) and let the treasury department to make returns on investing these in government papers. And whatever is left for lending is for those low risk (and protected) businesses. That makes banking a low-risk business, as well.

The businesses work on the concept of expected returns. As an entrepreneur, when you know that low risk businesses can have guaranteed returns, ensured demand or protection from outside work, why would anyone invest in riskier ventures? The returns on low risk are ensured high while the high-risk businesses have a probability of losing out too, and that makes expected returns on low risk higher than the riskier. That makes the structure lopsided and aversion of business groups to invest, and banks to lend.

This makes Pakistan a strange country where risk taking is simply not rewarded, and the free-market mechanism is crippled. The players that take risks ought to compete with others, which are not taking risks and have higher returns; so over the period risk takers lose out. That is why the SMEs (small and medium enterprises) in Pakistan do not grow. This is hollowing out the SMEs and limiting the development of new breed of entrepreneurs.

In Pakistan, most big businesses are in hand of a few families. Those who aren’t often become family members of those who do through marriage. The big businesses are like a clan, and they protect their turf, and resist if someone (from SMEs) attempts to become big, by using their clout and stop them from entering into big leagues.

No economy can grow and compete where new and innovative ideas are not rewarded, where risk taking is discouraged. The mind-set needs to be changed. A new breed of entrepreneurs is warranted, and the breeding ground is SMEs.

Small factories in Pakistan do not get loans from banks and other formal lending agencies. They rely on personal finance – and borrow from friends and families. And people usually take limited risk on personal finance. And here the role of banks, development finance institutions, venture capitalists and private equity finance comes into play.

However, banks in Pakistan (as other lending institutions rarely exist) are afraid of non-performing loans. A certain amount of NPLs (non-performing loans) is good, and banks should encourage risk taking, and find successes from failures. But why would banking owners (dominated by seths) would do that when they make abnormal profits by lending to low-risk ventures.

Venture capital and private equity funds are missing in Pakistan, and if there is any funding in small projects, that is by funds situated outside Pakistan. Lenders do not think much beyond businesses, which are in the brick and mortar business. No one really values intellectual capital.

The country badly needs to expand exports. However, there is no big sector except textile, and within textile, players are less innovative and competitive (barring a few exceptions). They are mostly inefficient, and these inefficiencies are periodically washed out through currency devaluation. And by this, the import substitution companies’ protection against imports remains intact.

The problem is that the private businesses’ debt is denominated in Pak Rupee while the forex is arranged by the government. That is another lop-sidedness in the Pakistani economic system.

The skewed risk reward system is one manifestation of the boom-and-bust cycles whose frequency is growing while the wavelength is shortening. It appears that the existing model has ran out of its productive life, and until the country does not get new breed of entrepreneurs, it will keep swimming in sand.

Copyright Business Recorder, 2024