Export ambitions vs economic realities

While the Government is seeking a 100% increase in exports over the next three years, maintaining even the current level would be miraculous given current economic policies that fail to promote industrialisation or exports.

Last week a high-level committee began consultations on rationalizing import tariffs with a view to increasing exports to $60 billion. Simultaneously, the FBR undermined industrial competitiveness and exports by withdrawing the sales tax exemption on locally manufactured inputs for export manufacturing, disproportionately impacting SMEs, especially in upstream segments.

This sales tax does not impact a small number of large vertically integrated firms, providing them with an edge over many unintegrated firms staggered across the value chain. It also makes duty-free and sales tax-free imports of the same inputs through the Export Facilitation Scheme more attractive than local procurement as unintegrated firms in downstream segments must now pay sales tax on the latter and wait several months for it to be refunded, if at all.

That the EFS does not extend across multiple stages of the value chain, combined with existing and fresh import duties including 2% additional customs duty on all 0% base tariff goods, reinforces this as enterprises in upstream segments, like yarn and cloth manufacturers, cannot import duty-free inputs since their products go through multiple stages of production before reaching the final exporter.

This follows SRO 350(I)/2024 that requires linking up the entire supply chain to file sales tax returns, conditioning them on compliance by upstream suppliers. Firms are blocked from filing their returns on time due to upstream suppliers’ non-compliance, resulting in sales tax already paid by them to be disregarded and incurring substantial penalties. Government-owned entities in the energy sector top this list, frequently delaying filing and preventing their consumers from doing the same.

The rule has cascading effects; when a buyer cannot file their return, their customers also cannot claim input sales tax, leading to further delays. Despite persistent requests and the Prime Minister’s assurances, the FBR is yet to address these issues.

Then comes the energy sector; one of the most significant factors contributing to the low competitiveness of Pakistan’s textile industry, and overall manufacturing, is the prohibitive cost of energy. While the government took an appreciable step to reduce cross subsidies embedded in industrial power tariffs by around Rs. 150bn, they have not been eliminated entirely.

Simultaneously, unutilized capacity costs in the power tariff have ballooned so much that for the upcoming year industrial power tariffs will range between 15-17 cents/kWh compared to 6-9 cents/kWh in competing economies.

The same disparity exists in gas/RLNG prices, with gas supplied to industry in Bangladesh, for example, costing as low as $7.4/MMBtu, while rates for Pakistani industry are as much as $14/MMBtu.

While on one hand the government is reducing cross subsidies in power tariffs, on the other, RLNG consumers are being subject to a Rs 50 billion cross subsidy to the fertilizer sector, increasing the cost of gas supplied to industries.

There are also ill-advised and impractical plans to cut-off gas supply to captive power plants by January 2025, despite the fact that the grid is in no position to supply the quantity or quality of power required by manufacturing units. This move will force them onto a financially unviable grid, leading to more closures and severe negative impacts on employment and the economy.

The textile sector—responsible for over half of the economy’s exports and employing up to 40% of the industrial workforce—has been struggling to compete internationally for the past two years as the sector’s exports have declined from $19.3bn in FY22 to $16.7bn in FY24.

The government should be actively cutting down red tape and slashing expenditures to reduce the fiscal burden on the private sector and bringing manufacturing costs at par with international levels. Instead, it is continuously ignoring on-the-ground realities and going against economic fundamentals.

Comparisons with major competitors such as India, Bangladesh, and Vietnam highlight significant disparities in key input costs like energy and an overall high cost of doing business that erode Pakistan’s competitiveness in the international market.

The minimum wage—an indicator of labour costs—is around $0.64/hour in Pakistan compared to $0.55 in Bangladesh, $0.68 in India, and $1.59 in Vietnam. While Pakistan enjoys relatively competitive labour costs, this does not offset the high energy costs and other inefficiencies.

Moreover, the lack of investment in skill development and technological advancements means that Pakistani labour is less productive compared to its counterparts in these countries.

Similarly, while Pakistan has an advantage with domestic cotton production over countries like Bangladesh, its yield and productivity are low and there are serious quality issues that make it unfit for export without mixing with higher quality imported cotton. These productivity and quality gaps further exacerbate the un-competitiveness of Pakistan’s textile industry.

To add to these challenges, the budget has increased the tax on export proceeds from a 1% fixed tax regime to 2% advance tax on export proceeds, adjustable against a 29% tax on profits plus a 10% super tax.

Not only is this significantly higher than regional benchmarks, the advance tax increases cost of compliance and dries up liquidity in low-margin high-volume businesses like textiles, leaving no space for working capital or reinvestment.

In contrast, regional economies offer a highly favourable environment for exporters. In Bangladesh, export-oriented industries are eligible for exemptions from income tax for up to 50% of their earnings and preferential income tax rates of 10-12%.

India provides substantial incentives as well, including rebates of state and central taxes and levies for exporters, rebate of up to 3% of the turnover of new export-oriented units and R&D finance for up to 80% of project costs. Vietnam’s policy environment is similarly favourable, with lower corporate tax rates and extensive support for export enterprises.

The financial support available to exporters in Pakistan is inadequate and prohibitively expensive compared to its competitors as caps on financing schemes like EFS and LTFF have not been increased despite repeated demands from the industry.

Bangladesh offers 15% cash credit for pre-shipment expenses and post-shipment finance at 50-80% of the Letter of Credit (L/C) value. India provides pre- and post-shipment working capital financing through foreign exchange accounts and term loans for capital expenditures.

Vietnam and India also facilitate long-term financing for the acquisition of plant machinery and ancillary equipment. In contrast, Pakistani manufacturers face high benchmark interest rates at 20.5%, significantly higher than the 8.5% in Bangladesh, 6.8% in India, and 5.3% in Vietnam.

While TERF was successful in supporting the upgradation and expansion of production capacity across the industry, much of this investment was never operationalized due to unviable energy and other operational costs.

India and Bangladesh also have more favourable policies regarding the import of raw material and intermediate inputs, offering lower import duties and other support to their textile and apparel sectors.

Vietnam has signed multiple free trade agreements (FTAs) that allow for duty-free import of raw materials, significantly reducing production costs. In contrast, Pakistan imposes 5% and 7% import duties in addition to up to 12% anti-dumping duty on imports of purified terephthalic acid and polyester staple fibre, basic raw material for man-made fibre-based products, to protect select inefficient manufacturing facilities that keep domestic PSF prices around 20% above the international market.

The result of these disparities is that Pakistan has seen its exports, as well as the domestic value addition in exports, plummet.

According to the PBS, yarn production is down by ~30% compared to FY22 and cloth production by ~20%. Importing intermediate goods has become cheaper than procuring the same domestically due to increasing costs and tax and compliance burden, as evidenced by a dramatic surge in imports of cotton yarn, up seven times from 2 million KG in July 2023 to 14 million KG in May 2024, because the basic textile industry cannot compete—even in the local market—and is thus being wiped out.

These trends have serious economic implications. The economy has an annual foreign exchange shortfall of over $25bn. Any reduction in exports or domestic value addition in exports exacerbates this shortfall. The country desperately needs higher exports with significant domestic value addition to meet its foreign exchange requirements.

Furthermore, Pakistan has a large, young, and unskilled population that needs employment opportunities to escape poverty. Manufacturing export-led growth represents the only viable solution for addressing these issues and avoiding a major social and political catastrophe.

Yet, the FY25 budget fails to prioritize the growth of this important sector and has significantly increased the challenges facing it, further diminishing its ability to compete internationally. To expect the manufacturing base and exports to increase and the economy to grow under these circumstances is purely unrealistic; even maintaining the current level of exports would be miraculous.

To turn the tide around, a major reorientation in policies, reduction in energy costs, and a holistic export-focused strategy are essential.

Copyright Business Recorder, 2024