A requiem for manufacturing?

Amidst a deepening economic crisis, the government seems intent on pushing the economy’s most vital sector—the textile industry—off a cliff. Instead of confronting real issues, officials are choosing policies that strangle an industry capable of driving economic growth and stability and supporting millions of livelihoods through productive jobs.

The slow asphyxiation of textile manufacturing, however, isn’t just a policy failure; it is more and more a deliberate dismantling of the very engine that could power Pakistan’s economic revival. If there is a strategy behind this, it is one that sacrifices long-term growth for short-term survival, with devastating consequences unfolding in real time.

Energy costs, whether for electricity or gas, remain prohibitively high. While the government has removed a substantial portion of the Rs 240 billion cross-subsidy from industrial power tariffs, Rs 75-100 billion remain. The economic downturn and escalating grid tariffs have also suppressed power demand so much so that around 30% of the power tariff is now comprised of stranded costs, which represent capacity payments for unutilized capacity, as only around half the generation capacity is ever used.

Moreover, the power sector is rife with inefficiencies—high line losses, under-collection of billing, outdated and inadequate infrastructure—that further inflate power costs, making industrial grid tariffs around twice the regional average and rendering manufacturing sectors internationally uncompetitive. We estimate that the stranded cost and other inefficiencies account for around 50% of the final consumer tariff and should these be managed correctly power tariffs can be easily brought within the regionally competitive range.

When government officials are confronted with this issue, however, their scripted response highlights the recent reduction in the cross-subsidy, without ever discussing the inefficiencies nor their economic consequences. This completely misses the point.

The question is simply whether Pakistani manufacturers face energy costs at par with their regional competitors—they do not. Until the spectrum of power sector inefficiencies is wholly addressed, industrial growth in Pakistan, particularly in the textile sector, remains a distant reality.

The situation with gas is equally dire. With an unreliable and unaffordable power grid, around 80% the industry that has survived has done so only through gas-fired captive generation. Captive power plants are an integral part of the industrial process as most are high efficiency combined heat and power plants that, in addition to power, provide hot water and steam for use in various applications across manufacturing value chains. Manufacturing export-quality products requires a stable and reliable supply of electricity which the grid, in its present form, cannot provide.

Over the past year, gas/RLNG prices for captive consumers have surged to well over $13/MMBtu. RLNG is being sold at significantly above cost, with explicit overcharging to offset revenue shortfalls from supplying highly subsidized RLNG to the fertilizer sector.

Additionally, despite clear ECC directives specifying that RLNG volumes and prices should be ring-fenced for UFG benchmarking, with transmission losses capped at 0.5% and distribution losses based on actual figures, OGRA has failed to establish a UFG benchmark for RLNG. Instead, the excessive UFG standards for natural gas are being applied to RLNG consumers, imposing undue financial burdens.

Adding fuel to the fire, the government has also committed to the IMF that it will cut off captive gas supply by January 2025, without any consideration of the catastrophic economic consequences this will have. Pakistan is already locked into long-term LNG contracts, with the power sector and captive consumers being main off-takers.

However, because of various factors, including mismanagement and outdated planning methods, the system regularly faces surplus RLNG, which must then be diverted to highly subsidised domestic consumers at a significant cost to the exchequer.

If captive consumers are cut off from the network, this will severely exacerbate the surplus RLNG issue, forcing the surplus to be diverted to domestic consumers, adding to the circular debt which is already at ~Rs 3 trillion, or to the power sector, forcing deviations from the economic merit order with additional costs passed on to consumers through higher fuel prices. A price-reopener for these contracts is scheduled for next year and this opportunity should be used to significantly reduce the price and volumes of contracted LNG, thereby creating space for a market-driven gas system.

Moreover, as acknowledged by power sector officials, there is simply not enough power available in the South to meet the energy demand currently being fulfilled through captive generation. Similar issues plague the North, where several industrial applications for load enhancement have been pending for over three years.

And finally, with gas/RLNG priced at over $13/MMBtu for captive consumers, they are the highest-paying customers of SSGC and SNGPL, effectively cross-subsidizing all other consumers. Cutting off gas to captive consumers will financially cripple both Sui companies, with high risk of cascading default across several state-owned entities, which will eventually reach the Government of Pakistan.

In the taxation domain, the Finance Act 2024 has shifted from a 1% fixed tax on export proceeds plus 0.25% export development surcharge to a 1% tax on export proceeds, 0.25% export development surcharge and 1.25% minimum turnover tax, adjustable against a 29% normal income tax and up to 10% super tax. Combined with various other taxes and surcharges such as the Worker’s Welfare Fund and Worker’s Participation Fund this step results in effective tax rates of up to 135% depending on the original margin for the product.

The textile sector operates on low margins and high volumes. This inexplicable tax burden erodes all profitability, leaving businesses with insufficient capital for operations and investment. This financial strain cannot be passed on to international customers, who are already wary due to high operational costs. Low regional tax rates for competitor firms further disadvantage Pakistan’s exporters, inevitably leading to a loss of both business and FDI to more favourable economies.

Similarly, the withdrawal of zero-rating on local supplies for export manufacturing under the EFS has further harmed domestic manufacturers. Exporters are finding it increasingly cost-effective to import duty-free and sales tax-free raw materials and inputs instead of sourcing domestically.

This has had a devastating impact on local producers of upstream products, with imports of cotton yarn, for instance, rising from ~2 million KG in July 2023 to over 15 million KG in July 2024. Procuring the same domestically, already uncompetitive due to high energy and operational costs, now entails paying 18% sales tax and waiting months for a refund—when and if it is processed—incurring an opportunity cost of at least 20% per annum. Over 40% of domestic yarn production has shut down as a result, with similar trends across other sub-sectors of the textile industry. This has severe implications for employment, government revenue, and external sector stability.

Simultaneously, the incomprehensible SRO 350 remains in force, despite explicit instructions from the Prime Minister to suspend it until it is made workable for all stakeholders involved. The new requirement of linking the entire supply chain to file sales tax returns has created chaos, where firms across the country are unable to file their returns within the deadline.

Input tax claims of the buyer are restricted based on the seller’s timely filing of their returns, even when the buyer has paid the full amount, including sales tax, to the seller. Buyers are being penalized for circumstances beyond their control, and are forced to pay additional taxes and penalties, which are otherwise not their liability. The rule has a cascading effect: when a buyer is unable to file their return due to the above situation, their customers are also unable to claim input sales tax, leading to a widespread inability to file returns.

The list of issues is endless—one could write many books on it, and many have been written. But the critical question remains: why is nothing being done despite mountains of research, countless committees, and numerous reports? No one in the government or bureaucracy is willing to take responsibility. If every issue is to be blamed on the IMF, why not simply hand them formal control?

For the sake of increasingly expensive foreign loans and rollovers, the government is decimating a sector capable of generating $25 billion annually at current installed capacity, with the potential to expand to $50 billion per year within five years—if only it were supported by a conducive policy environment.

Given the multitude of issues decimating Pakistani products’ international competitiveness, if the unintended consequences of an economic shutdown are not understood, then perhaps a swift and decisive end would be less cruel than the slow poison being administered to the industry.

Dragging this process out only prolongs the suffering of millions whose livelihoods depend on a once-thriving sector. The path we’re on leads only to economic collapse, and it’s time for those in power to choose: either commit to genuine reform that allows industry to thrive, or be honest about the fatal trajectory that has been set in motion.

Yet, even now, there is hope. With the recent turmoil in Bangladesh, Western decoupling from China, and growing calls for sourcing diversification amidst heightened GVC risks, Pakistan is well placed to capitalize on these opportunities if market distortions are addressed and manufacturing is made financially viable again; but the window of opportunity is already closing fast.

Copyright Business Recorder, 2024