'Pakistan's labour costs lower than India's and China's,' says Lead Economist, World Bank, South Asia Region

Vincent Palmade is Lead Economist for the South Asia Region Department at the World Bank HQ in Washington D.C. Before joining the World Bank in 2004, Vincent had worked for twelve years with the consulting major McKinsey and Co, where he was a Partner of the McKinsey Global Institute. He is a graduate from the Kellogg Graduate School of Management (US) and the École Nationale des Ponts et Chaussées (France).

Last week, BR Research sat down with Vincent on the sidelines of PIDE's annual moot in Islamabad. We had a wide-ranging discussion on Pakistan's competitiveness, in the particular context of the China-Pakistan Economic Corridor (CPEC). Edited excerpts are produced below:

<B>BR Research: Let's commence with the World Bank publication* that you launched today at the PIDE conference. What are some of the key messages in the book for Pakistan?</B>

<B>Vincent Palmade:</B> There are three main messages in the book. The first one is that the competitiveness's starting point is low for South Asia, and also for Pakistan, in particular. Pakistan's level of exports are five to ten times lower, on a per capita basis, compared to countries like Vietnam, China, or even Bangladesh and Sri Lanka. Also, exports have been stagnant in terms of quality and number of products, as there is very little diversification away from textiles. Then there is the issue of the productivity of firms, which, on average, is low, especially for smaller firms. Unfortunately, most of the workers are still trapped in low productivity, semi-formal jobs.

The report's second message is that the potential is really there with favourable external and internal conditions. Externally, labour costs in Pakistan are now extremely competitive. They are two times lower than India and five times lower than China. It means that well-managed firms can find ways to employ the workforce productively and they can be really competitive, especially in labour-intensive industries. The other favourable condition is that, with rapid urbanisation, conditions are now in place for industries to cluster together into ecosystems, which can create economies of agglomeration, specialisation, cooperation, as well as competition, between clusters, cities, and provinces.

And finally, the potential is also demonstrated in that already today, across South Asia, including in Pakistan, the World Bank have identified a number of what we call 'islands of excellence'. These are firms and clusters which have proven that world-class performance can be achieved in Pakistan in terms of productivity and innovation. The most impressive example that we have seen in Pakistan is of Sialkot. Despite the energy crisis, the security situation, and despite the fact that Sialkot is more than a thousand kilometres away from the Karachi port, clusters of Sialkot have managed to retain their dominant market share abroad in key products, such as sports goods and surgical instruments. Sialkot is an inspiring example of what can be done in Pakistan, even in the middle of difficult conditions. Imagine if the conditions were better, what could be achieved.

Besides, good practices are found in other industries, too, such as automotive. Just like we are seeing in India, here in Pakistan, too, the next wave should be to start exporting auto parts. Especially in the context of CPEC, there should be some major opportunities to help bring Chinese investors in both existing and new industries such as electronics, where Pakistan is not at all a player today.

<B>BRR: You mentioned Pakistan's wage competitiveness. But wage is not the only thing. If Pakistan's productivity is not at par with, say, India, would a Chinese investor still want to re-locate their factories in Pakistan?</B>

<B>VP:</B> That's a very good question. But the good news is that investors don't look at average productivity numbers when they make a decision. They rather look at how much productivity they will get if they could train the workers, equip them, and provide them with a factory that allows them to be more productive. The fact that Pakistan already has some firms with high productivity is what investors would be looking at, as opposed to the aggregate numbers. The aggregate numbers are really taken down by the majority of small firms who are not able to increase productivity. That does not reflect on the workers, but rather the conditions into which the smaller firms operate.

<B>BRR: So what kind of conditions a Chinese investor is likely going to look at?</B>

<B>VP:</B> Chinese investors are going to look at the kind of conditions they can get in the special economic zones in terms of business environment and the kind of productivity they can get out of the workers if they provided them with the right kind of training. That's where Pakistan's growing wage advantage becomes significant.

<B>BRR: Right. But specifically, what other factor conditions need to be there to materialise that advantage?</B>

<B>VP:</B> So, you need three things. Number one is the connectivity to global markets, where the Chinese investors, other foreign investors, and Pakistani investors can easily access export markets as well as import markets. Number two is the availability of good infrastructure in terms of access to electric power and access to industrial lands. And number three is a good business environment, in terms of regulations and a tax regime that is okay, if not perfect.

What's interesting is that when you look at China, and now in Vietnam, too, they have provided these things by developing on the one hand world-class ports and then putting their special economic zones (SEZ) right next to their world-class ports. Doing that assured connectivity, it assured access to good infrastructure and land, and it also assured a good business environment, as those zones had simplified regulations and taxes and so on.

<B>BRR: Keeping in mind that Pakistan has a smaller coastal belt than, say China, even India, is the port-centric SEZ model still relevant for Pakistan?</B>

<B>VP:</B> Yes, Pakistan needs to adopt this model to the conditions in Pakistan. Clearly, the Karachi port has to be improved, because it has the potential and it is Pakistan's lifeline to the world. In the future, there is Gwadar. The challenge in Gwadar is that it has only 100,000 workers right now. You need to put in place conditions that attract many more migrant workers as the ecosystem will grow.

But this is precisely what the Chinese did with Shenzhen, which started as a small fishing village but it is now a metropolis of eight million people. These things, we know, can happen. The fact that you have China as a partner is a double opportunity, because not only will they bring the investments both from the public and the private sectors, but also, they have done it before and they want you to succeed with the corridor.

<B>BRR: As you said, productivity can differ within and among sectors. If you were to scan China's major primary, secondary and tertiary sectors, among which Chinese sectors (that are hit by the higher wage rate) does Pakistan seem to have the most potential to attract Chinese investment?</B>

<B>VP:</B> China is actually very explicit about it. Now there is a policy to move leather and footwear industry out of China. And I think Pakistan is particularly well-positioned on that front. When you are going to discuss with China how to benefit from the transfer of leather industry from China to Pakistan, first of all, make sure that your local industry is not going to be wiped out and they will benefit from partnership with this new class of investors. Also, take advantage of this new investment to tackle the environmental issues that you already have in this industry.

<B>BRR: So, leather and footwear is one. What other sectors can you identify?</B>

<B>VP:</B> Everything that is labour-intensive, by definition, is in play, because that is where the labour cost in China is hurting the most. So that means, in particular, sectors such as textiles, leather and footwear, apparel, and toys. Then there is the final assembly part of electronics, including packaging and testing. Also, some segments of the auto parts industries, which are also labour intensive.

To get an idea, look at what is happening in Vietnam, which is very similar to Pakistan in terms of development. Vietnam is now benefiting in a big way from the transfer of these industries, including electronics, from China.

<B>BRR: What is your assessment of the local automotive industry on local demand kicking off and attracting foreign investment vis-à-vis CPEC?</B>

<B>VP:</B> More players would be a good thing for competition. At the same time, domestic market size is not too big to accommodate too many players. What's interesting in Pakistan is that medium-sized cars are being produced more than smaller-sized cars, unlike in India. So I can see space for someone who can produce smaller, cheaper cars.

In the same book*, we have three recommendations for the automotive sector. One, gradually remove the high protections but give visibility to the sector so they keep doing things better. Two, adopt the latest standards, like the Euro6, so that you are not producing cars in Pakistan that you cannot even export. That's something you can do sooner rather than later. And three, where you can really develop exports now, and you are starting to see glimpses of it, is auto parts. After gradually reducing import tariffs on auto parts over the past fifteen years, India is now becoming a serious player in auto-parts' exports.

Auto-parts are more labour-intensive, so it fits better with your sources of competitive advantage. Final car assembly is pretty capital-intensive and you need scale. So, start with auto parts. Besides cars, you have motorcycles and tractors, where you are already competitive. But the use of old technology has restricted the export market to Afghanistan. You should be exporting to the rest of the world, too.

<B>BRR: Let's try another lens with CPEC. FDI can be for different reasons: there is resource-seeking FDI, market-seeking FDI, efficiency-driven FDI, strategic FDI, etc. Using that lens, what is your analysis on the type of potential, private-sector Chinese investments coming into Pakistan?</B>

<B>VP:</B> Well, I think the big opportunity is in efficiency-seeking FDI, which uses Pakistan as an export platform, especially in labour-intensive manufacturing, and which takes advantage of Pakistan's duty free access to Europe as part of the GSP+. For me, that's the biggest opportunity. And in the short-term, it will be present, as I mentioned earlier, in sectors like leather and footwear, apparel, toys, and segments of electronics. And by the way, there is a big opportunity to increase female employment in these sectors through a combination of policies. For example, the Factory Act prohibits women to work in factories at night. That's a big deal when you talk to the private sector. The head of the Lahore Chamber of Commerce and Industry told me last month that he could not employ women because they could not take their fair share of the night shift. Workers have to rotate.

If you look at historical market-seeking FDI numbers, the biggest FDI in Pakistan has been in banking and telecoms. That's not where you would expect the Chinese to come in, but with players like Alibaba, it might happen. Again, the opportunity lies in industries such as automotive, where you have a big domestic market but also the potential to export. Protective tariffs can help you attract those investors in the first place to build capacity and scale, and then you tell them that you are going to reduce the tariff gradually.

<B>BRR: Chinese state and private sector companies have been investing overseas for a while now. Keeping their African investments in mind, what kind of an investment model or mindset do you think the Chinese are likely going to apply in Pakistan?</B>

<B>VP:</B> It's a great question. Keeping in mind that Africa is not Pakistan, I think there are many lessons one can draw from China's Africa experience, to date. I think it is fair to say that China has encountered more challenges than expected in Africa, and also that Africa has experienced more challenges than they expected with Chinese investors.

To analyse it, you have to separate Chinese investments focused on mining and resource extraction from the rest of their investments, because in mining and resources, China has had to secure resources in a tricky environment of poor governance and geopolitics. The lesson in the resource extraction industry is that financing of such project is long-term in nature and if the host country does not have the technical and negotiation capacity, they may not get the best deal. That could be relevant for Pakistan in the context of Balochistan, for example, because there the federal government will have to really build the capacity of Balochistan. And I think development partners, after having experience on our side, will be quite happy to make sure that it's a win-win for both parties.

But mining is a class of its own, it has its own challenges, and for a government it is really about having the capacity to negotiate and evaluate the deal from a technical standpoint. Now, when it comes to simpler, private sector, industrial investments, here it is important to look at the experience of China itself, which relied on multiple models for flexibility, but also had the monitoring capability to evaluate what was going on. So in China, and now in Vietnam, too, there's an explicit policy of supplier development, where foreign investors come in with their own suppliers for value-addition but there is also an expectation that they will develop local suppliers. You don't want that criterion to be too high and too fast, because then you will have no deals, so it's better to have a gradual approach.

That's one. The other one is to encourage joint ventures (JV), but keeping in mind that JVs don't always work. Again, you don't want to force any of these models, but you want to facilitate and let the private parties decide what is best for them. And then, for example, I know that in Vietnam, the electronics investors are asking the government to help with the training of local SMEs and local workers. In super-competitive industries like electronics, developing a local supplier base is part of the answer.

<B>BRR: China's economic entry into Pakistan is relatively recent. And now there is CPEC. Specifically, we are trying to understand Chinese experience in Africa and what issues they had to grapple with.</B>

<B>VP:</B> What I can say is that China's strategy is one small step at a time. That is why it is important to make sure that this first wave of Chinese investments under CPEC is successful. There are thousands of Chinese companies who will be observing what is going on. If this first wave goes through successfully, you can expect a tsunami of Chinese investments. The Chinese are going to ask Chinese investors 'how is it going' and not anyone else to find out whether it is working out.

But it is really of strategic importance that the government puts in place the conditions for success, not only for the Chinese but also for all foreign and Pakistani investors. Otherwise, what we have seen in Africa is some backlash against Chinese investors: they would bring the Chinese workers and thus become easy targets for people who say 'they are taking our jobs'. So, it is important to make this first wave to work both for the Chinese and the Pakistanis. One way to do that is to include conditions where the Chinese train local workers from the get-go, and to have explicit expectations that over time, Pakistanis will account for majority of the workers.

<B>BRR: Finally, how do you think the World Bank is currently reading CPEC?</B>

<B>VP:</B> It is a unique historical opportunity, a potential game-changer, where you can really take a fresh look at critical infrastructure such as ports, power, and connectivity. It will also be a stimulus for even more business-environment reforms, because the Chinese investors are going to expect those reforms. And in a number of more tricky areas, such as industrial zones and development of SMEs' capabilities, the Chinese can bring a lot of expertise. CPEC is potentially a really positive reason to do things better, across the board, with a unique kind of partner.

*The publication, "South Asia's Turn: Policies to Boost Competitiveness and Create the Next Export Powerhouse", can be downloaded at www.worldbank.org/SouthAsiaCompetes.