Improving Pakistan’s Investment Climate

As part of its advocacy aiming to improve the investment climate of Pakistan, PBC retained Mr. Sakib Sherani to conduct the study. We used Egypt, Bangladesh, Indonesia and Vietnam as comparative jurisdictions. Pakistan needs a comprehensive roadmap for inducing an investment response from all private investors, including domestic ones. The main takeaways are as follows:

Pakistan’s ability to attract investment, whether domestic or foreign, has been far below potential, and far lower than regional peers, for a long period of time. Pakistan’s fixed investment rate, at 11.9 per cent of GDP in 2022-23, is less than half of the regional average for South Asia (27.8 per cent of GDP), and 60 per cent lower than the average for the low- and middle-income cohort.1

For its GDP per capita in nominal US dollar terms, Pakistan’s “predicted” fixed investment rate should be 25.4 per cent of GDP – more than twice the current level. If Pakistan had been able to generate, from 1980 onwards, an investment rate that was close to the average for a select sample of high performing developing country peers, the size of its economy today would have been 60 per cent larger – at Rs 133.4 trillion instead of the present Rs 84.7 trillion.

At the prevailing exchange rate, this would have amounted to the country’s GDP being higher by US$ 167 billion, or by almost two-thirds. In other words, the size of Pakistan’s economy would potentially have been slightly over US$ 518 billion, instead of US$ 340 billion currently. This highlights the opportunity cost of not addressing over a long period the investment climate issues bedeviling the economy.

Comparing Pakistan with a select group of “regional” peers, including Bangladesh, Indonesia Vietnam and Egypt, shows that the divergence in the domestic investment rate as well as quantum of inward FDI generated is stark. Bangladesh’s investment rate is 32 per cent of GDP, the highest in South Asia, while inward FDI amounts to 0.8 percent of GDP (twice Pakistan’s level). Egypt’s figures stand at 15.2 per cent and 2.9 per cent of GDP respectively, Indonesia’s 29.1 per cent and 1.7 per cent of GDP respectively, and Vietnam’s 31.7 per cent and 4.4 per cent of GDP, respectively.

These countries have been selected on the basis of their relative success in attracting FDI as low- and middle-income developing countries, having some characteristics similar to Pakistan, providing useful lessons on which set of policies and institutions generate a higher chance of success in attracting investment, and for being among potential targets of investment interest by large-sized Pakistani businesses.

Pakistan’s long run, below-par performance with regards to investment extends across all forms of fixed capital formation: investment by the public sector, private investment, as well as foreign direct investment. Manufacturing and the export sector in particular are not attracting the levels of investment required to support the country’s growth ambitions.

This situation is not new, and its persistence indicates long-standing systemic and structural issues with the country’s investment climate. These issues have been periodically highlighted by business associations, investor forums, international consultancies, think tanks and academic researchers, as well as multilateral development institutions, but have failed to elicit a timely, sustained, holistic or concerted response from policymakers since the 1990s.

Political instability has been identified by foreign investors as well as domestic firms as the top constraint to the business environment in Pakistan. Domestic firms identified access to finance, tax rates, corruption and electricity supply as the next biggest constraints they face, according to the World Bank’s 2023 Enterprise Survey. For large firms (with 100+ employees), tax rates and corruption were the top two constraints.

Political instability and macroeconomic uncertainty lower the overall investment rate in an economy, and, over a protracted period, distort the investment incentives and choices of investors. With lower levels of predictability, resources are allocated to investments with shorter payback periods and higher returns – and are increasingly required to be backed by sovereign-guarantees as well as fiscal incentives. Prospects of sovereign-guaranteed super normal profits in a handful of sectors affects the efficient allocation of overall investment resources in the economy.

This situation has been reinforced by the design of tax policy. Tax policy and its enforcement have encouraged informalisation in the economy by creating a large tax arbitrage between the formal and informal sectors, further distorting investment choices.

Improving Pakistan’s investment climate requires a holistic, back-to-basics approach across a wide front. Investment policies should aim for improving the overall investment environment via deep-rooted and wide ranging structural as well as institutional reforms, with a focus on domestic firms, rather than be tailored to the specific needs of a smaller pool of foreign investors. Domestic firms achieving scale in operations and becoming viable partners for foreign investors is a tried and tested route most dynamic and successful emerging markets have taken in improving the competitiveness of domestic businesses as well as attracting foreign investment.

Ad hoc and tactical approaches such as creating different “classes” of investors by according preferred status to some over others, may assist in easing the short run foreign exchange constraint faced by the economy. However, such approaches belie a “financing” reflex as opposed to an “adjustment” mindset. In the longer run, these constructs may do more harm than good by setting up perverse incentives and creating unintended consequences.

Given that there is path-dependence in the constraints to investment, the unaddressed challenges cannot be resolved in the short run, and will require a concerted and sustained reform effort anchored by a whole-of-nation consensus, and implemented across several consecutive governments.

An immediate entry point for enhancing inward FDI into the country, however, is the China-Pakistan Economic Corridor (CPEC) Phase II. If Pakistan is better able to leverage the “CPEC opportunity”, it can still attract higher investments initially from mainland China, and subsequently from other regional investors. Unfortunately, the window of opportunity on this front appears to be closing.

Key Takeouts

Comparing Pakistan with a select group of “regional” peers, including Bangladesh, Indonesia, Vietnam and Egypt, shows that the divergence in the domestic investment rate as well as quantum of inward FDI generated is stark. Bangladesh’s investment rate is 32 per cent of GDP, the highest in South Asia, while inward FDI amounts to 0.8 per cent of GDP (twice Pakistan’s level). Egypt’s figures stand at 15.2 per cent and 2.9 per cent of GDP respectively, Indonesia’s 29.1 per cent and 1.7 per cent of GDP respectively, and Vietnam’s 31.7 per cent and 4.4 per cent of GDP respectively.Key reasons for low investment, particularly of foreign investors in Pakistan are:

  1. Political instability and macroeconomic uncertainty: Both lower the overall investment rate in an economy, and, over a protracted period, distort the investment incentives and choices of investors. With lower levels of predictability, resources are allocated to investments with shorter payback periods and higher returns – and are increasingly required to be backed by sovereign-guarantees as well as fiscal incentives. Prospects of sovereign-guaranteed super normal profits in a handful of sectors affects the efficient allocation of overall investment resources in the economy. Twenty-three IMF programmes later, fundamental flaws in Pakistan’s economy have not been addressed. Whilst Egypt too faces macro-economic challenges, its geo-strategic importance in the Middle East and superior market access come to its assistance. Bangladesh has proactively sought IMF’s umbrella. Vietnam and Indonesia are able to manage their external accounts through exports.
  2. Short Tenure of Governments: Governments in Pakistan have had short tenures:
    1. Number of years from 1988 to 2022:33 yrs
    2. of elected govts: 12
    3. Average tenure of elected government:2 yrs
    4. In contrast with Pakistan, governments in all counties in the comparative set enjoyed long tenures.
  3. Policy unpredictability: Examples of arbitrary and abrupt policy changes
    1. Group Taxation: introduced in FA 2007, group taxation led to establishment of several holding companies and flotation of subsidiaries on the stock exchange. However, it was withdrawn in 2016, reintroduced in 2019 and withdrawn again in 2021, with the result that holding company shareholders now suffer multiple levels of taxes as dividends flow from subsidiaries to them
    2. Independent Power Producers: Financial returns in US$ for the life of the projects were sovereign-guaranteed in various Power Policies of the Government of Pakistan (GoP), attracting an estimated over US$ 19 billion cumulatively in investment in power generation since 1989. However, unable to perform its obligations under the agreements due to being cash strapped, GoP began re-opening and renegotiating the underlying Power Purchase Agreements in 2020. At the same time, IPPs have faced severe cashflow issues due to their liabilities not being promptly settled under the PPAs.
    3. Tax Credit on Investment in Plant: A tax credit of 10% of the amount invested in plant and machinery was allowed to qualifying companies via Section 65B of the Income Tax Law in 2010. The provision was to be a part of the law till June 30, 2021. The tax credit was reduced to 5% in 2019 and completely withdrawn from 2020, before expiry of its term.
    4. Inflation related adjustment in price of drugs: The 2018 drug pricing policy permitted increase in price of drugs to the extent of 70% of the change in CPI. This was reversed in the following year (2019) with the result that several MNCs have left Pakistan as their operations became unfeasible.
    5. Captive Power Generation: Through supply of cheap gas, the government encouraged large consumers, including exporters, to establish at substantial cost of their own, captive generation plants to overcome the power generation shortfall. GoP policy now, however, requires captive power plants to buy electricity from the DISCOs, effectively making the capital outlay on the captive power plants a deadweight investment.
    6. Tuwairqi Steel Mills: A multimillion US$ project involving a joint venture (JV) between a Saudi group and Korea’s largest steel producer POSCO, with an annual import substitution potential of Rs. 100 bn, was denied supply of natural gas at the committed subsidy of Rs. 5 bn per annum post-commercial operation, leading to suspension of production and the filing of an international arbitration case against Pakistan.
    7. Tethyan Copper: A multimillion US$ copper and gold mining project awarded to Chile’s Antofagasta was forestalled due to denial of extension in lease, leading to award of damages by ICSID (International Centre for Settlement of Investment Disputes) of US$ 5.9 bn against Pakistan.
    8. As a result of abrupt and arbitrary changes in policies and terms of investment, Pakistan has also been involved in international arbitration cases brought by foreign companies that have invested here. The two most high-profile and recent cases have involved the Tethyan Copper Company (TCC) and its investment in the Reqo Diq mine in Pakistan’s Balochistan province, and Karkey Karadeniz Elektrik Uretim A.S. of Türkiye’s setting up of a rental power plant. In all, Pakistan has been involved in 12 cases since 2001 as a respondent state in international dispute settlement forums, according to UNCTAD’s Investment Dispute Settlement Navigator. These disputes have involved investors from Australia (1), Türkiye (4), Saudi Arabia (1), Kuwait (1), Italy (2), Switzerland (1), Mauritius (1), and UK (1).
    9. A common theme of successive governments in the comparative set of countries is policy consistency, notwithstanding change in governments. Bangladesh serves as a good model as do the Communist Party in Vietnam and the military-led regime in Egypt. The essential point is not the form of government but policy consistency and predictability.
    10. In the 2023 Kearney FDI Confidence Index, Pakistan raked 23 out of 25 countries, significantly below Indonesia, Vietnam and Egypt.
  4. Predatory Tax Policy: Unpredictability has been reinforced by the design of the tax policy. Tax policy and its enforcement have encouraged informalisation in the economy by creating a large tax arbitrage between the formal and informal sectors, further distorting investment choices. Industry is burdened by a disproportionate share of taxes, whilst retail, wholesale, service providers, undocumented real estate, transporters, feudal landlords and urban property owners escape or are under-taxed. Tax policy discourages scale and consolidation; it penalizes it by double taxation of inter-corporate dividends and through levy of super tax. Tax compliance procedures are complex and result in harassment. Salaried employees are taxed at high rates leading to brain drain.
  5. Poor Market Access: All countries in the comparative set enjoy superior market access to Pakistan:
    1. Egypt: FTAs with the GCC and Africa; duty free access to the EU, USA and Canada
    2. Vietnam: Membership of trading blocks covering SE and NE Asia via ASEAN, RCEP (ASEAN plus Australia and New Zealand); VEUFTA (Russia, Central Asia), CPPTP (Latin America and Canada); preferential access to Japan and Korea; FTAs with UK and the EU
    3. Indonesia: Membership of trading blocks covering SE and NE Asia via ASEAN, RCEP and CPPTP
    4. Bangladesh: LDC status for most of the developed world; Duty-free access to China for 95% of HS lines. Duty free access to EU under Everything But Arms. Duty free access to UK
    5. Pakistan: FTA with China for duty-free access for 45% of HS lines; FTAs with Sri Lanka and Malaysia, PTA with Mauritius and Indonesia. Duty free access for textiles and a few other HS lines into the EU and UK.
    6. South Asia is the least integrated regional trading block. Pakistan neither benefits from trade with India or Iran. With Afghanistan, benefits from trade are more than offset by misuse of the Afghan transit trade, which impedes the formal sector.
    7. Whilst market access is an important enabler of exports, Pakistan’s exports have been heavily reliant on low value-added textiles and rice and Bangladesh’s on more value-added apparel. In contrast to both, Vietnam broadened its export basket substantially by integrating into the global value-chain and Indonesia is increasingly focusing on shifting away from export of minerals to value-added products, such as lithium batteries.
    8. Another notable difference is the market-seeking FDI in Pakistan, focused on extracting the demographic dividend of a large, young and rapidly urbanizing population, whereas Samsung alone contributed to a fifth of Vietnam’s exports and Egypt is able to attract MNCs by leveraging its superior market access.
  6. Underdeveloped Human Capital and Low Productivity: Pakistan has the 4th largest labour force in Asia, consisting of 71 million people. However, despite its size, it compares poorly with its regional peers in terms of skills structure, level of education, mean years of schooling and productivity indicators. Another striking feature in the case of Pakistan, is the abysmally low female participation rate in the workforce, at only 23 per cent compared to 61 per cent for Bangladesh, 44 per cent for Egypt, 68 per cent for Indonesia, and 78 per cent in the case of Vietnam, according to the World Bank. In terms of skills structure, Pakistan’s labour force is predominantly unskilled or semi-skilled. This fact is reinforced by the level of education of the civilian labour force. According to labour force statistics from the Pakistan Bureau of Statistics, 9.15 per cent of the civilian labour force has a bachelor’s degree or higher. A full 40 per cent is illiterate, while a further 45 per cent has an educational level of less than higher secondary (i.e. less than “Intermediate” pass). The advantage of abundance of low wage labour is completely wiped out without productivity; ultimately, it is unit labour cost that a foreign investor uses as a metric to compare the competitiveness or otherwise of producing in one country compared to another. This is also a reason why the Chinese labour intensive industries prefer Cambodia and Laos to relocate their plants, now and Vietnam previously. Pakistan, unlike Indonesia and India has also not benefited from the “China +1” strategy of MNCs to diversify sourcing.
  7. Poor Logistics: Pakistan ranks a lowly 122nd on the LPI overall, the lowest among its South Asian comparators. Significant gaps and shortcomings compared to its regional peers appear in customs, infrastructure, tracking & tracing as well as timeliness. In international shipments and logistics competence Pakistan fares better than Bangladesh and Sri Lanka. However, in all parameters, it lags substantially behind South Asia’s best-performing country on the LPI – India – which ranks 38th globally, followed by Vietnam at 43rd. The silver lining on this front is, however, that the launch of the Pakistan Single Window Initiative is expected to address some of the deficiencies in clearance of inward and outward shipments by removing bureaucratic overlap and introducing digitization.
  8. Unreliable and Expensive Energy: Within overall physical infrastructure, energy plays an important role. Unreliable supply of energy, in addition to higher tariffs, especially for industry relative to countries in the region, is also a crucial factor that disadvantages exporter-firms or Foreign Invested Enterprises (FIEs) from relocating production to Pakistan. Industrial Tariffs are burdened with cross subsidies to residential users, charges for unutilized generation capacity, transmission and distribution losses, theft and under-recovery of bills. As a result, the industrial power tariffs are between more than 50% higher than the comparative set.Gas tariffs have also been revised upwards for industry in view of growing reliance on imported LNG.
  9. Special Economic Zones: Pakistan ranks well behind the comparative set of countries in developing economic zones. Bangladesh has 88, Indonesia 19 and Vietnam 18 such zones. In the absence of operational SEZs with plug and play facilities, major investors in Pakistan experience difficulty in finding affordable land and obtaining adequate utility connections. The Board of Investment’s efforts to create a single window have been thwarted by fragmentation between the federation and the provinces.

The PBC is a private sector not-for-profit advocacy platform set-up in 2005 by 14 (now 96) of Pakistan’s largest businesses. PBC’s research-based advocacy supports measures which improve Pakistani industry’s regional and global competitiveness. 

Download