Pakistan Leasing Industry Report

The reports at IBA have always been a source to gain insight into the practical applications of what is taught during the course of the academic terms. This report is also one of them. It allowed us to realize how the different concepts that we studied in our course are practiced in business organizations.

This report has only been possible under the able guidance of the instructor, Dr. Manzoor Khalidi. Without his continuous guidance the report may not possibly have been what it is now.

We also acknowledge the support and help from our class fellows and Well-Wishers, who helped us a lot with the collection of information for the report.

Last, but not the least, we express our gratitude for our parents who have been and will be an inspiration at each stage of life.
What is a lease?

A lease is an arrangement whereby an equipment owner confers right of usage of a piece of equipment to an equipment user, in return For a periodic rental for a specific period of time.

Leasing is not a new concept. It is one of the most widely used forms of financing capital assets. In leasing, the ownership of the asset remains with the lessor, but the asset is available for use to the lessee.

The multitude of items, which are brought under the umbrella of leasing, has been steadily increasing. It now includes cars, computers, machinery, and manufacturing plants, along with houses, offices, and land.

The global leasing industry amounts to about US $450 billion, which is around 25 – 30% of the global capital market. However, it is astonishing to know that 75% of this business is in the G-7 countries or the seven developed nations, which clearly depicts the importance of this form of capital financing in an economy.

Leasing: “The growing industry

Leasing is tracked back thousand of years and has evolved considerably during last four decades. It has evolved as an industry from a manufacturer’s selling techniques into a specialized financial service with the formation of first leasing company in 1952 in United States. It extended to Europe and Japan in 1960s’ and has been spreading to developing companies since the mid 70s’. By 1994, leasing has been established in over 80 countries including more than 50 developing economies.

Leasing is a contract whereby the owner of something transfers the rights for usage to another person for an agreed period at an agreed consideration. This arrangement particularly suits new, small or medium sized enterprises (SMEs) without a long history of financial statements.

Lease is categorizes as operating and finance lease. Financial leasing allows one party (lessee) to use an asset owned by the leasing company in exchange for specified periodic payments. The asset itself provides security for the transactions.

Operating lease is the same with a difference that ownership is not transferred to lessee at the end of lease period.
The idea of finance lease initially followed by operating lease business soared up this new industry in a short span of time. By 1994, over US $ 350 billion of new vehicles, machinery and equipment was financed through leasing, accounting for about an eight of the world’s private investment. In OECD countries up to a third of private investment is financed through leasing.

Developing countries are driving most of the leasing industry’s growth today. Leasing has addressed an unmatched demand from new, small and medium sized firms and attracted borrowers away from traditional bank loans due to the potential advantages that it offers, like simple security arrangements, availability, convenience, lower transaction costs, little cash requirements, flexibility and tax incentives.

In Pakistan, the leasing sector comprises leasing companies, Modarbas and investment banks. The regulatory bodies that monitor leasing sector are the State Bank of Pakistan, SECP and Ministry of Finance, Government of Pakistan.

The leasing companies initiated in 1985. There are currently many leasing companies, whose main business is financial lease. These companies include: ORIX, NDLC, First Grindlays Modarba, BRR International Modarba and Askari Leasing with 70% of industry share.

Most of the Modarbas, established to promote Islamic mode of financing, are also engaged in extensive leasing as well, with 8 of those registered with Leasing Association of Pakistan, such as: First Allied, Al Ata, Al Zamin & First Fidelity Modarbas etc.

The government has allowed investment and commercial banks to enter lease financing. These institutions enjoy strong financing ability and huge equity base.

Over the years leasing has become an increasingly important source of financing. However the share of leasing in capital formulation in Pakistan is 12 to 15 percent, which is very low as compared to other financial institutions.

Literature Review

We believe that our report is infact a representation at the microcosm level of the broader issue of the development of leasing as a form of capital market in a developing country like Pakistan. The over whelming demand for capital and the accompanying market forces are and will inevitably create the regulatory and policy environment required to sustain these markets. People will always be willing to finance in a host environment. As Walter Wriston, CitiCorp’s ex-chairman once remarked, “Capital goes where it is wanted, and stays where it is well looked after”. In these few words, lies the essence of the emergence of numerous and diverse capital markets in the developing countries.

Methodology

This report has been prepared primarily with the help of a series of interviews conducted with the executives, professionals, and senior fellow Students.

In addition to this, secondary data has also been collected from various local and international journals and periodicals. Very important contributions were the complete transcripts of the speeches made by top personalities in the field of leasing from all over Asia.

We believe that it was an asset for our research process.

Leasing Industry And The Developing Markets

Leasing holds special importance as a source of financing in the developing countries. Unlike in the developed countries, the capital structure of the business entities of the developing world suffers from a lack of sound capital base, and hence depends heavily on debt capital as a source of funding.

The idea of lease financing has not been that widespread in Pakistan as compared to the developed segments of the globe. The reasons are not far to trace: Lease finance history in Pakistan is only a decade old. Leasing business in Pakistan, although past the embryonic stage, has still to travel a long way to get well entrenched. This is manifested by the fact that leasing business has contributed only a shade higher than one percent to the capital formation in Pakistan. This augurs well for the potential for leasing business in Pakistan.

Pakistan’s economy is constantly short of liquidity. The nationalized commercial banks are always finding it difficult to muster up enough funds and the DFIs are very selective in the matter of projects that they would be interested in financing. On the other hand, the leasing companies have a very vast scope of operations and can cater to the needs of the clients faster and more effectively. Lease facility is available to all the financially sound companies with satisfactory credit standings. Lease has thus fired the imagination of entrepreneurs, particularly those who want to make the most effective use of their funds, or whose limited budget does not permit urgent capital acquisition.

Background

Leasing was introduced in Pakistan during late 1970s as a result of the then government’s attempt towards the Islamization of the economic system. The first leasing company in Pakistan was established in the year 1985, and since then each year, one or two companies are entering the leasing industry. There has been tremendous growth both on the demand and the supply sides. The growth rate has been about 25% to 30%.

The business of leasing gained a foothold in our economy and started growing at a tremendous pace back in 1985 when the performance of the nationalized commercial banks started deteriorating and they began losing the confidence of their customers. They were not client-oriented. Most of their offerings were stereotyped, and were not in line with the dynamic state of the economy and the changing needs of the customers. They were working under rigid patterns with no incentives to prosper since there were no signs of competitiveness in the economy. Leasing companies then started flourishing because they came out with products that were tailor-made and in accordance with the changing business needs. Efficient services coupled with quick processing offered by the leasing companies grabbed public’s attention and helped the leasing companies in gaining the confidence of the customers. Although, at that time, their offerings relating to project financing were very few, the entrepreneurs or the lessees began realizing that profits are generated through productive use of the assets and not through owning the assets. And thus leasing industry prospered as provider of an alternative mode of financing fixed investments.

Types Of Lease Financing

Leases are broadly classified into two categories:

I) Finance Lease:
A finance lease is a contract involving payment over a certain period of time, of specified sums, which in total, liquidate the lessor’s capital outlay and provide him with a profit. Here, the leasing company simply acts as a financier. The lessee specifies the equipment needed, and acts as the lessor’s agent in the matters of selection and ordering of the relative equipment, and its maintenance and use. The lessor is simply interested in the lawful ownership of the assets, to which he has resources if the lessee fails to repay the rentals.

ii) Operating lease:
Under an operating lease, the leasing company purchases an asset, and leases it out to the lessee. The lease is at a rate and terms, which do not cover the cost, interest and profits of the lessor. In order to fully amortize and write down the asset in the books, further lease terms should be entered into.

The distinguishing feature between an operating lease and a finance lease is that in the case of the former, the lessee makes use of the equipment for a short period without having to pay its entire capital cost, and the lessor’s total profit.

In Pakistan, almost all leases being transacted are finance leases in which the lessee becomes the owner of the asset after the end of the leased period at a pre-determined price. All lease financing falls into one of the following three types:

a) Sale and Leaseback:
Under this arrangement, a firm sells an asset to another party, who in turn leases it back to the lessee. Usually, the sale takes place at the market value. Lessee receives the sales price in cash and the unfettered use of the asset during the basic lease period. In turn, the firm contracts to make periodic lease payments and give up the title to the asset. The lessor realizes any residual value that the asset might have at the end of the period.

This form of leasing is the most common form in leasing real estate and property, e.g. retail stores, office buildings, shopping centers, etc.

b) Direct Leasing:
This is an arrangement whereby a firm acquires the use of an asset it did not own previously. A firm may lease an asset from the manufacturer. It is a common practice among computer manufacturers to lease their computers. A wide array of capital goods is offered to the clients on this basis.

c) Leveraged Leasing:
This mode of leasing arrangement is widely used in the financing of assets involving large capital outlays. In contrast to the above-mentioned two leasing arrangements, there are three parties involved in leveraged leasing: the lessee, the lessor, and the lender. Under this arrangement, the lessor borrows a substantial portion of the acquisition cost of the leased asset from a third party. The leverage refers to the financial leverage used by the lessor in structuring the lease and the risk associated with default by the lessee is particularly borne by the third party tender.

d) Syndicate Leasing:
Syndicate leasing involves more than one lessor in leasing out an asset. It is the requirement of the Corporate Law Authority that each company must provide a certain percentage of its business to other companies, which is an indicator of the considerable growth of this industry in the past nine years.

The Competitors

There are four fronts from which the leasing industry faces competition and against which Leasing Companies aims to safeguard itself. They are as follows:

1. Nationalized Commercial Banks (NCBs) and Development Financial Institutions (DFIs)
NCBs and DFIs have clients distinct and separate from those of leasing companies, despite the fact that they are all in the same business. Clients of leasing companies are generally those under a heavy tax bracket and are attracted primarily by the large tax benefits offered through lease rentals. DFIs also stick to traditional sectors and are unwilling to finance projects in new areas. Such borrowers also resort to leasing companies for financing. Thus there is very little direct competition with NCBs and DFIs.

The methodology and procedures followed by these DFIs and NCBs are also important factors to consider. Political considerations have a great deal of importance for government owned organizations. It is well known and well accepted that these institutions have their own criteria of merit which give weightage to political support and backing. This permits the leasing industry a larger market to serve such groups, which despite being financially sound are denied credit by the government controlled institutions.

2. Modarbas
These are the major competitors of leasing companies. Modarbas as a whole account for 33% of total leasing, with the major Modarbas engaged in leasing being 1st Grind lays, BRR 1, LTV Capital, etc.
Operating in a somewhat different regulatory environment, Modarbas enjoy certain advantages as well as disadvantages over the leasing companies.

Modarbas are required to pay tax at a relatively lower rate than leasing firms — 25% for retained earnings and 5% on income distributed as dividends. This advantage is however offset by the fact that leasing firms are allowed high initial depreciation on their assets, which effectively turns reasonable profits into tax return losses.

Modarbas are restricted from obtaining foreign lines of credit. International financial firms are hesitant to extend credit to Modarbas since they cannot use the words ‘markup’ or ‘interest’.

3. Private Banks
Banks in the private sector are expected to cut into some of the leasing companies’ client portfolio, due to their aggressive marketing.

The private banks can be divided into three major segments:
• Foreign banks
• Newly licensed banks
• Newly privatized banks

The foreign banks enjoy the backing of their parent organizations and therefore have stepped into the leasing industry. They also have access to better management and expertise of their operations around the world.

The newly licensed banks and the newly privatized banks will find small-unexplored market segments and offer competition to the leasing firms in those areas.

4. Equity Market
The equity market can be seen as a method of raising funds for the companies, and are therefore a potential source of competition for the leasing industry.

Leasing industry enjoys the opportunity for greater business due to the downturn in the stock exchange and the resultant trouble that the financial companies are faced with in raising funds.

Types Of constraints

1. FUNDING CONSTRAINTS
In Pakistan, virtually the only institutions that provide medium or long-term finance are the government-owned DFIs. However, the DFIs normally require the security of a bank guarantee from any borrower prior to lending them any funds. In early 1992, the state bank issued new regulations prohibiting the commercial banks from issuing guarantees. The DFIs therefore stopped providing finance to lessors, and consequently this source of term financing is no longer available to the leasing industry.

2. CROSS BORDER LEASING
This refers to foreign lessors leasing to Pakistani lessees. Under existing law, withholding tax has to be deducted by the lessee and deposited with the government on the entire rental paid to the foreign lessor. In the case of finance lease, this becomes an unacceptable situation since the withholding tax is deducted on rental payments as well as capital repayments. Therefore, these policies need to be revised by the government.

3. LEGISLATIVE FRAMEWORK
The laws governing the leasing business are very ambiguous. Currently, leasing holds the status of non-banking institution. Leasing must be declared as banking institutions to the extent that the lessee and the lessor receive protection under tribunals.

4. COMPETITION
As explained under the section titled “Competition Faced by the Leasing Industry”, leasing industry faces competition from commercial banks, DFIs, Modarbas, and Equity Markets.

5. NEED FOR SECONDARY MARKETS
It is very essential for the leasing industry to have a secondary market for the assets, which it leases out. The non-availability of secondary markets, except for automobiles, is one of the main reasons of the restricted growth of leasing industry in Pakistan.

6. OTHER FACTORS AFFECTING THE GROWTH OF THE LEASING INDUSTRY
These include the recent deregulation and privatization of the economy, greater investment confidence, technological upgradation, and foreign investment. Also the deteriorating law and order situation in the country and the unstable political scenario has also negatively affected the growth of the leasing industry.

The leasing industry in Pakistan has significant prospects of growing at a pace of at least 25 % to 30 %. It cannot be doubted that over the past years, leasing industry has made a substantial contribution to the country’s economic progress. However, leasing in Pakistan still has a long way to go before becoming well entrenched.

The leasing industry is a vital component in the process of liberalization of the economy as a major catalyst in capital formation and in extending the credit delivery system. The sector is poised to become the second largest taxpayer in the country, within the next few years. Therefore it is incumbent on the government to nurture its growth in the formative years.

Findings & Analysis

Leasing industry in our country is only a decade old, but during this time this sector has made impressive strides. At present, more than 25 leasing companies are operating in country, which are engaged in a variety of leasing activities.

We know that the leading provider of capital to the emerging markets will now be Institutional and private investors either in the form of direct investment or as mutual fund portfolios. As the total demand for capital increases dramatically in these markets – the opportunities for financial intermediaries as banks and leasing companies have continued to expand.

Recommendations on Analysis

However, in our analysis we found out that the following steps can help in the growth of leasing industry in Pakistan:

• Strong and unambiguous legal support for lessor rights.
• A simple process of incorporation with strong regulatory supervision – State bank in our case. Foreign investors should also be allowed to own 100% of a leasing company to encourage foreign investment.
• Benefits of investment tax credits on sales tax for purchasers of fixed assets can be passed to lessees.
• Inflation has a very important role in the financial markets of a country. Therefore, adaptation of an inflation- adjustment accounting system whereby all non-monetary assets on every balance sheet must be adjusted for the inflation rate as and differences registered as taxable income. This favors the utilization of leasing by many big firms because of off-balance sheet status of leasing transaction of lessees.