LEASING IN PAKISTAN
TAYYEB AFZAL
Today, one of the most talked about subjects in the corporate and financial world is the subject of leasing. In the developed countries, it is almost an integral part of the overall financial system and often advocated as the least expensive and most advantageous form of funding.
Leasing has been used extensively in the financing of ships, aircraft, containers and other equipment and assets of substantial value. Th e concept of leasing is applicable to both medium-term and long-term financing.
Recently, the leasing industry in Pakistan has seen tumultuous growth in both the supply and demand side. With the concept of an interest-free environment taking hold in Pakistan, leasing has become a favoured mode of financing. It also fills a market niche, providing medium-term funds to companies to meet their requirements.
There has been no turning back for the entire industry, and its mushrooming growth has taken a toll on the margins of the leasing companies. Th e common feeling in the market, however, is that the success story of the leasing industry is far from over. The percentage of leased assets to total fixed investment is estimated to be just 7%, thus leaving a large potential for the industry to tap. This compares with 42% in Hong Kong, 30% in the USA and 10% for South-East Asian Countries.
The sector has achieved more than 20% annual growth in lease disbursements during the past few years and is expected to grow at the same pace. Funding has been a cause for concern for the sector generally, although large leasing companies have been able to tap cheaper foreign credit lines. Th e International Finance Corporation (IFC) in 1994 sanctioned US$ 70 million for six leasing companies in Pakistan, thus relieving some of the pressure caused by funding constraints in the local market.
The Asian Development Bank (ADB) is currently in the process of obtaining their Board’s approval for a US$60 million long-term credit line to four leasing companies; in addition, they have provided substantial funds in the past to various leasing companies besides equity investment.
The Lease Advantage
In times of strained liquidity positions and near-choking lines of credit and related facilities, leasing arrangements articulated with proper care may help the preservation of credit facilities, particularly if the lessee resorts to, and is permitted to adopt, “off balance sheet” treatment. This factor may become more relevant in the case of foreign-based or multinational companies that are subject to borrowing restrictions under the State Bank of Pakistan regulations.
Leasing arrangements, as opposed to borrowing, usually are perceived as free from corporate strings, or to put it plainly, from any significant restrictions on the freedom of management. A lender, in a typical situation, having advanced loans extended over a reasonably long time, is likely to impose conditions which may fetter to some extent certain specific corporate actions or decisions. This may not generally be so if funding through the expedience of leasing is resorted to.
A disregard of certain positive or negative covenants in a typical loan agreement may impact corporate image, with attendant consequences. Moreover, under a leasing arrangement, it is generally believed that recourse to other funding facilities is usually not curbed by lessors, subject, of course, to certain safeguards being applied in this context.
Typical loaning arrangements are subject to a wide range of regulatory provisions and restrictions. Under leasing contracts, however, the arrangement may be tailor-made, taking into consideration the mutual business considerations of a lessor and its prospective client. It is because of this feature that lease agreements are quite often termed a ‘customised’ arrangement, with a variety of versions and variations in terms of lease payment schedule, tenure of the lease etc., to suit valuing sets of circumstances.
The speed and convenience with which leasing contracts may be concluded is also often cited as an advantage of leasing, which, however, would vary from case to case and include, in the main, the corporate character of the lessor as well as of the lessee. Generally, leasing companies can compete, owing to efficiency of internal appraisal approvals and disbursements, over development financial institutions (DFIs), and that permits it to charge IRR rates higher than that of DFIs and still permit the borrower to take advantage of completing the project in a timely manner and avoid over-runs due to delays.
Capital expenditure budgetary constraints may sometimes be mitigated by leasing, if a particular acquisition of equipment was not contemplated in any original forecast or projection. A fairly common justification for leasing equipment is, therefore, understood to exist where a company has its capital budget in place and desires to undertake further capitalisation through additional acquisition of equipment, primarily to take the tax advantage off increased profitability.
Rather than wait for customary approvals at various corporate tiers, including the Board of Directors, the company may well decide to go for leasing of additional assets and may subsequently have it ratified.
Last but not least, given favourable tax treatment, a lease arrangement properly structured may confer the advantage of a better cash flow stream, particularly on an after-tax basis.
It would, perhaps, not be deemed over simplistic to state that most of the perceived merits of leasing would materialise in an economic environment where tax laws were conducive to, and compatible with, the dictates of leasing as a preferred expedient of funding. It may also be pertinent to add that if the experience of other countries of the world is any guide, leasing has encouraging prospects provided it has sufficiently effective fiscal support.
The Lease or Loan Decision
With the budget of 1994-95, the more ominous of leasing companies’ technical problems have been solved. Specifically, the budget has allowed the company to take the transfer price of the asset at the end of the lease life as the residual value, instead of leaving it to the discretion of the income tax officer; this is also a provision that will limit the presence of financial institutions like commercial banks in the leasing industry. Budget 1995-96 further extended the initial depreciation to leasing companies for five years that hitherto had expired on 30 June, 1995.
Practically speaking, a lessee needs to determine whether leasing an asset gives a more favourable tax treatment and is consequently less costly than buying it. Correspondingly, from the lessors’ standpoint, it must decide the lease on the lines enabling it to produce a targeted or desired rate of return.
Considering the fact that a lease is closely comparable to a loan, at least in the sense that a corporate entity in both situations is required to make a specified series of payments, the default whereof may result in significant repercussions quite identical in both the situations, from a practical standpoint the most appropriate comparison should be from the perspective of cost of leasing versus financing cost of acquiring equipment.
A simple way of evaluating a lease versus a buying option is to carry out an IRR analysis, i.e., internal rate of return. Under this analysis, if the equivalent after-tax loan rate implicit in the lease is lower than the after-tax cost of borrowing, all other things being equal, the inference would be that leasing as an option is advantageous.
The privatisation, deregulation and industrialisation policy of the Government of Pakistan further lends support to the growth of the leasing sector as a shift to private ownership, and the enhanced role of the private sector is likely to lead to prudent asset management, better utilisation of resources and higher demand for long-term finance, adding to the strength of an already increasing investment growth rate. Leasing, therefore, is poised to out-perform almost all other sectors.
Problem Areas
To achieve the desired growth rate, leasing sector companies have to resolve a number of problems confronting them at present. Some of the major problems are enumerated as follows:
1. The competitive environment is expected to get fiercer as more and more players enter into leasing, as a result of which the average IRR charged on leased assets is likely to decline.
2. The average cost of funds on the other hand is likely to increase. The decrease in IRR coupled with an increase in the cost of funds will squeeze the spreads by a sizeable margin. The shrinkage is likely to hit new entrants with greater intensity as compared to the established companies who have already built a capacity to absorb the shock of reduced spread.
3. Commercial banks’ expansion in credit is closely regulated. This restricts commercial banks to providing lines of credit to leasing companies, as they would naturally prefer to deal with corporate customers that enable them to enhance their yields quite significantly.
4. While long-term credit lines are generally available from multilateral agencies such as the Asian Development Bank (ADB) and the International Finance Corporate (IFC), the regulators’ reluctance to provide a hedge against such foreign currency credit lines is understandable in an open market operation.
However, the regulators, on the other hand, are not permitting the borrower to hold on to the foreign currency loan proceeds so that appropriate hedging techniques® can be developed. This only leaves the option of taking forward cover from other commercial banks for short periods at fairly steep rates generally equal to, or greater than, the cost of funds in foreign currency loans.
5. Real estate lease financing is generally not permitted by the regulators. If Pakistan is to transform into an Asian tiger and improve the quality of commercial buildings, leasing companies should not only be permitted, but encouraged, to enter this area of activity.
6. Most of the leasing companies in Pakistan suffer from mismatch of assets against liabilities, meaning that they have funds tied up in long-term assets against short-term borrowing.
7. The leasing companies should be allowed an LMM facility as allowed to DFIs. This will ease the availability of funds and the mismatching of long-term commitments and particularly encourage local manufacturers. The aggressive approach under SBP guidelines will boost the local manufacture of machinery.
Solutions
1. The recently enforced prudential regulations have brought about a greater degree of discipline in our system, as in the past, public money had been mismanaged in a big way. The stepping in of the Central Bank has definitely brought immediate public confidence and now our disciplined behaviour will certainly help in achieving better results.
2. The introduction of new products such as securitisation of lease receivables needs to be developed, so that the market term funds are raised from the domestic market.
3. The future lies in larger balance sheet sizes, as higher volumes become necessary to compensate for declining margins. The key factors that give a competitive advantage to companies in this business include greater access to low-cost funds, proper evaluation of lease proposals, adequate diversification of the leased assets portfolio and a dedicated team of suitably qualified and experienced persons.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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