ASIAN DEVELOPMENT BANK Operations Evaluation Department

PROJECT PERFORMANCE AUDIT REPORT

FOR

PAKISTAN

In this electronic file, the report is followed by the Management response.

Project Performance Audit Report

PPA: PAK 23341 (Final)

Financial Sector Intermediation Loan (Loan 1371-PAK) in Pakistan July 2005 Operations Evaluation Department

Asian Development Bank

CURRENCY EQUIVALENTS

Currency Unit – Pakistan rupee (PRe/PRs)

At Appraisal At Project Completion At Operations Evaluation (June 1995) (October 2001) (October 2004)

PRe1.00 = $0.03225 $0.01752 $0.01658 $1.00 = PRs31.01 PRs57.08 PRs60.30

ABBREVIATIONS

ADB – Asian Development Bank BEL – Bankers Equity Limited BSAL – Banking Sector Adjustment Loan CDR – credit to deposit ratio CLA – Corporate Law Authority CMDP – Capital Market Development Program COS – country operational strategy DFI – development finance institution DLC – Dawood Leasing Company Limited EA – executing agency EFS – export finance scheme ELL – English Leasing Limited ESAF – Enhanced Structural Adjustment Facility FED – foreign exchange deposit FSDIP – Financial Sector Deepening and Intermediation Project FSIL – Financial Sector Intermediation Loan FX – foreign exchange GDP – gross domestic product ICP – Investment Corporation of Pakistan IMF – International Monetary Fund LIBOR – London interbank offered rate MOC – Ministry of Commerce MOF – Ministry of Finance NBFC – nonbanking finance company NBFI – nonbank financial institution NBP – National Bank of Pakistan NCB – nationalized commercial bank NIC – National Insurance Corporation Limited NLC – Network Leasing Corporation Limited NIT – National Investment Trust Limited OEM – operations evaluation mission OTC – over-the-counter PCR – project completion report PFI – participating financial institution PIC – Pakistan Insurance Corporation PICL – Pakistan Industrial and Commercial Leasing Limited PKI – Pakistan Kuwait Investment Company (Private) Limited PPAR – project performance audit report RRP – report and recommendation of the President SBP – State Bank of Pakistan SECP – Securities and Exchange Commission of Pakistan TA – technical assistance

NOTES (i) The fiscal year (FY) of the Government ends on 30 June. (ii) In this report, “$” refers to US dollars.

Director General, Operations Evaluation Department : Bruce Murray Director, Operations Evaluation Division 2 : David Edwards Evaluation Team Leader : Tetsu Ito

Operations Evaluation Department, PE-664

CONTENTS Page

BASIC DATA iii EXECUTIVE SUMMARY iv I. BACKGROUND 1

A. Rationale 1 B. Formulation 1 C. Purpose and Outputs 2 D. Cost, Financing, and Executing Arrangements 2 E. Completion and Self-Evaluation 4 F. Operations Evaluation 4

II. PLANNING AND IMPLEMENTATION PERFORMANCE 4

A. Formulation and Design 4 B. Achievements of Credit Line 7 C. Achievement of Policy Reforms 11 D. Organization and Management 14

III. ACHIEVEMENT OF PROJECT PURPOSE 15

A. Performance Indicators 15 B. Project Outcome 17

C. Sustainability 18 IV. ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS 19

A. Socioeconomic Impact 19 B. Environmental Impact 19

V. OVERALL ASSESSMENT 19

A. Relevance 19 B. Efficacy 20 C. Efficiency 20 D. Sustainability 20 E. Institutional Development and Other Impacts 21 F. Overall Project Rating 21 G. Assessment of Borrower and ADB Performance 21

VI. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS 22

A. Key Issues for the Future 22 B. Lessons Identified 22 C. Follow-Up Actions 24

Tetsu Ito, evaluation specialist (team leader), was responsible for the preparation of this report, and conducted document reviews, key informant interviews, and guided the fieldwork undertaken by Yawer Sayeed and Farid Alam (staff consultants) and A. Ali Qureshi (research assistant). Barbara Palacios, senior evaluation officer, supported the team with research assistance from Manila.

The guidelines formally adopted by the Operations Evaluation Department (OED) on avoiding conflict of interest in its independent evaluations were observed in the preparation of this report. To the knowledge of the management of OED, there were no conflicts of interest of the persons preparing, reviewing, or approving this report.

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APPENDIXES 1. Compliance Status of Key Loan Covenants on Participating Financial Institutions 25 2. Profile of Bankers Equity Limited (Under Liquidation) 28 3. Characteristics of Subloans 29 4. Overview of Subprojects 31 5. Profile of First Dawood Investment Bank (Formerly Dawood Leasing Company 36 Limited) 6. Profile of English Leasing Limited 40 7. Profile of Network Leasing Corporation Limited 44 8. Profile of Pakistan Industrial and Commercial Leasing Limited 48 9. Profile of Pakistan Kuwait Investment Company (Private) Limited 53 10. Policy Matrix 57 11. Statistical Data 66

Attachment: Management response

BASIC DATA

Project Preparation/Institution Building TA No.

Technical Assistance Name Type Person-Months

Amount1 ($ ‘000)

Approval Date

2393 Capital Market Development Advisory

Technical Assistance

21 865.0 7 Sep 1995

Key Project Data ($ million) As per ADB Loan

Documents Actual

ADB Loan Amount/Utilization 100.0 24.5 ADB Loan Amount/Cancellation 75.5 Amount of Parallel Financing 216.02 28.03

Key Dates Expected Actual Fact-Finding 5–21 Apr 1994 Appraisal III—IV June 1994 26 Nov–16 Dec 1994Loan Negotiations III Mar 1995 17–19 Jul 1995Board Approval III Apr 1995 7 Sep 1995Loan Agreement 7 Oct 1995Loan Effectiveness 4 Jan 1996 28 Jun 1996First Disbursement 23 Jun 1997Loan Closing 31 Dec 2000 31 Dec 2000Months (effectiveness to completion) 60 54 Borrower Government of Pakistan Project Administrator Banker’s Equity Limited Executing Agencies Dawood Leasing Company Limited English Leasing Limited Network Leasing Corporation Limited Pakistan Industrial and Commercial Leasing Company Limited Pakistan Kuwait Investment Company (Private) Limited Mission Data No. of Missions Person-Days Contact 1 14 Consultation 3 11 Fact-Finding 1 96 Appraisal 1 168 Project Administration Review 2 13 Project Completion 1 23 Operations Evaluation 1 76

1 Financed by the Japan Special Fund. 2 World Bank. 1994. Financial Sector Deepening and Intermediation Project (FSDIP). 3 During implementation, FSDIP was significantly restructured and its loan amount was reduced.

EXECUTIVE SUMMARY

The Asian Development Bank (ADB) approved the Financial Sector Intermediation Loan (FSIL) to the Islamic Republic of Pakistan for $100 million on 7 September 1995. The FSIL’s objectives were to (i) support the Government in its financial sector and capital market reforms, (ii) diversify the credit delivery system and strengthen the resources base of qualified financial institutions, and (iii) meet part of the investment requirements of the private sector. To meet these objectives, the FSIL was structured as a credit line with a substantial program of policy actions addressing broad financial sector issues. The FSIL was to share the same purpose, scope, and policy requirements with the World Bank’s Financial Sector Deepening and Intermediation Project (FSDIP) approved in October 1994. In conjunction with the FSIL, ADB also approved a technical assistance (TA) grant for capital market development (TA 2393-PAK).

Under the FSIL, the Government was to relend the loan proceeds to nine financial

institutions, which signed on the project agreements with ADB. The participating financial institutions (PFIs) were to onlend the loan proceeds to private sector activities that required foreign exchange (FX) to finance the cost of eligible goods and services. Bankers Equity Limited (BEL), a development financial institution (DFI), was to administer the credit line. At the time of loan approval, ADB estimated the total private investment for the next 2 years to be about $4.9 billion per year and identified a substantial gap in the credit market. On this basis, ADB expected that the FSIL would be fully committed within 3 years of loan effectiveness. However, only $24.5 million was actually disbursed to the five PFIs (four leasing companies and one DFI) under the FSIL to support 73 subprojects; the remaining $75.5 million was cancelled. The loan was closed on 31 December 2000 as originally scheduled. The credit line under the FSDIP was not utilized and was cancelled in three stages, with final cancellation in December 1998. In January 2004, the Government fully prepaid the FSIL.

The Operations Evaluation Mission (OEM) attributed the underutilization of the FSIL to

the (i) cost of hedging the FX risk, (ii) nonavailability and cost of the third-party guarantee by the PFIs to the Government, (iii) restrained domestic credit demand during 1998–2000, (iv) downtrend in the domestic market interest rate from 1998 to date, and (v) relatively high pool-based dollar interest rate of ADB relative to the London interbank offered rate (LIBOR) from 2001 to date. The first three factors were aggravated by unstable political and external conditions facing Pakistan during 1998–2001.

Of the 73 subloans for a total of $24.5 million, 62 for $11.4 million were fully repaid by

subborrowers; 1 for $4.3 million is being repaid; 1 for $7.2 was rescheduled and is being repaid; 3 for a total of $0.4 million had defaulted and court decisions were made; four for a total of $1.0 million have defaulted and are currently under litigation; and there is no information on 2 subloans totaling $0.2 million. At the OEM, three PFIs maintained profitable operations while the remaining two were facing financial problems due to the fraudulent practice of previous managements, which surfaced subsequent to FSIL implementation. As a result, the two PFIs have suspended payments to the Government under the FSIL. BEL’s management had also been involved in fraudulent activities soon after its privatization in 1996, and the DFI was eventually put under receivership. The Government and ADB unsuccessfully explored the replacement of BEL as project administrator as well as third-party guarantor of the FSIL to the Government.

The policy matrix of the FSIL included 45 policy actions concerning the (i) macroeconomy, (ii) financial sector and institutions, and (iii) capital market. The 31 policy actions in the first and second components were identical to those in the policy matrix of the

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FSDIP. The remaining 14 actions under the third component covering the capital market were specific to the FSIL. During the two reviews the Government and ADB, in coordination with the World Bank, were to exchange views on the progress of the policy reform program. Both institutions retained the right to suspend their credit lines in case of a substantial failure by the Government in complying with the policy matrix. However, ADB did not review the policy matrix during review missions, and the World Bank voided the FSDIP’s policy matrix. The OEM confirmed full compliance with 40 of 45 FSIL policy actions. Of the remaining five actions, three were deemed partly complied with, one was not applicable, and the remaining one could not be verified. Many policy requirements under the FSIL were only broadly defined, indicating either the direction of reforms or the need for studies and/or reviews. Others were specific, but formed a fractional part of broader reforms supported under the subsequently extended ADB loan Capital Market Development Program (CMDP), the Enhanced Structural Adjustment Facility (ESAF) from the International Monetary Fund, and the Banking Sector Adjustment Loan (BSAL) from the World Bank.

The OEM assessed the FSIL as irrelevant. To fill the “shortage of FX term funds to meet the investment demand from private entrepreneurs” was the key rationale for the FSIL. However, the FSIL was not designed as such, and subborrowers simply availed themselves of local currency term funds. In fact, financial institutions were not allowed to extend FX term loans at the time of FSIL approval. Appraisal of the FSIL overlooked this key regulatory constraint. The FSIL objectives lacked prioritization, and the credit line and the policy matrix were not closely linked. Given the growing concern on the deteriorating performance of commercial banks and DFIs at appraisal of the FSIL, ADB could have prioritized the restructuring of these institutions through program lending. Alternatively, the FSIL policy matrix could have focused on issues directly related to the credit line or nonbank financial institutions. Either way, the project could have been more cohesive, timely, and relevant. The OEM assessed the FSIL as partly efficacious. The credit line under the FSIL was significantly underutilized. Of the five PFIs, two effectively utilized the FSIL to attain sound company growth. The experience of another PFI was not so encouraging because of the underperformance of its largest subloan, which represented 29.4% of the total disbursement under FSIL. The fraudulent activities and the subsequent financial problems of the remaining two PFIs undermined the significance of the FSIL. The overall contribution of FSIL’s credit line to the country’s financial intermediation and private sector activities was far less than expected. The financial and capital market indicators suggest the noteworthy recovery of the banking system and the capital market in the recent years. However, the Government attributed this recovery mainly to CMDP, ESAF, and BSAL rather than the FSIL. The OEM supported this view of sequencing of influences and impacts. Perhaps, the key contribution of the FSIL to policy reforms was that it highlighted the need for a more significant financial sector program and full-fledged policy-support loans in view of the complexity and urgency of reforms required in the sector. The underperformance of the project administrator marks the management of the FSIL credit line as inefficient. The service provided by the administrator was not worth the administration fees that PFIs paid. ADB, on its part, vigorously marketed the FSIL to financial institutions while partly offsetting the underperformance of the administrator. However, four financial institutions that had finalized the project agreements could not actually utilize the FSIL. ADB’s effort in this regard was not fully cost-effective.

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The outcomes of the FSIL, though far less than expected, are likely to be sustained. Most subprojects visited by the OEM had maintained positive project outcomes. Management of the three PFIs appeared to have clear vision of a viable business model. The policy achievements under the FSIL are generally irreversible, complemented by significant follow-on measures. The OEM assessed the overall impact of the FSIL as negligible given that (i) its contributions to institutional strengthening of the five PFIs was marginal, and (ii) its socioeconomic and environmental contributions were considerably less than what had been expected. On the basis of the above, the overall rating of the FSIL is unsuccessful. The OEM confirmed the earlier audit’s successful rating of TA 2393-PAK, which contributed to capacity building of the Securities Exchange Commission of Pakistan.

The FSIL demonstrated the risks associated with a project that was formulated based on a weak logical framework, namely (i) inconsistency between the project rationale and objective; (ii) excessively broad project objective (without specifying immediate objective, or purpose); (iii) weak linkages among expected project outputs (or lack of cohesiveness in project scope); and (iv) lack of an explicit monitoring mechanism. Most importantly, the experience with the FSIL underscores the necessity of a clear project purpose. The project purpose should not be used only to design the project; it should constantly be referred to in monitoring project implementation. When a project encounters unforeseen events, the project purpose should be the basis for adjusting the project scope/design or, if necessary, to cancel its implementation. This judgment can only be effective if the project purpose is clearly stated.

The FSIL encountered a series of negative unforeseen events, resulting in suspension of the repayment from two PFIs to the Government as well as insolvency of the guarantor of these repayments. The OEM was of the opinion that the FSIL should have been restructured or cancelled in 1999 when the project administrator (as well as guarantor) was put under receivership and a replacement could not be assigned. Such a decision could be made in consideration of not only the project purpose but also the project cost and risks. The OEM was of the view that a system was not effectively in place within ADB to appropriately reassess these important aspects and take responsive action to restructure/cancel underperforming loans.

There were changes in ownership and management of the two PFIs and the administrator during FSIL implementation. Subsequently, gross criminal irregularities and misappropriations were detected which necessitated harsh legal and regulatory measures. These experiences underscore the need for ADB to thoroughly reevaluate the continuing qualification criteria as and when there is a management or ownership change in PFIs during project implementation. Even after loan completion, ADB should monitor major events of the concerned financial institutions to the extent possible. Such monitoring activities would deserve extra resource allocation in some cases, depending on the type of issues that subsequently surface and the extent of ADB’s direct or indirect loan exposure to the institutions.

In the past, ADB defined fraud and corruption terms narrowly, focusing on procurement

issues in ADB-financed activities, under the anticorruption policy adopted in 1998. However, it was recognized that this narrow definition may place ADB in a position where parties that it had found not to have maintained the highest ethical standards might find ways to participate in ADB-financed activities other than those covered by contracts. On this basis, ADB in November 2004 defined fraudulent practice as “any action, including misinterpretation, to obtain a financial or other

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benefit or avoid an obligation by deception.” With this new definition in place, ADB could have taken more decisive action when the fraud scandals in the two PFIs and BEL surfaced. The OEM held the view that strict adherence to the revised anticorruption policy is essential to improving the governance of ADB’s credit lines.

A credit line with a program of policy actions addressing broad sector issues may not be effective unless it is designed cohesively. The FSIL was diffused in scope; the logical linkage between the credit line and the policy matrix was weak. Given that the entire loan amount was to be directed to the PFIs, the Government did not pay attention to the policy matrix. Reflecting the underutilization of the loan, ADB's emphasis on the policy matrix also faded during implementation.

Parallel financing with another aid agency should be justified on the basis of project cost, credit demand, and complementary effects of the loans. Even when a counterpart aid agency has appraised the project, ADB should independently and diligently assess such appraisal. Regular contact with the counterpart aid agency throughout project implementation should be essential. Withdrawal/cancellation of the counterpart agency’s support should be a signal that a review and reassessment of the project are warranted. Under the FSIL, PFIs were required to submit summary environmental impact assessment reports for all subprojects. The Loan Agreement, however, did not specify the contents of the report. Perhaps partly for this reason, ADB did not pay enough attention to this requirement, and the PFIs did not submit adequate information on the environmental aspects of subprojects. This experience underscores the need for diligent application of the ADB environmental policy revised in November 2002, especially the guidelines on Environmental Assessment for Financial Intermediation Loans and Equity Investments. It is recommended that the Ministry of Finance (i) discuss the possible restructuring of the remaining balance under the FSIL with BEL and the two PFIs that have suspended repayments; and (ii) clarify BEL’s status as FSIL administrator and guarantor, and verify PFIs’ payment obligation as regards the administration and guarantee fees. MOF should inform the PRM of outcomes of the recommended follow-up actions by end-June 2006.

Bruce Murray Director General Operations Evaluation Department

I. BACKGROUND A. Rationale 1. From the late 1980s to the early 1990s, the Government of Pakistan implemented major policy reforms in the financial and industry sectors as well as in the external trade regime. These reforms stimulated private sector investment, and resulted in the growth of the industry sector and the gross domestic product (GDP) by 7.9% and 5.8% per annum, respectively, from FY1987 to FY1992. Under the Eighth Five-Year Plan (FY1993–FY1998), the Government continued to emphasize the role of the private sector and set the GDP growth target at 9.9% per annum. To achieve that target, the Government underscored the need for further improvement of financial intermediation and capital market development. 2. The Asian Development Bank’s (ADB) financial sector operations in Pakistan between 1968 and 1994 were represented by 19 development finance institution (DFI) loans, covering 14 projects and totaling $957 million. These projects aimed to support domestic banks to cope with a growing credit demand from private sector investors. However, the findings of the evaluation of the projects were not encouraging: 78% were partly successful—mainly because of low loan recovery, but also because of the complex technical, administrative, and legal aspects of the projects.1 Based on this observation, ADB’s country operational strategy (COS)2 prepared in July 1995 envisioned the refocusing of financial sector operations in Pakistan from traditional DFI loans to policy-based lending. 3. The report and recommendation of the President (RRP) gave the following rationale for the Financial Sector Intermediation Loan (FSIL): “The main source of economic growth in Pakistan in recent years has been the private industry sector. This has necessitated increased private sector investment in the manufacturing and other productive sectors. Concurrently, the country’s financial sector has experienced a shortage of foreign exchange term funds to meet the investment demand from private entrepreneurs. At the same time, a number of constraints remain in Pakistan’s financial system inhibiting efficient financial intermediation and the development of the capital markets. The proposed Project responds to those requirements.” B. Formulation 4. During the 1992 Country Programming Mission, the Government requested ADB to assist the newly privatized DFIs and commercial banks. At about the time ADB's first consultation mission was fielded in late 1992, the World Bank was at the early stage of processing its Financial Sector Deepening and Intermediation Project (FSDIP). 3 After dialogue and ADB’s participation in the World Bank’s processing missions, it was decided that ADB would provide parallel financing with the World Bank’s FSDIP, sharing the same scope, design, and policy requirements. It was agreed that in implementing the policy matrix, ADB would focus mainly on the capital market and the World Bank on the banking sector. The two institutions believed that this collaboration would enhance the leverage on necessary financial sector reforms and provide resources to narrow the large financing gap in the financial system. ADB

1 ADB. 1995. Pakistan: Economic Review and Bank Operations. Manila. 2 ADB. 1995. Country Operational Strategy Study for Pakistan. Manila. 3 World Bank. 1994. Financial Sector Deepening and Intermediation Project (FSDIP), for $216 million equivalent.

The World Bank supported the financial sector reform in Pakistan during FY1989–FY1991 through a Financial Sector Adjustment Loan (FSAL). To build on the achievements under the FSAL, the World Bank approved the FSDIP. The key elements of the FSDIP included (i) an umbrella credit line, (ii) a policy matrix, and (iii) technical assistance to carry out financial sector reforms as well as to implement the credit line.

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fielded processing missions between April and December 1994. The loan negotiation was completed in July 1995 and further consultation was undertaken in August 1995. C. Purpose and Outputs 5. The FSIL objectives, as stated in the RRP, were to (i) support the Government in its financial sector and capital market reforms, with a

view to increasing the efficacy of financial sector policies and management; improving efficiency in the system’s intermediation function, thereby reducing the cost of financial intermediation and enhancing domestic resource mobilization; strengthening the institutional capabilities of concerned organizations; and promoting the development of the capital market;

(ii) provide an efficient and broader range of services to the private sector, diversify

the credit delivery system and strengthen the resource base of qualified public and private sector banking and nonbank financial institutions (NBFIs) through supplementing their long-term foreign exchange resources; and

(iii) support private sector development through meeting a part of its investment fund

requirements, with focus on high technology and export-oriented industries, including small-scale industry.

6. Following the FSDIP, an umbrella credit line, a policy matrix, and a technical assistance (TA) grant were the key elements of the FSIL. At the time of loan approval, two joint-venture DFIs, one private commercial bank, and six private NBFIs had been identified to qualify for participation. It was assumed that in the event of substantial failure by the Government to meet the policy requirements, the disbursement of the credit line would be suspended (or the undisbursed portion cancelled). D. Cost, Financing, and Executing Arrangements 7. On 7 September 1995, ADB approved the FSIL to the Islamic Republic of Pakistan for $100 million from ADB’s ordinary capital resources. At the time of loan appraisal, ADB estimated the total private investment for the next 2 years to be about $4.9 billion per year and identified a substantial gap in the credit market even considering the FSDIP. On this basis, ADB expected that the FSIL would be fully committed within 3 years of loan effectiveness. 8. The Government was to relend the loan proceeds to participating financial institutions (PFIs). Any public and private sector financial institution could be a PFI provided that it could comply with the financial covenants (Appendix 1) and ADB would approve its participation. The PFIs were to onlend the loan proceeds (or provide leases) to private sector activities that required foreign exchange (FX) to finance the cost of eligible goods and services. 4 The

4 To qualify, subborrowers were to be enterprises that (i) carried on any legitimate private sector activity other than

real estate or trading; (ii) had a debt/equity ratio not greater than 60/40; and (iii) were not in default of repayment to any bank or development finance institution (DFI), and the principal sponsors of which were not sponsors of other enterprises in default of repayment to any bank or DFI. Moreover, all the subprojects were to fully comply with all applicable environmental regulations and legislation in Pakistan. In principle, subloans were to finance up to a maximum of 60% of the debt or lease requirements of subprojects. The PFIs were to finance at least 20% of the debt or lease requirements from its own resources and the rest from other sources including FSIL.

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maximum subloan5 size was $8 million, and the free limit was $3 million.6 Each of the PFIs was the executing agency (EA) of the FSIL. Bankers Equity Limited (BEL) was to administer the credit line through an administrative unit (AU)7 of its organization (Appendix 2). The AU was to (i) monitor the eligibility status of each PFI, (ii) provide information on financial institutions interested in participating in the FSIL, (iii) channel repayments due to the Government from PFIs, and (iv) account for expenditures under the FSIL. In addition, the AU was expected to maintain an environmental expert to address the environmental aspects of subprojects and to assist PFIs in environmental matters in respect of subprojects. 9. The lending rate to the Government was determined in accordance with ADB’s pool-based variable lending rate for dollar loans. The Government's relending rate to the PFIs was ADB's lending rate plus an administration fee of 0.5% to BEL.8 Non state-owned PFIs were required to have repayment obligations guaranteed by a suitable third-party guarantor. State-owned PFIs, not subject to this guarantee requirement, were subject to a fee of 0.5% payable to the Government. Each PFI was to onlend to subborrowers at prevailing market interest rate. The PFIs were to have either an FX risk covered under an appropriate facility, enter into a swap agreement with acceptable counterparties, or pass on the risk to subborrowers.9 The loan to the Government had a repayment period of 15 years, including a grace period of 3 years. The relending to the PFIs had a repayment period of a maximum of 15 years, including a grace period of not exceeding 3 years. The repayment period applicable to subloans should not exceed 12 years, including a maximum grace period of 2 years. A lending mechanism, eligibility requirements, and terms and condition of the FSIL were similar to those of the FSDIP. 10. The policy matrix of the FSIL included 45 policy actions10 concerning the (i) macroeconomy, (ii) financial sector and institutions, and (iii) capital market. The 31 policy actions in the first and second components were identical to those in the policy matrix of the FSDIP. The remaining 14 actions under the third component covering the capital market were specific to the FSIL. Of the 45 actions, 26 were to be taken up during the first interim review (first quarter 1996); and the remaining 19 during the second interim review (first quarter 1997). During the two reviews the Government and ADB, in coordination with the World Bank, were to exchange views on the progress of the policy reform program. The Ministry of Finance (MOF) was responsible for reporting progress in the macroeconomic, sector and institutional components of the program, and the Corporate Law Authority (CLA)11 was responsible for the capital market component. 11. One TA12 was attached to the FSIL. It aimed at (i) increasing the transparency and enhancing the operational efficiency of the stock market, (ii) improving efficiency in the mutual

5 In this report, “subloan” includes lease investments made by PFIs under the FSIL. 6 Before requesting a withdrawal for subloans above the free limit from the FSIL, the PFIs were required to submit an

application to ADB, with detailed information on subprojects, for approval. For subloans below the free limit, the PFIs were required to submit the simplified application documents for ADB’s confirmation.

7 BEL established the AU, supported under FSDIP, to administer the credit lines from the World Bank and ADB. 8 According to the Loan Agreement, “the Administrator shall receive from the Borrower a fee payable at the rate of

one fourth of one percent (0.25%) per annum on the amount withdrawn from the Loan Account and outstanding from time to time with respect to subloans.” Under this arrangement, PFIs were to pay 0.5% on the outstanding balance of subloans, and 0.25% of the revolving fund (the difference between loan payable to the Government and loans receivable from subborrowers) at a later stage.

9 The Loan Agreement did not specify the currency for relending and subloans. Instead, it merely noted “foreign exchange risk of the Loan shall be borne by the Qualified Enterprises.”

10 In addition, the policy matrix indicated 14 actions taken prior to the approval of the FSDIP in October 1994. 11 The CLA was an “attached department” of the Finance Division of the Government, responsible for regulating the

capital market. 12 ADB. 1995. Technical Assistance to the Islamic Republic of Pakistan for Capital Market Development. Manila (TA

2393-PAK, for $865,000, approved on 7 September 1995).

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fund industry with focus on Government-owned investment companies, and (iii) expanding the resource base of the leasing industry. CLA was the EA. E. Completion and Self-Evaluation 12. Under the FSIL, $24.5 million was disbursed to support 73 subprojects and the remaining $75.5 million was cancelled. The loan closed on 31 December 2000 as originally scheduled, and the project completion report (PCR) was circulated in January 2002. The PCR rated the FSIL as partly successful based on the following: first, the project’s principal objective of supporting the Government’s efforts to reform the financial sector was achieved; second, the $24.5 million disbursed out of $100 million had minimal impact on the financial and private sector development; third, seven measures13 in the policy matrix were not fully complied with. The PCR offered adequate information on the PFIs’ performance and the implementation status of the policy matrix. However, it did not assess subproject benefits and attributions of the actual policy reforms to the policy matrix. Hence, the PCR assessment of the project outcome was weak. 13. The consulting services and consultant’s report for the attached TA 2393-PAK (footnote 12) were largely completed in October 1997. The training component was delayed because of the transformation of CLA into the Securities and Exchange Commission of Pakistan (SECP) as an independent regulatory body. The TA closed in October 2003, almost 6 years beyond the targeted closing date. The TA completion report, circulated in May 2004, rated the TA successful noting its substantive outputs that laid the foundation in building the capital market institutions. F. Operations Evaluation 14. The Operations Evaluation Mission (OEM) to evaluate the FSIL was conducted from 19 September to 10 October 2004. The OEM met with representatives of MOF, Ministry of Commerce (MOC), State Bank of Pakistan (SBP), SECP, Karachi Stock Exchange, National Commodity Exchange Limited, BEL, five PFIs, 12 selected subborrowers, the World Bank, and other relevant institutions. This project performance audit report (PPAR) incorporates the OEM findings, observations of concerned ADB staff, and a review of reports and documents related to the FSIL. The OEM also considered the TA performance audit’s successful rating14 of TA 2393-PAK (footnote 12) in view of its complementarity with the FSIL. The draft PPAR was circulated to the Government and within ADB. Comments received were considered in finalizing the PPAR.

II. PLANNING AND IMPLEMENTATION PERFORMANCE

A. Formulation and Design

1. Inadequate Appraisal of Market Regulations and Conditions 15. The diagnosis of the FSIL relied largely on the appraisal of the World Bank's FSDIP. On this basis, the RRP succinctly assessed the policy and institutional issues in the financial sector.

13 These covenants concerned (i) prudential regulations for minimum capitalization of nonbank financial institutions,

(ii) study on restructuring of State Life Insurance Corporation (LIC) and Pakistan Insurance Corporation (PIC), (iii) implementation of the LIC’s and PIC’s restructuring plans, (iv) empowerment of the Controller of Insurance, (v) rate setting of the insurance industry, (vi) restructuring of the mutual fund industry, and (vii) formulation and implementation of an action program of the mutual fund industry.

14 ADB. 2003. Technical Assistance Performance Report on Selected Advisory Technical Assistance for Capital Market in Pakistan. Manila.

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However, its assessment of the FX forward/swap market and the related regulation was weak. The RRP noted: “to assist subborrowers (or lessees) in managing this risk, the PFIs will have the foreign exchange risk covered under an appropriate facility available in the market or arrange, if possible currency swaps with acceptable market counterparts. If none of these can be arranged, the PFIs will pass the foreign exchange risk to subborrowers.” However, neither a FX forward/swap market nor any particular facility was readily available for financial institutions to hedge against FX risks associated with medium-term loans.15 Moreover, SBP did not permit financial institutions to extend FX term loans at the time of FSIL approval. These suggest that the proposed handling of the FX risk by PFIs reflected an overly optimistic view of FX forward/swap market development as well as lack of understanding of the FX regulation. 2. Inconsistency between Diagnosis and Project Design 16. The RRP correctly pointed out that “the loan recovery of financial institutions is at an uncomfortably low level, particularly for some NCBs [nationalized commercial banks] and DFIs. Without taking decisive remedial measures, these NCBs and DFIs will face permanent difficulties in improving their portfolio, which could undermine their overall solvency. The difficulties in the financial sector go beyond the lack of available long-term credits.”16 Despite this concern, the FSIL policy matrix did not adequately address the emerging issue of non-performing loans. Perhaps the more critical aspect of the FSIL concerned the credit line, especially its timing: should ADB have prioritized the credit line of this kind when the difficulties in the financial sector went beyond the lack of long-term credits? 3. Overambitious Objective and Lack of Cohesiveness in Scope 17. The objectives of the FSIL referred to “financial sector and capital market reforms,” “efficacy of financial sector policies and management,” “efficiency of the system’s intermediation function,” “cost of financial intermediation,” “domestic resource mobilization,” “diversity of the credit delivery system,” “resource base of qualified public and private sector banking and NBFIs,” “private sector development,” and so on. Each subject was relevant to the country's development strategy as well as to ADB's COS. Nevertheless, to tackle all these areas in one project was overly ambitious. It reflected a lack of focus and weak prioritization, leading to a project scope that was not cohesive. 4. Weak Linkage between Project Components 18. The lack of cohesiveness in scope related to the hybrid nature of the FSIL. The credit line was to support the private sector investment and operations of qualified financial institutions, while the policy matrix was to support reforms of the entire financial sector. A logical linkage was missing between the credit line and the policy matrix so that it was possible for a PFI to be penalized for the Government’s failure to comply with the policy conditions. This was a potential design flaw of the FSIL.

15 The RRP referred to the forward cover scheme introduced by the state-owned National Bank of Pakistan (NBP) as

one of the available hedging mechanisms. However, the NBP scheme was applicable only to registered importers and exporters and not to financial institutions, and no other hedging mechanism was readily available in the market.

16 As reported in the RRP, the banking system in Pakistan was on the verge of a crisis in late 1996 (footnote 48).

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5. Weak Financial Covenants for Nonbank Financial Institutions 19. The FSIL did not specify a particular type of financial institution eligible for the credit line, and thus, it was open to DFIs, banks, and leasing companies.17 This flexible arrangement provided a buffer against possible fluctuation of the domestic interest rate and other uncertainties, which could affect the demand for this credit line.18 However, more appropriate financial covenants should have been identified for leasing companies so that the FSIL could complement the country’s weak regulatory framework on NBFIs and their governance. It is noted that prudential guidelines were not yet in place for leasing companies at the time of FSIL approval. Among the covenants that should have been considered are (i) capital adequacy, (ii) provisions for nonperforming assets, (iii) portfolio concentration, (iv) connected lending/leasing, and (v) FX exposure limit. It is also noted that the FSIL policy matrix did not adequately address the regulatory issues on NBFIs. 6. Some Weakness in the Policy Matrix 20. The policy matrix of the FSIL was comprehensive and consistent with its objectives. It had two unique features: (i) most policy requirements were broadly defined, indicating either the direction of reforms or the need for studies and reviews; and (ii) 31 of 45 policy actions echoed the FSDIP’s policy matrix. These features could be justified, considering that this policy matrix was a supplementary component attached to a DFI loan. However, the policy measures in the areas directly related to the credit line could have been prioritized and detailed so that the FSIL could have been more focused and coherent. In particular, the introduction of the prudential guidelines for NBFIs should have been a key program measure. Corporate governance in NBFIs is another area that the FSIL could have focused on. TA 2393-PAK (footnote 12) was appropriately designed to complement the capital market component of the policy matrix, which aimed at improving the stock exchanges’ operations and market rules. 7. Inadequate Collaboration with the Other Multilateral Agency 21. The capital market component of the FSIL policy matrix, together with TA 2393-PAK, was to complement the FSDIP. Likewise, the World Bank‘s technical assistance to BEL was to complement the FSIL. As the usual practice in parallel financing, there was no cross-conditionality or cross-default clause between the FSIL and the FSDIP. Nevertheless, close coordination between the two organizations was envisaged during interim reviews of the policy matrix. In this way, the FSIL and the FSDIP assumed unique collaboration at the design stage. This collaboration was well intentioned, and could have worked better if there were enough credit demand for the two loans. One critical issue, however, was that the RRP did not analyze the slow progress of the credit line under the FSDIP, which was approved 9 months earlier than

17 The RRP projected that about 50% of the FSIL would be utilized by DFIs and the balance by private sector banks

and NBFIs. 18 In general, banks were more favorably placed in terms of cost of fund, mobilizing noninterest-bearing demand

deposits whereas nonbanks, including leasing companies, could accept only high interest-bearing time deposits. Additionally, being in competition, nonbanks were offering interest on those deposits at a higher band than the commercial banks. The leasing companies also relied heavily on borrowed funds. Therefore, the lending rates of leasing companies were also higher. Therefore, even with the cost of guarantee and forward cover for the FSIL, these companies could have a comfortable margin until such time that the overall interest rate regime was at a higher level. For leasing companies, the cost of the FSIL ranged between 17% and 19%, with the lending rate averaging 21%–24%.

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the FSIL.19 This suggests that ADB failed to capitalize on this collaboration even at the time of appraisal. B. Achievements of Credit Line

1. Loan Utilization 22. The FSIL became effective on 28 June 1996, more than 5 months after the targeted date. This delay was attributable to the late (i) finalization of the Administration Agreement between the Government and BEL due to the decision to privatize BEL subsequent to FSIL approval (para. 46); and (ii) submission of the legal opinion on the subsidiary and project agreements acceptable to ADB. 23. The following five institutions actually utilized the FSIL: (i) English Leasing Limited (ELL), (ii) Network Leasing Corporation Limited (NLC), (iii) Pakistan Industrial & Commercial Leasing Limited (PICL), (iv) First Dawood Investment Bank Limited (formerly Dawood Leasing Company Limited [DLC]), and (v) Pakistan Kuwait Investment Company (Private) Limited (PKI).20 ELL, NLC, PICL, and DLC are not state-owned leasing companies,21 while PKI is a DFI jointly owned by the Governments of Pakistan and Kuwait. In addition, one more leasing company and three commercial banks also signed project agreements but did not actually utilize the FSIL. As of the terminal date of subloan applications for ADB approval/authorization on 30 June 2000, the total committed amount (by the nine financial institutions) under the FSIL was $55.8 million. The uncommitted balance of $44.2 million was cancelled on 31 July 1999. Of the committed $55.8 million, ADB had disbursed $24.5 million to finance 73 subloans of the five PFIs by the loan closing date of 31 December 2000 (Appendix 3). The remaining balance of $19.9 was cancelled on the same day. 24. The OEM attributed the underutilization of the FSIL (including the revolving fund, or the fund generated from the recovery of subloan principals) to the (i) cost of hedging the FX risk, (ii) nonavailability and cost of the third-party guarantee by the PFIs to the Government,22 (iii) restrained domestic credit demand during 1998–2000,23 (iv) downtrend in the domestic market interest rate from 1998 to date,24 and (v) relatively high pool-based dollar interest rate of ADB relative to the London interbank offered rate (LIBOR) from 2001

19 The credit line component of the FSDIP was not utilized, and was cancelled in three stages with final cancellation

in December 1998. The Implementation Completion Report of the FSDIP noted that onlending terms and conditions of the FSDIP could not be met by the beneficiaries, pointing to the fact that “it was apparent even during appraisal that there will be serious problems in finding eligible FIs [financial institutions] to participate.”

20 ELL, PICL, and PKI finalized the project agreements with ADB during March–May 1996, while NLC and DLC finalized the agreements in October 1997.

21 DLC transformed itself into an investment company in 2003. 22 The third-party guarantee was not required for PKI as half of its shares were owned by the Pakistan Government. 23 Total bank's credit outstanding/GDP decreased from 40.1% in end-June 1998 to 38.0% in end-June 1999, and

further to 34.9% in end-June 2000, based on GDP data before revaluation in FY2004 with retrospective effect from FY2000 (Table A11.5, Appendix 11).

24 The average 6-month Treasury bill yield progressively decreased from 18% in June 1998 to 1.7% in June 2003 except that it temporally increased to 14% in June 2001.

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to date (Figure 1).25 The first three factors were aggravated by the political situation and external conditions during 1998–2001.26

Figure 1: ADB Pool-Based Interest Rate versus LIBOR (%)

0.01.02.03.04.05.06.07.08.0

J-91

D-9

1

J-92

D-9

2

J-93

D-9

3

J-94

D-9

4

J-95

D-9

5

J-96

D-9

6

J-97

D-9

7

J-98

D-9

8

J-99

D-9

9

J-00

D-0

0

J-01

D-0

1

J-02

D-0

2

J-03

D-0

3

ADB Pool-based ($) 6-month LIBOR ($)

ADB = Asian Development Bank, D = end of December, J = end of June, LIBOR = London interbank offered rate.Sources: Asian Development Bank’s Treasury Department and the International Monetary Fund. 2003. International Financial Statistics Yearbook . Washington, D.C..

25. As noted earlier, there was no mechanism available in the formal market to hedge the FX risk associated with medium-term loans. Under the circumstances, SBP offered 1-year renewable forward covers to the PFIs especially for the FSIL, at an annual cost varying between 7.5 and 13.0% (of the disbursed amount). All the PFIs except PKI27 initially took this forward cover from the SBP, and some later resorted to the so-called “synthetic hedging.”28 In either case, the FX risk was only partially hedged, and the costs of hedging were high.

25 Under the situation, PKI inquired about the possibility of converting the pool-based interest rate scheme to the

LIBOR-based loan (LBL) facility in April 2002. However, ADB responded negatively with reference to its lending policy stipulating that "only those loans with undisbursed balances of more than 40% of original loan amount as of 30 July 2001 are eligible for transformation to the LBL facility."

26 Amid the Seachin and Kargil conflicts, the resulting tension with India, and in the aftermath of the nuclear detonation on 28 May 1998, the country had to face international sanctions that led to the freezing of FX accounts and the imposition of stringent austerity and exchange control measures. Thereafter, the civilian political Government was taken over by the military on 12 October 1999, which saw furtherance of international pressures. The situation was aggravated by the 11 September 2001 terrorist attack on the United States. In a critical turnaround, the Government decided to extend support and facilities to US military intervention in Afghanistan, that move led to the easing of the sanctions and brought Pakistan back to the international fold. Following the successful rescheduling of its bilateral debt obligations and increased inflow of remittances and external aid, gross FX reserves increased to more than $10 billion by end 2003, the highest amount ever, allowing the Pakistan rupee to stabilize.

27 PKI opted for “synthetic hedging” from the start of FSIL implementation because it had access to FX liquidity and investment opportunities.

28 It is a mechanism prevalent in Pakistan wherein a financial institution buys foreign currency from the informal market, the so-called Kerb Market and places it with a bank or financial institution on long-term deposit or invests in dollar denominated bonds. Thereafter, the depositor draws a Pakistan rupee-denominated credit line of similar maturity by pledging the FX deposit or bond. Even though the cost may be high, many institutions preferred to lock in their open positions through this particular mechanism at that time, given the high exchange rate volatility and absence of forward cover or swap facilities. The informal currency market thrives on informal remittance, known as hwala or hundi from Pakistani expatriates, especially from the Middle East, which bypasses the normal banking channels.

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26. At the initial stage of the FSIL, BEL was the only eligible financial institution that was willing to offer the third-party guarantee at a fee ranging from 1.8% to 2.5% per annum, acceptable to the PFIs. Subsequently, BEL’s financial problem surfaced, and the SBP took over the management and suspended its operations (Appendix 2). Consequently, the Government’s Finance Division barred BEL from issuing guarantees as per SBP’s decision in November 1999. Mainly for this reason (and nonavailability of the third-party guarantee from other eligible financial institutions), no disbursement had been made under the FSIL since December 1999.29 27. In January 2004, the Government fully prepaid the FSIL, amounting to $24.5 million. PKI prepaid its loan for $14.9 million under the FSIL in March 2003.30 DLC and NLC have been repaying the loan to the Government on schedule, while ELL and PICL were in arrears at the time of the OEM. The OEM estimated that the total outstanding balance of the remaining four PFIs’ payables to the Government under the FSIL was around $8.3 million.31 On the asset side (of PFIs), PICL and ELL recovered their subloans while the total receivables of DLC and NLC stood at $1.2 million equivalent32 at the time of the OEM. On this basis, the OEM estimated the revolving fund retained in the four PFIs under the FSIL to be around $7.1 million.

2. Characteristics and Performance of Subloans 28. Appendix 3 summarizes the characteristics of the subloans. The PFIs received a total of $24.5 million to finance 73 subloans, of which 70, totaling $9.7 million and representing 40% of the total amount and 96% of the total number, were below the free limit of $3 million. Of the total disbursed amount, $14.8 million for 3 subloans was through PKI, $4.7 million for 42 subloans through PICL, $3.1 million for 15 subloans through DLC, $1.0 million for 6 subloans through NLC, and $0.9 million for 7 subloans through ELL. All the subloans below the free limit were actually below $1 million. The three largest subloans, or 60.5% of the total disbursement, had maturities of 7–10 years. Twenty-one subloans had maturities of 3–5 years, and the others less than 3 years.

29. Of the 73 subborrowers, 55 were in Sindh Province, 15 in Punjab Province, two in North-West Frontier Province, and one in Balochistan Province.33 FSIL’s sectoral distribution was $7.5 million (3 subloans) to the chemical/fertilizer industry, $7.3 million (20 subloans) to textile, $3.3 million (1 subloan) to oil refining, $2.1 million (13 subloans) to food processing, $1.0 million (2 subloans) to power and energy, and $3.3 million (34 subloans) to others (transport,

29 Aside from the total disbursed amount, ADB had additionally approved/authorized more than $13 million for 633

subprojects of NLC. However, ADB could not disburse this amount due to the absence of third-party guarantees. This was a major disappointment for NLC.

30 Two of the three subloans of PKI are still active. At the time of OEM, payment of the principal of the larger subloan of $7.2 million had not started based on the rescheduling arrangement. The OEM could not verify the outstanding balance of the other active subloan of PKI.

31 DLC, ELL, NLL provided the OEM with their outstanding balance of payables to the Government in dollars while data from PICL was denominated in PRs (without indicating the FX rate used). Data provided by BEL to the OEM was incomplete, while the Ministry of Finance could not provide the aggregate loan balance under the FSIL. Therefore, this total outstanding balance is estimated based on data from the PFIs. In doing so, PICL’s outstanding balance in dollars was computed using the FX rate as of end-June 2004 ($1=PRs58.1). It is noted that PICL continues to resort to forward cover from the SBP for the liabilities under the FSIL. Meanwhile, the OEM could not verify the premium that PICL paid to the SBP under the current arrangement and the period it covers.

32 All the subloans were actually denominated in PRs. However, one of the PFIs could not submit complete information on subloans to the OEM, while the information submitted by BEL was also incomplete. ADB, on its part, did not keep track of PFIs’ actual disbursements in PRs during FSIL implementation. For this reason, this PPAR refers to ADB’s disbursement in dollars for each subloan as proxy for the actual subloan amount. On this basis, the PFIs indicated their receivables from subloans in dollars using the exchange rates at which the subloan was originally booked.

33 Data on geographical distribution is based on the location of manufacturing plants (not the head office).

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information technology, medical products, cement, poultry feeds, and a school). Forty-eight subloans were for expansion, 17 for modernization, and 8 for new products. 30. Of the total 73 subloans for $24.5 million, 62 for $11.4 million were fully repaid by subborrowers; 1 subloan for $4.3 million is being repaid; 1 for $7.2 million was rescheduled and is being repaid; 3 for a total of $0.4 million had defaulted and court decisions were made; 4 for a total of $1.0 million have defaulted and are currently under litigation; and there is no information on 2 subloans totaling $0.2 million34 (Appendix 4). 3. Performance of Participating Financial Institutions 31. Appendixes 5 to 9 describe the performance of the five PFIs and the significance of the FSIL to their operations. The five PFIs largely complied with most of the financial covenants under the FSIL during the period that ADB approved/authorized subloans.35 To date, DLC, NLC, PKI have maintained profitable operations while ELL and PICL are facing financial problems due to the fraudulent practice36 of previous managements. 32. DLC received $3.1 million for 15 subloans, 13 ($2.9 million) of which were fully repaid while the remaining two ($0.2 million) defaulted and are under litigation. NLC availed of $1.0 million for six subloans, five ($0.9 million) of which were fully repaid by subborrowers and one for $0.1 million was recovered through litigation. PKI availed of $14.8 million for three subloans, of which one ($3.3 million) was prepaid, one ($4.3 million) is being repaid, and one ($7.2 million) was rescheduled and is being repaid.37 The management of both DLC and NLC consider the long tenor and its demonstration effect38 to other lenders to be an important benefit they enjoyed from the FSIL. They also find some benefit from cultivating a relationship with institutions like ADB. These are the reasons why DLC and NLC have not prepaid the loan to the Government despite its relatively high interest rate. 33. NBFIs have been facing increasingly strong competition from commercial banks in recent years. DLC, NLC, and PKI have responded by diversifying and/or broadening their operational scope. For example, DLC became an investment bank in 2003, and added investment banking services and housing finance to its operations. In 2001, NLC diversified into operating leases, in addition to financing leases, and recently it set up a subsidiary specializing in microfinance. PKI has expanded its activities into asset management, stock brokerage, and small and medium enterprise (SME) financing. 34. ELL extended seven subloans for $0.9 million under the FSIL, of which six ($0.8 million) were fully repaid on schedule and one ($0.1 million) was recovered through litigation. PICL extended 42 subloans for $4.7 million, of which 37 for $3.7 million were fully repaid; 1 for $0.1 34 The current PICL management could not verify the two subloans, $19,565 and $172,826, respectively, which are

recorded in the ADB project files. Therefore, the OEM could not verify the use of $192,391, and information on these subprojects is tentatively based on ADB’s project files. Moreover, there are discrepancies between ADB’s and PICL’s records as to disbursement amounts of another three subloans.

35 The OEM could not independently verify the collection and infection ratios of all the PFIs (except DLC). 36 ADB defines fraudulent practice as “any action, including misinterpretation, to obtain a financial or other benefit or

avoid an obligation by deception” under the anticorruption policy (adopted in June 1998), which was revised in November 2004. Prior to this revision, ADB narrowly defined the fraud and corruption terms, focusing on procurement issues in ADB-financed activities.

37 DLC’s and NLC’s payables to the Government under the FSIL at the time of the OEM were $2.3 million and $0.8 million, respectively, according to these institutions. They resorted to “synthetic hedging” to cover the FX risk associated with the remaining balance under the FSIL.

38 DLC’s management noted that “having ADB’s name on the balance sheet adds value to the company in seeking credit from other institutions.” It is noted that all the PFIs (except PKI) indicate ADB as the source of their long-term borrowings in their recent annual reports.

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million had defaulted and court decisions were made; 2 for $0.7 million have defaulted and are currently under litigation; and PICL does not have any record of the remaining 2 subloans for $0.2 million, as noted earlier. 35. Since its establishment in 1992, ELL had been managed by a group of individuals who sold their 18% equity stake in the company in 2001 to ELL’s present chairman. Soon after this equity transaction, the management restated the company’s financial statements for 2000 in the year 2001 and accused the previous finance manager of committing fraud. The management extended its control of the company by delaying board elections. SECP suspended ELL’s leasing license in December 200139 and appointed an auditing firm in May 2002 to investigate the affairs of the company from July 1998 to December 2001. The board elections of ELL were finally held when the new sponsor, with support from other institutional shareholders of the company, took control. The auditing firm concluded that the previous management swindled company resources causing ELL to lose PRs106 million. The previous management group was arrested and remains in custody of the National Accountability Bureau. The new management has been diversifying its revenue base by expanding capital market investment, and reported a cumulative loss of PRs63 million during 2001–2003. In 2003, ELL suspended payments to the Government under the FSIL. Payments continue to be suspended.40 36. The current sponsors of PICL acquired its controlling stake of over 50% in 2001. Subsequent to the acquisition, the new sponsors determined that the previous management had grossly misstated and underreported nonperforming leases,41 and kept very low provisions.42 The entire management and the company’s auditors were replaced. As a result of the detailed audit, PICL needed to make a large amount of provisions for nonperforming leases in 2001 and 2002, thus creating huge losses. It is reported that the previous sponsors have fled the country to escape prosecution. PICL is currently pursuing the rescheduling of the repayment of FSIL- related liabilities to the Government.43 MOF has not responded to the request. C. Achievement of Policy Reforms

37. The requirements under the FSIL policy matrix have been largely met (Appendix 10) and are summarized as follows:

(i) The OEM confirmed full compliance with 24 of 26 FSIL policy requirements, which were to be met before the first interim review originally scheduled in the first quarter of 1996.44 The policy requirement concerning the FX forward market

39 The immediate reason for the suspension was ELL’s noncompliance with the newly introduced minimum capital

requirement of PRs200 million for leasing companies. 40 ELL’s outstanding balance payable to the Government under the FSIL was $0.8 million at the time of the OEM.

Since 2003, ELL has not taken FX cover for the outstanding liabilities under the FSIL. In 2003, ELL requested the Government for loan rescheduling. However, the Government suggested that ELL contact ADB. ELL then wrote a letter to ADB in 2003 but never received a reply.

41 While the total number is not large, the size of a handful of nonperforming leases is fairly substantial according to PICL’s management.

42 Infected leases were purposely rescheduled to benefit from a regulatory loophole wherein it was not required at that time to report such restructured leases as nonperforming assets. (This regulation has since been changed and the rescheduled lease/loan continues to be a nonperforming asset until repayment regularizes for at least a year.) Moreover, as the provisioning requirement was determined after deducting the forced sale value of the asset pledged, the previous management got inflated valuation of leased assets to reduce its provisioning requirements.

43 PICL booked PRs258.3 million as the outstanding balance of loans payable to the Government under the FSIL as of the OEM. The OEM could not identify the FX rate that PICL used to calculate this amount.

44 The Loan Agreement included one more policy requirement, which was not included in the policy matrix, concerning the growth of SBP credit to the private sector vis-à-vis overall private sector credit. The OEM confirmed the compliance with this requirement.

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is deemed partly complied with. The requirement concerning empowerment of the Controller of Insurance is not applicable as this office was abolished in 2000.

(ii) The OEM confirmed full compliance of 16 of 19 FSIL policy requirements, which

were to be met before the second interim review originally scheduled in the first quarter of 1997. The requirements concerning risk-weighted capital adequacy norms for NBFIs and restructuring of the two state-owned insurance companies are deemed partly complied with. The OEM could not verify if the premium setting exercise by the Insurance Association of Pakistan was reviewed as envisaged under the policy matrix.

38. Many policy requirements under the FSIL were only broadly defined, indicating either the direction of reforms or the need for studies/reviews. Others were specific, but formed a fractional part of broader reforms supported under other policy-based loans including the Capital Market Development Program (CMDP)45 and the Financial (Nonbank) Markets and Governance Program (FMGP),46 Enhanced Structural Adjustment Facility (ESAF)47 from the International Monetary Fund (IMF),48 and Banking Sector Adjustment Loan (BSAL)49 from the World Bank, The relevant Government agencies generally acknowledge the contributions of these subsequent loans in policy and institutional reforms, but not the FSIL despite the noteworthy compliance status in the policy matrix. This suggests that the FSIL policy matrix only played a marginal guiding role for the Government in implementing relevant measures.

1. Central Bank Operations

39. The key achievements of the FSIL policy matrix in relation to SBP operations concerned (i) transition from direct to indirect instrument in monetary control; (ii) strengthening of prudential guidelines, including introduction of the risk-weighted capital adequacy requirement, for banks and DFIs; (iii) strengthening of the legal bases for loan recovery; and (iv) rationalization of SBP’s refinancing schemes. In achieving the first item, SBP maintained close consultation with IMF under ESAF and other arrangements during 1990s. SBP also continued working with the World Bank in policy dialogues under BSAL to achieve the second and third items. In relation to the fourth, SBP streamlined its concessionary refinancing schemes, except the export finance scheme (EFS) during FSIL implementation. To date, SBP has progressively raised the EFS interest rate per policy discussion with IMF. 40. A policy agenda of the FSIL that has not been fully realized is the development of an efficient FX forward/swap market. Consequently, synthetic hedging remains prevalent.

45 ADB. 1997. Program Completion Report on Capital Market Development Program in Pakistan. Manila. (Loan 1576-

PAK, for $250 million, approved on 6 November 1997). 46 ADB. 2002. Report and Recommendation of the President to the Board of Directors on Proposed Loans and

Guarantees to Pakistan for the Financial (Nonbank) Markets and Governance Program. Manila (Loan 1955-PAK, for $260 million, approved on 5 December 2002).

47 International Monetary Fund. 1998. Enhanced Structural Adjustment Facility. Washington, D.C. 48 The IMF described the financial sector issues in this period as follows “The structural weaknesses in the banking

system are evidenced by a worsening level of nonperforming loans, a slowdown in domestic deposit mobilization, creeping dollarization of the economy, and an increasing dependence on volatile foreign currency deposits. In particular, the stock of nonperforming loans almost quadrupled from the equivalent of US$1 billion in 1989 to US$3.8 billion (PRs 135 billion, equivalent to some 30 percent of the banks’ portfolio). Consequently, the solvency of the banking sector is threatened and two large nationalized commercial banks (and all development finance institutions) are experiencing liquidity problems.” (IMF. 1996. Staff Report. Washington, D.C.). To address these issues, the Government formulated the banking reform program in 1997. Implementation of the program was supported under the ESAF and Banking Sector Adjustment Loan (BSAL) and complemented by the CMDP.

49 World Bank. 1997. Banking Sector Adjustment Loan.

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2. Regulation and Supervision of Nonbank Finance Companies 41. One of the key FSIL requirements was the restructuring of CLA. Promulgation of the Securities and Exchange Commission (SEC) Act in December 1997 could be considered as a descendant of this measure, forming the legal basis for transforming CLA into an independent body, the SECP. Prior to the establishment of SECP, regulatory and supervisory authority over leasing companies was transferred from SBP to CLA by virtue of an amendment to the Banking Companies Ordinance 1997. CLA raised the capital base requirements of the leasing industry from PRs100 million to PRs200 million to be effective by 30 October 1999 (later extended to 30 June 2001). SECP started operations in January 1999 supported under the CMDP, and by December 2002, regulatory and supervisory authority over mutual funds, venture capital companies, investment finance service companies, discount houses, and housing finance companies had been completely transferred to it. Subsequently, SECP issued Nonbanking Finance Companies (NBFC) Rules 2003 covering all NBFIs except DFIs, supported under the FMGP. The rules define the minimal capital requirements for the respective NBFCs. 42. Introduction of risk-weighted capital adequacy norms for NBFCs is one of the two outstanding policy measures under the FSIL. SECP is currently reviewing NBFC rules 2002 while planning to introduce the risk-weighted capital adequacy requirement.

3. Insurance Reform

43. The key achievements in insurance reform under the FSIL included (i) progressive increases in the minimum capital requirement for insurance companies, and (ii) corporatization of the state-owned Pakistan Insurance Corporation (PIC) in March 2000. 50 Moreover, the National Insurance Corporation Limited (NIC) was also incorporated as a public limited company in March 2000 supported under the CMDP and TA 2866-PAK. 51 Since the incorporation, the Boards of these two companies have been reconstituted with experienced personnel from the private sector. However, progress in reforming the State Life of Pakistan has been slower than expected and is being pursued under the FMGP. 44. The FSIL envisaged empowering Controllers of Insurance (COI) under MOC, while the CMDP assumed the establishment of an independent and autonomous body replacing COI to regulate the insurance industry. On this basis, the draft Pakistan Insurance Regulatory Authority Bill was prepared under TA 2825-PAK.52 However the final Government decision was to make SECP responsible for this task, and the SEC Act 1997 was accordingly amended in October 2000. The oversight arrangement over the insurance industry remains unclear; SECP and MOC had issued their own rules and SECP has no significant enforcement powers, including powers of revoking licenses. 4. Capital Market Reform 45. The key achievements of the FSIL policy matrix in relation to the capital market includes (i) establishment of the SECP, (ii) enhanced accountability and improved operational efficiency of the stock exchanges, and (iii) privatization of mutual funds run by the state-owned Investment Corporation of Pakistan (ICP) in 2003, and the ongoing privatization of mutual funds run by National Investment Trust Limited (NIT). The second item included (i) establishment of the 50 PIC was then renamed as the Pakistan Reinsurance Company. 51 ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Reform of the Insurance Industry. Manila

(TA 2866-PAK, for $700,000, approved on 15 September 1997). 52 ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Capital Market and Insurance Law

Reform. Manila (TA 2825-PAK, for $100,000, approved on 14 July 1997).

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investor protection funds in all stock exchanges; (ii) issuance of the insider trading guidelines, stock exchange members (inspection of books and record) rules and other market regulations; and (iii) introduction of a mandatory disclosure requirement on quarterly accounts of listed companies. All these measures were supported under TA 2393-PAK (footnote 12). Privatization of the state-owned mutual funds was supported under CMDP, TA 2865-PAK,53 and TA Loan 1577-PAK(SF).54 D. Organization and Management

1. Credit Line 46. The performance of BEL, both as the administrator and guarantor of the FSIL credit line, was unsatisfactory. Moreover, ADB’s inappropriate responses to the following events with respect to BEL are considered partly responsible for the discouraging performance of the FSIL.

(i) Privatization of BEL in 1996. The Government announced the privatization plan of BEL, 3 months after the FSIL was approved. The ADB project officer raised the possibility of “conflict of interest” should a private financial institution administer the FSIL. Less development orientation under private ownership should have also been a concern. Nonetheless, ADB consented to the Government’s plan without resolving these issues. As anticipated, BEL did not actively identify potential beneficiaries of the FSIL, and failed to properly account for expenditures under the FSIL. It merely channeled disbursements and repayments between the Government and the PFIs, and offered little additional value to the information submitted by the PFIs to ADB. Understandably, the PFIs felt that the administration fee was quite high, considering the scope and amount of service BEL extended.

(ii) Suspension of BEL’s operations in 1999. Soon after the privatization, BEL’s

new management was involved in fraudulent activities and swindled the company’s financial resources. In August 1999, SBP took over BEL’s management and suspended its operations. Subsequently, BEL was brought under receivership and the Government and ADB unsuccessfully explored the possibility of replacing the FSIL administrator. Likewise, no one took over the third-party guarantees for the outstanding balance payable to the Government from the PFIs under the FSIL. It is intriguing that BEL continues to be the third-party guarantor and administrator of the FSIL credit line despite its being liquidated and the Government has prepaid the FSIL to ADB.55

53 ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Restructuring of Public Sector Mutual

Fund. Manila (TA 2865-PAK, for $800,000, approved on 15 September 1997). 54 ADB. 1997. Report and Recommendation of the President to the Board of Directors on Proposed Loans to the

Islamic Republic of Pakistan for the Capital Markets Development Program. Manila (Technical Assistance Loan for Capacity Enhancement of the Securities Market [TA Loan 1577-PAK(SF), for $5 million, approved on 6 November 1997]).

55 Accordingly, DLC and NLC continue to pay the third-party guarantee and administration fees to BEL during the OEM. ELL stopped paying these fees due to its financial problem. The OEM could not verify whether or not PICL continued to pay the administration and third-party guarantee fees.

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47. ADB vigorously marketed the FSIL to financial institutions and conscientiously assessed their applications. Understandably, however, the assessment did not go beyond the audited financial statements. The ADB Review Mission of July 1997 reassessed the eligibility of PFIs. A review of the project files suggests that ADB paid less attention to the PFIs’ performance after this mission until the PCR mission of July 2001. The PCR recommended that the Pakistan Resident Mission (PRM) monitor ELL and PICL. 56 However, no document in the project files suggests that these institutions were monitored. 48. The PFIs submitted adequate subproject information for ADB's approval/authorization. ADB, on its part, diligently assessed the subloan applications. Initially, ADB did not approve/authorize some subloan applications for failure to meet FSIL’s requirement. Eventually, the rejection ratio was reduced as the PFIs gained better understanding of FSIL's requirement. In addition to the regular correspondences, the concerned ADB project officer visited most PFIs to discuss the outstanding issues that impeded higher loan utilization, and pursued ways to enhance disbursement during the review missions in 1996–1997. Most PFIs appreciated ADB's effort in this regard. However, there is no record of subproject visits by ADB review missions.

2. Policy Matrix 49. Only one document57 is available in the project files that may give some information on the progress in the policy matrix, suggesting little policy dialogue took place during FSIL implementation. The PCR pointed out “a midterm review mission was not fielded, which was a major shortcoming of project administration, as a mission would have allowed the reassessment of the Project’s sustainability and purpose.” The OEM supports this view. The World Bank voided the policy matrix when it cancelled the FSDIP in 1998.

III. ACHIEVEMENT OF PROJECT PURPOSE

A. Performance Indicators 50. Table 1 contains the key financial sector indicators related to the FSIL. The indicators suggest that (i) the banking sector and the capital market were stagnant during FY2000–FY2001 compared with FY1995–FY1999; (ii) banking performance in terms of both volume and efficiency started to recover in FY2002; and (iii) secondary capital market transactions increased from FY2003, and the primary capital market indicated signs of recovery from FY2004. The next paragraphs further assess these indicators.

56 Administration of the FSIL was transferred from headquarters to the Pakistan Resident Mission in January 2000. 57 The document is not dated and the author is not indicated. No cover letter is attached to the document.

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Table 1: Key Financial Sector Indicators

Banking Indicator FY1995–FY1999

FY2000–FY2001

FY2002–FY2003 FY2004

Bank Credits/GDP (%)a 36.6–40.1 34.3–34.9 36.5-39.9 — — 28.2–28.9 30.9-33.7 36.8 Interest Rate Spread (%) 3.8–5.6 4.6–5.2 4.1-4.7 — Bank Assets/Financial Sector Assets (%) 84.2–87.9 89.4–91.6 92.4-92.7 —

Capital Market Indicator FY1995–FY1999

FY2000–FY2002 FY2003 FY2004

Number of IPOs 0–59 2–5 2 11 Market Capitalization/GDP (%)a 9.6–25.8 10.0–12.5 18.6 — — 8.2–10.4 15.7 26.0 Average Daily Trading Volume (million shares) 9.5–103.4 118.2–192.7 214.4 553.8 — = not available, FY = fiscal year, GDP = gross domestic product, IPO= initial public offering. a The Government rebased the GDP in FY2004 with retrospective effect from FY2000. Consequently, the GDP in

FY2000 was increased by 20.5%. Data in upper rows do not reflect this revaluation while data in lower rows reflect the revaluation.

Source: Appendix 11. 51. The total bank credits (as % of GDP) contracted from a range of 36.4–40.1% during FY1995–FY1999 to 34.3–34.9% during FY2000–FY2001. 58 This can be explained by the surfacing in 1997 of the distressed state of the banking system and the subsequent bank restructuring (footnote 48), and the restrained credit demand due to political instability and external shocks during 1998–2001 (footnote 26). The banking reform initiated in 1997 started to bear fruit from 2002, supported by the favorable macroeconomic and external conditions. The total bank credits (as % of GDP) increased from 28.2–28.9% during FY2000–FY2001 to 30.9–33.7% during FY2002–FY2003, and further to 36.8% in FY2004. 59 Bank credits to the manufacturing sector (as % of GDP) also slightly increased in recent years (Appendix 11). The interest rate spread was reduced from 4.6–5.2% during FY2000–FY2001 to 4.1–4.7% during FY2002–FY2003, suggesting enhanced competition in the financial market. Many banks have increased their earning assets while diversifying their operations into leasing and investment banking, squeezing out some NBFCs from the market for the recent years. 52. Market capitalization (as % of GDP) decreased from a range of 17.6–25.9% during FY1994–FY1997 to 9.6–12.5% during FY1998–FY2002, and increased to 18.6% in FY2003.60 Market capitalization further increased to 26% in FY2004. 61 The recovery in market capitalization reflected the rise in share prices, supported by the favorable macroeconomic and external conditions. The average daily trading volume in shares progressively increased from 6.5 million in 1994 to 214.4 million in FY2003 (except for FY2000), and significantly increased to 553.8 million in FY2004. The number of IPOs dropped from a range of 10–51 during FY1994–FY1997 to 0–5 during FY1998–FY2003, but increased to 11 in FY2004. 62 Overall, these indicators suggest signs of recovery in the capital market in recent years.63

58 Based on the GDP figures before the revaluation (footnote a, Table 1). 59 Based on the GDP figures after the revaluation (footnote a, Table 1). 60 Based on the GDP figures before the revaluation (footnote a, Table 1). 61 Based on the GDP figures after the revaluation (footnote a, Table 1). 62 As of 21 March 2005, 12 IPOs were recorded in KSE for FY2005. 63 Subsequent to the OEM, the Pakistan stock market experienced a major bullish run. The KSE-100 index, which

surged by 65% since January 2005 to a peak of 10,303 on 15 March 2005, fell by about 35% to 6,725 on 13 April 2005.

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B. Project Outcome

1. Credit Line 53. Profiles of selected subprojects in Appendixes 5–9 illustrate the outcomes for 12 subborrowers of 13 subprojects totaling $16.7 million (68.2% of the total disbursed amount), including the three largest subprojects. 64 Of the 12 subborrowers, 9 subborrowers' annual turnover as of the OEM ranged between PRs15 million and PRs28 billion, and 11 subborrowers’ total employees ranged from 18 to around 3,800. Of the 13 subprojects, 8 had higher production, and also 8 contributed to job creation ranging between 2 and 400. Nine subprojects were geared to earn or save FX; two were concerned with introduction of high technology; one was engaged in high value-added products; while none of the 13 subprojects were particularly environment-friendly.65 The OEM noted that most of these 12 subborrowers had other funding options with interest rates comparable with those of the subloans under the FSIL. Most subborrowers also highlighted the simple and quick appraisal process as well as tax benefits of leasing relative to bank loans. The OEM could not collect information to evaluate the financial and economic rate of return of any of these 13 subprojects.66 54. The total disbursement of $24.5 million under the FSIL may be negligible when compared with the size of the financial sector assets of $34.8 billion equivalent and banks’ foreign liabilities of $1.3 billion equivalent (as of end-2000, when the FSIL was closed). However, this amount could be large enough to influence the PFIs’ operations. Disbursements under the FSIL were 8.7–23.2% relative to the respective PFIs’ assets; and 24.7–39.7% (as of end 2000) relative to the PFI’s total long-term liabilities. The total assets of the five PFIs represented 6.3% of the NBFIs total assets (as of end-2000). This was not a negligible amount and suggests that the FSIL could have been a catalyst for improving the NBFI/leasing subsector if it had been appropriately framed and implemented. DLC and NLC effectively utilized the FSIL to attain sound companies’ growth. DLC management confided that because of their participation in the FSIL, their project appraisal capacity improved. PKI’s experience with the FSIL was not so encouraging, given the underperformance of its largest subproject (which was also the largest among all the subprojects). The fraud scandals and the subsequent financial problems of ELL and PICL significantly undermined contributions of the FSIL. The subloans through ELL and PICL performed relatively well. However, the FSIL was not effective in improving the governance of those institutions. It could also be said that ADB sent a wrong signal to other lenders who trusted ADB’s due diligence capability. Overall, FSIL’s net contribution to financial intermediation was far less than expected.

64 Thirteen subloans included three each from PICL, DLC, and PKI, and two each from NLC and ELL. Eleven

subloans had been fully repaid, and two are still repaying. Six are located in Karachi, three in Islamabad/Rawalpindi, and three in Lahore. The 13 subprojects are not statistically representative samples. Given that 12 of the 13 subloans were repaid on schedule or earlier, the sample subloans presumably outperformed the remaining 60 subloans (of which 49 were repaid on schedule or earlier) in terms of project benefits.

65 The project agreements stipulated that PFIs shall prioritize development projects that are (i) geared to earn or save FX, (ii) based on high technology, (iii) environment-friendly, and (iv) based on high value-added processes. On these bases, the RRP identified the following as expected project benefits: additional capital formation, value added, employment, FX earnings or savings, and promotion of new entrepreneurs. The RRP did not quantify these benefits. Review of the project files and the OEM interviews suggest that both ADB and PFIs did not pay much attention to these four criteria in identifying subprojects.

66 The Loan Agreement/project agreements did not specify the type of data to be collected and the timing of their collection for benefit monitoring and evaluation (BME). Hence, the PFIs and BEL did not particularly attempt to monitor the subproject benefits. Understandably, some subborrowers were not willing to submit post-project information to the PFIs and reluctant to meet with the OEM. The PPAR on the Second Development Finance Project in Indonesia (ADB. 2004. Project Performance Audit Report on the Second Development Finance Project in Indonesia. Manila) highlighted the weak BME as a general issue in most of ADB’s DFI loans.

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2. Policy Matrix 55. The FSIL policy matrix concerned (i) central banking, (ii) NBFIs, (iii) insurance industry, and (iv) capital market. The FSIL measures on central banking represented a small fraction of broader reforms supported by ESAF and BSAL, forming the basis of the recent recovery of the banking system. Establishment of the SEC, an indirect output of the FSIL, was a key initial step in strengthening the regulatory and supervisory framework of NBFIs, and insurance and capital markets. Moreover, the comprehensive review of the stock exchanges’ operations supported under the FSIL and TA 2393-PAK resulted in the introduction of several important market rules. All these achievements formed the basis for implementing the CMDP, leading to the recent recovery of capital market performance. Other key policy achievements under the FSIL included (i) corporatization of PIC, and (ii) privatization of ICP. It is expected that these achievements, together with several follow-on measures supported under the CMDP and the FMGP, will positively affect the performance of the insurance and mutual fund industry.67 The outcomes are not fully discernible with respect to studies and reviews, required under the FSIL, on a level playing field among financial institutions, long-term finance, DFIs, leasing industry’s resource base, and venture capital. 56. The Government attributed the recent noteworthy performance of the financial sector to successful implementation of comprehensive reform programs supported under subsequent policy-based loans from IMF, World Bank, and ADB rather than the FSIL. The OEM supported this view of sequencing of influences and impacts. Perhaps, the key contribution of the FSIL in the policy domain was that it highlighted the need for a more significant financial sector program and full-fledged policy-support loans in view of the complexity and urgency of reforms required in the sector. TA 2393-PAK contributed to capacity building of SECP subsequent to the FSIL period. C. Sustainability 57. Of 12 subborrowers, 11 visited by the OEM had largely maintained positive subproject impacts and were profitable. However, the viability of their businesses should largely depend on the management capacity to maintain their competitiveness as well as on market conditions, which could not be adequately examined by the OEM. The remaining one subborrower, a fertilizer manufacturer, is the recipient of the largest subloan amounting to $7.2 million, equivalent to 29.4% of the total disbursement under the FSIL. It started encountering problems from the early stage of its operations: (i) the company could not get enough natural gas to attain the targeted production and even when it did, the pressure was low; (ii) part of the procured plants, a used ammonia plant, had technical problems; (iii) the international price of its product, diammonium phosphate (DAP), declined and the Government did not discharge its duty on the guaranteed price; and (iv) the price of raw material (phosphoric acid) increased. As a result, the company incurred significant losses in FY2000 and FY2001, shut down the DAP plant in September 2001, and suspended its debt obligation to the creditors. The company negotiated with the creditors and the Government68 on debt restructuring, and reached a conclusion in June 2002. In 2003, the company resumed DAP operations and started interest payments to its creditors. However, it has not declared dividends since resuming operations, and the sustainability of the business remains uncertain.

67 Fourteen mutual funds were launched during FY2002–FY2004 after a 4-year period of no launching of any new

fund. Consequently, the aggregate mutual funds’ assets (as percentage of the total bank deposits) rose from 1.6% as of end-FY2002 to 4.3% as of end-FY2004.

68 The Government took over the loans from export credit agencies, which was rescheduled at the Paris Club.

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58. Of the five PFIs, three are profitable and their managements appear to have a clear vision of a viable business model. The sustainability of the two other PFIs remains uncertain. 59. Most policy achievements discussed in paras. 37–44 are generally irreversible, and their impacts will be felt over the coming years.

IV. ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS A. Socioeconomic Impact 60. Of the 12 subborrowers that the OEM visited, 8 confirmed that the subprojects created new jobs. There had been 300–400 new jobs from one subproject, 40–50 each from two subprojects; and less than 10 from four subprojects. One subborrower was unable to give an estimate of the number of new jobs created. The eight subborrowers have been able to retain the number of employees at the time of subloan approval except for one (who created 50 extra jobs through a subproject, but subsequently reduced its staff strength of over 700 to around 670). The majority of the employees of the 12 subborrowers were males except for two (a metallized polypropylene film manufacturer and a private junior high school). B. Environmental Impact 61. The OEM did not discern any environmental impact of subprojects from information provided by the PFIs and the subborrowers that were visited. A review of the project files confirmed that the PFIs had ensured the compliance of most subprojects with all applicable environmental regulations in Pakistan, as required in the Loan Agreement. However, the OEM was informed by some subborrowers that they were not required to assess the environmental impacts. In this regard, the PFIs’ assurance on environmental matters might not be fully reliable. There is no record suggesting that PFIs consulted with BEL on the environmental issues as provided for in the Loan Agreement. The Loan Agreement required PFIs to submit summary environmental impact assessment reports for all subprojects as part of the subloan application documents. The Loan Agreement, however, did not specify the contents of the report.69 Perhaps partly for this reason, ADB officers do not appear to have paid enough attention to this requirement while the PFIs generally submitted inadequate environment-related information. ADB should have more diligently reviewed the environmental aspects of subprojects, especially those for the oil refinery and fertilizer plants.

V. OVERALL ASSESSMENT A. Relevance 62. The OEM assessed the FSIL as irrelevant considering its (i) inadequate appraisal, (ii) inconsistency between diagnosis and project design, (iii) overambitious project objectives and lack of cohesiveness in scope, (iv) weak linkage between project components, (v) weak financial covenants for PFIs, (vi) weak prioritization in the policy matrix, and (vii) inadequate collaboration with other relevant multilateral agencies. To fill the “shortage of FX term funds to meet the investment demand from private entrepreneurs” was the key rationale for the FSIL

69 ADB’s Operations Manual (OM Section F1/OP), based on the current ADB environmental policy approved on 8

November 2002, assumes that a typical environmental impact assessment report includes the following major elements: (i) description of the project, (ii) description of the environment, (iii) anticipated environmental impacts and mitigating measures, (iv) alternatives, (v) economic assessment, (vi) an environmental management plan that includes institutional requirements and an environmental monitoring program, (vii) a public consultation and disclosure, and (viii) conclusion. These guidelines were not in place during FSIL implementation.

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(para. 3). However, the FSIL was not designed as such, and subborrowers simply availed of PRs term funds. The OEM was of the view that the first three factors above caused this critical mismatch. Given the growing concern on the deteriorating performance of commercial banks and DFIs at appraisal of the FSIL, ADB could have prioritized the restructuring of these institutions through program lending. Alternatively, the FSIL policy matrix could have focused on issues directly related to the credit line or NBFIs. Either way, the Project could have been more cohesive, timely, and relevant. B. Efficacy 63. The OEM assessed the FSIL as partly efficacious. The credit line under the FSIL was significantly underutilized due to weak project design which in turn was based on the overly optimistic assumptions on the FX forward/swap market development and the availability of the third-party guarantee. This was aggravated by the unfavorable market conditions at the later stage of project implementation. Of the five PFIs, two effectively utilized the FSIL to attain sound companies’ growth. The experience of another PFI was not so encouraging because of the underperformance of its largest subloan, which represented 29.4% of the total disbursement under the FSIL. The fraud scandals and the subsequent financial problems of the remaining two PFIs undermined the significance of the FSIL. The overall contribution of FSIL’s credit line to the country’s financial intermediation and private sector activities was far less than expected. 64. The OEM considered the contribution of the FSIL policy matrix as moderate based on the following observations: (i) the FSIL policy matrix had played a limited guiding role for the Government to implement relevant reform measures; and (ii) the recent noteworthy recovery of the financial sector’s performance has been attributed mostly to policy measures under policy-based loans subsequently extended by IMF, World Bank, and ADB rather than the FSIL. It is, however, noted that the FSIL contributed to the reform process by demonstrating the need for full-fledged policy support loans in view of the complexity and urgency of reforms required in the sector. C. Efficiency 65. The underperformance of the project administrator marks the administration of the FSIL credit line as inefficient. The service provided by the administrator was not worth the administration fees that PFIs paid. ADB, on its part, vigorously marketed the FSIL to financial institutions while partly offsetting the underperformance of the administrator. However, four financial institutions that had finalized the project agreements could not actually utilize the FSIL. Moreover, one of the PFIs had to withdraw its disbursement applications of more than $13 million for 633 subprojects—which had been approved/authorized by ADB—due to the nonavailability of third-party guarantees. The OEM could not collect enough information to conduct the financial and economic analysis of the subprojects. D. Sustainability 66. The outcomes of the FSIL, though far less than expected, are likely to be sustained. Most subprojects visited by the OEM had maintained positive project outcomes, whereas the sustainability of the largest subproject under the FSIL is questionable. The management of the three PFIs appeared to have a clear vision of a viable business model. That did not seem to be the case for the remaining two institutions. The policy achievements under the FSIL are generally irreversible, complemented by significant follow-on measures.

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E. Institutional Development and Other Impacts 67. The OEM assessed the organizational development and other impacts of the FSIL as negligible given that (i) its overall contributions to institutional strengthening of the five PFIs was marginal, and (ii) its socioeconomic and environmental contributions were considerably less than what had been expected. Establishment of the SECP was only an indirect output of the FSIL policy matrix. The attached TA 2393-PAK contributed to capacity building of SECP. However, this improvement could have been done without the FSIL, and the FSIL’s complementary effect on this TA was not so significant. F. Overall Project Rating 68. On the basis of paras. 62–67, the overall rating of the FSIL is unsuccessful.70 The OEM confirmed the earlier audit’s successful rating of TA 2393-PAK in view of its contribution to capacity building of SECP. G. Assessment of Borrower and ADB Performance 69. The performance of three PFIs was largely satisfactory but the remaining two PFIs and the project administrator (as well as guarantor) significantly underperformed because of the fraudulent activities of their previous management. The repayments of these two PFIs to the Government have been suspended, while the guarantor has been under receivership and is unable to fulfill its financial obligation. The Government has not settled this issue as yet. Overall, the Borrower’s performance is assessed as unsatisfactory as regards management of the credit line. As regards compliance with the policy matrix, the Borrower’s performance can be assessed as satisfactory. 70. ADB endeavored to identify the potential beneficiaries of the FSIL, and conscientiously assessed their applications. Perhaps this diligence contributed to the relatively good repayment performance of the subloans. The policy dialogue under the FSIL was rather disappointing. Most of the key reform measures in the FSIL policy matrix were covered under subsequent policy-based loans from ADB and other agencies. Furthermore, ADB’s performance fell short of expectations with respect to three important matters: (i) diagnosis and appraisal were inadequate; (ii) potential issues in conjunction with the privatization of the project administrator were not fully clarified; (iii) when fraudulent issues involving the project administrator and the two PFIs surfaced, decisive action was not taken; (iv) coordination with the World Bank was not vigorously pursued especially when the World Bank cancelled the credit line component of the FSDIP; and (v) postimplementation monitoring was weak despite the PCR recommendation. For these reasons, ADB’s performance is assessed as unsatisfactory.

70 The rating reflects that the number of criteria receiving a rating of less than 1 exceeds two (with reference to ADB.

2000. Guidelines for the Preparation of Project Performance Audit Reports. Manila). The OEM reviewed the PCR’s assessment and downgraded the overall rating on the basis of some new information, including deterioration of the two PFIs’ financial performance due to fraudulent activities of previous managements, their arrears to the Government, and underperformance of the largest subproject. Revision of ADB’s anticorruption policy in November 2004 (footnote 36) was also considered. Without such new information, the overall rating would have remained partly successful.

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VI. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS A. Key Issues for the Future 71. The experience of the FSIL exemplifies the indispensability of governance issues, more specifically the enforcement mechanism for rules and regulations. The performance of the two PFIs, which had been operating well, turned around when controlling shareholders became involved in fraud. The problem developed over time, ostensibly in collusion with the company auditors, but could not be detected by the regulator on time and was only uncovered when the companies were taken over by new owners. On the basis of these experiences, the regulatory and supervisory framework on NBFIs was strengthened in recent years. However, a weakness remains in SECP’s on-site inspection, and risk-weighted capital adequacy norms for leasing companies remain an overdue policy agenda. Moreover, corporate governance standards and auditing standards need to be enforced. Some of these measures are being supported under the FMGP (footnote 46). 72. The oversight arrangement over the insurance industry remains unclear—SECP and MOC have issued their own rules and SECP has no significant enforcement powers, including powers of revoking licenses. This dichotomy fuels uncertainty and has weakened ownership of the regulatory framework. Accordingly, it does not help SECP in exercising a regulatory function. From this perspective, the Government is currently considering an alternative regulatory arrangement by transferring jurisdiction from MOC to MOF. This action is expected to remove any complication that might cause a regulatory loophole.

73. Commercial banks have been engaging in the business of financial leasing and investment banking, stepping into NBFCs’ turf. Based on the agreement between SBP and SECP, banks’ and DFIs’ leasing and investment banking operations (up to a certain amount) are currently monitored by SECP. To prevent this arrangement from creating any regulatory loophole, SBP and SECP should continue to coordinate closely. B. Lessons Identified 74. The FSIL demonstrates the risks associated with a project that was formulated on the basis of a weak logical framework, namely (i) inconsistency between the project rationale and objectives, (ii) excessively broad project objective (without specifying immediate objectives, or purpose), (iii) weak linkages among expected project outputs (or lack of cohesiveness in project scope), and (iv) lack of an explicit monitoring mechanism. Most importantly, experience with the FSIL underscores the necessity of a clear project purpose. The project purpose should not be used only to design the project; it should constantly be referred to in monitoring project implementation. When a project encounters unforeseen events, the project purpose should be the basis for adjusting the project scope/design or, if necessary, canceling its implementation. This judgment can only be effective if the project purpose is clearly stated. Unfortunately, this was not the case with the FSIL. 75. The FSIL actually encountered a series of negative unforeseen events, resulting in suspension of two PFIs’ repayment to the Government as well as insolvency of the guarantor of these repayments. The OEM is of the opinion that the FSIL should have been restructured or cancelled in 1999 when the project administrator (as well as guarantor) was brought under receivership and a replacement could not be assigned. Such a decision could be made in consideration of not only the project purpose but also the project cost and risks. The OEM is of the view that a system was not effectively in place within ADB to appropriately reassess these important aspects and take responsive action to restructure/cancel underperforming loans.

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76. There were changes in ownership and management of the two PFIs and the administrator during FSIL implementation. Subsequently, gross criminal irregularities and misappropriations that were detected necessitated harsh legal and regulatory measures. These experiences underscore the need for ADB to thoroughly reevaluate the continuing qualification criteria in case of a management or ownership change in PFIs during project implementation. Even after loan completion, ADB should monitor major events of the concerned financial institutions to the extent possible. Such monitoring will deserve extra resource allocation in some cases, depending on the type of issues that subsequently surface and the extent of ADB’s direct or indirect loan exposure to the institutions. 77. In the past, ADB defined fraud and corruption terms narrowly, focusing on procurement issues in ADB-financed activities, in pursuance of the anticorruption policy adopted in 1998. However, it was recognized that this narrow definition might place ADB in a position where parties that it had found not to have maintained the highest ethical standards may find ways to participate in ADB-financed activities other than those covered by contracts. On this basis, ADB defined fraudulent practice as “any action, including misinterpretation, to obtain a financial or other benefit or avoid an obligation by deception” in November 2004. With this new definition in place, ADB could have taken more decisive action when the fraud scandals in the two PFIs and BEL surfaced. The OEM was of the view that strict adherence to the revised anticorruption policy is essential to improving the governance of ADB’s credit lines. 78. A credit line with a significant program of policy actions addressing broad sector issues, such as the FSIL, may not be effective unless its design is cohesive. The FSIL was diffused in scope; the logical linkage between the credit line and the policy matrix was weak. Given that the entire loan amount was to be directed to the PFIs, the Government did not pay attention to the policy matrix. Reflecting the underutilization of the loan, ADB's emphasis on the policy matrix also faded during implementation. 79. Parallel financing with another aid agency should be justified on the basis of project cost, credit demand, and complementary effects of the loans. Even in the case where the counterpart aid agency had appraised the project, ADB should independently and diligently assess such appraisal. Regular contact with the counterpart aid agency throughout project implementation is essential. Withdrawal/cancellation of the counterpart agency should be a signal that a review and reassessment of the project are warranted. 80. In considering financial covenants for PFIs under a DFI loan, prudential regulations and other market rules, their enforcement status, and PFIs' risk management and corporate governance should be thoroughly reviewed. Based on this review, financial covenants should be so determined that they complement PFIs' risk management and the country's prudential guidelines. 81. PFIs under the FSIL have kept little information on development impacts of subprojects. Weakness in benefit monitoring and evaluation (BME) has been a common issue in ADB’s DFI loans.71 Experiences underscore the need for ADB to consider an alternative approach in creating a functional monitoring framework that balances increased administrative costs with the need for, and use of, the data collected. One possibility is to specify the required data and timing of data collection in a loan/project agreement. Another option is to select sample subprojects in case their number is large. Assigning a project administrator responsible for BME

71 One PPAR (ADB. 2004. Project Performance Audit Report on the Second Development Finance Project in

Indonesia. Manila) also highlighted this issue.

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may not always be a viable option, depending on the fee that the agency charges. What is important is a pragmatic solution for the purpose of developing an effective and efficient monitoring and evaluation framework for a DFI loan. This framework could also be applied to SME credit, rural credit, and microcredit projects. 82. Under the FSIL, PFIs were required to submit summary environmental impact assessment reports for all subprojects. The Loan Agreement, however, did not specify the contents of the report. Perhaps partly for this reason, ADB did not pay enough attention to this requirement, and the PFIs did not submit adequate information on environmental aspects of the subprojects. This experience underscores the need for diligent application of ADB’s environmental policy revised in November 2002, especially the guidelines on Environmental Assessment for Financial Intermediation Loans and Equity Investments. C. Follow-Up Actions 83. It is recommended that MOF (i) discuss the possible restructuring of the remaining balance under the FSIL with BEL and the two PFIs that have suspended repayments; and (ii) clarify BEL’s status as FSIL administrator and guarantor, and verify PFIs’ payment obligation as regards the administration and guarantee fees. MOF should inform the PRM of outcomes of the recommended follow-up actions by end-June 2006.

COMPLIANCE STATUS OF KEY LOAN COVENANTS ON PARTICIPATING FINANCIAL INSTITUTIONS

(For the year ending June)

Covenant 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 1. Maintain a capital adequacy ratio of at least 4%,

increasing to 8% in 3 yearsa

Dawood Leasing Company Limited (DLC) N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A English Leasing Limited (ELL) N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Network Leasing Corporation Limited (NLC) N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Pakistan Industrial and Commercial Leasing Limited (PICL) N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Pakistan-Kuwait Investment Company (Private) Limited (PKI) — — — — 60.7% 61.4% 64.5% 52.2% 56.9% —

2. Maintain a current ratio of not less than 1.25b

DLC 6.74 0.88 1.44 1.26 1.32 1.04 1.04 1.00 1.01 —ELL 1.60 0.97 1.75 1.38 1.75 1.28 1.25 1.97 2.73 —NLC 7.12 2.66 2.94 3.46 3.43 1.39 1.25 1.29 1.29 —PICL 1.65 1.59 2.02 1.66 2.11 2.48 3.61 2.03 1.50 1.16PKI N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

3. Maintain a debt-equity ratio of not more than 10:1b

DLC 0.15 0.58 0.86 1.50 3.33 3.17 4.27 4.72 4.46 —ELL 0.86 1.01 0.79 0.87 1.17 1.49 1.83 1.65 1.17 —NLC 0.00 0.38 0.38 0.81 1.56 1.70 2.42 2.90 2.92 —PICL 2.65 2.16 2.14 2.19 2.57 2.97 4.29 33.11 (25.76) (15.06)PKI N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

Appendix 1 25

Covenant 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

4. Maintain a debt coverage ratio of not

less than 1.25 timesb

DLC 18.1 3.2 2.3 1.7 1.4 1.4 1.4 1.3 1.8 — ELL 2.0 2.4 2.0 2.2 1.7 1.4 0.9 0.6 1.4 — NLC 373.9 9.5 2.7 2.0 1.4 1.3 1.1 1.4 1.3 — PICL 1.5 1.3 1.8 1.7 1.5 1.4 0.7 0.8 0.3 (0.04) PKI N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

5. Maintain a minimum collection ratio on all term loans or lease financing of 80%, rising to 85% in 2 yearsc

DLC — — — 86.3% 87.8% 87.3% 86.6% 85.6% 86.7% — ELL — — — — — — — — — — NLC — — — — — — — — — — PICL — — — — — — — — — — PKI — — — — — — — — — —

6. Maintain pre-tax profit of at least 1% of total assets

DLC 5.3% 10.6% 7.8% 3.6% 2.9% 2.7% 2.6% 1.5% 9.6% —ELL 2.4% 6.1% 5.8% 8.4% 5.2% 3.1% (10.6%) (4.8%) (1.0%) —NLC 2.9% 7.2% 5.8% 4.0% 2.9% 2.4% 0.2% 1.4% 2.4% —PICL 2.7% 2.6% 3.7% 3.6% 2.5% 1.7% (7.7%) (13.5%) (4.9%) (1.51%)PKI 4.2% 3.2% 2.9% 1.0% 5.0% 3.3% 3.6% 18.7% 19.8% —

26 Appendix 1

Covenant 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 7. Maintain a portfolio infection rate of

less than 10%d

DLC N/A N/A N/A 0.0% 0.0% 6.0% 8.9% 9.9% 7.3% N/AELL N/A N/A N/A N/A N/A N/A N/A N/A N/A N/ANLC N/A N/A N/A N/A N/A N/A N/A N/A N/A N/APICL N/A N/A N/A N/A N/A N/A N/A N/A N/A N/APKI — — — — 1.6% 3.1% 1.8% 3.6% 1.6% —

— = not available, N/A = not applicable. a This covenant was not applicable to leasing companies. Being a development finance institution, PKI had to comply with the minimum capital adequacy ratio of 8%. b This loan covenant applied only to participating financial institutions (PFIs) engaged in leasing business. c As per domestic financial reporting requirements, banks and nonbanking finance companies have not been required to publicly disclose collection ratio. For this

reason, all the PFIs except DLC did not provide the relevant information to the Operations Evaluation Mission. DLC calculated the collection ratio as lease installments received/lease installments due.

d As per domestic financial reporting requirements, leasing companies are not required to publicly disclose the value of the nonperforming portfolio. The Operations Evaluation Mission requested all leasing PFIs for this information and only DLC provided the required data. DLC calculated this as the ratio of nonperforming lease to gross lease portfolio.

Sources: Operations Evaluation Mission and annual reports of DLC, ELL, NLC, PICL, and PKI.

Appendix 1 27

Appendix 2 28

PROFILE OF BANKERS EQUITY LIMITED (UNDER LIQUIDATION) 1. Bankers Equity Limited (BEL) was a development financial institution (DFI) set up in 1979 and commenced operations in 1980. In 1987, BEL was converted into a public limited company and listed on the stock exchanges. BEL grew to become a major DFI employing a staff of 360 people with a total equity of PRs1.4 billion and 14 branches across the country at end-FY1996. BEL was the administrating agency for the World Bank’s Microenterprise Project and Financial Sector Deepening and Intermediation Loan as well as the Financial Sector Intermediation Loan. 2. As part of the Government’s financial sector reform program, BEL was privatized in 1996 when 51% of its shares were sold in two tranches to a local Long Term Venture (LTV) group. The LTV group was mainly in leasing and modarba.1 The first tranche of 26% shares were sold in June 1996 for PRs315 million; simultaneously, management control was also transferred to the LTV group. The remaining 25% shares were acquired by the LTV group from the Government in December 1996 for PRs303 million. 3. There were some doubts about the transparency of the process followed in BEL’s privatization. The Operations Evaluation Mission (OEM) was informed that the LTV group, whose head had a close relation working at a very senior level in the Ministry of Finance, was favored by bringing about a regulatory change to allow modarbas to bid during the process of privatizing BEL. Moreover, handing over the management control prior to receiving full payment for 51% of Government stake provided the buyer the opportunity to misuse BEL’s resource to raise financing for payment of the second tranche of BEL’s 25% shares to the Government. 4. After the privatization, the new management reportedly got involved in fraudulent activities involving BEL’s financial resources. These activities included illegal write-offs of loans extended by BEL, shifting personal losses in stock market trading to BEL’s books, illegal use of borrowers’ pledged securities for raising finance or even their authorized sale, etc. 5. In August 1999, the State Bank of Pakistan (SBP) took over the management of BEL and suspended its operations. SBP appointed a new set of board of directors in December 1999. On 18 April 2001, the Sindh High Court passed order for the liquidation of BEL and the order was later upheld by the country’s Supreme Court. The President and the Chief Executive Officer of BEL’s new management was appointed as the official liquidator. He had previously retired from BEL as president in May 1995 when BEL was still a public sector entity. 6. BEL continues to be under liquidation; no deadline for the process has been fixed. At the time of the liquidation order, BEL had a loan portfolio of PRs12 billion comprising 181 projects. At the time of the OEM, there were 128 projects with an outstanding amount of PRs9 billion. Eighty-six of these 128 projects were under litigation and decreed; 18 were nonperforming assets that had not yet gone into litigation, and the remaining 24 were performing loans. There were about PRs9 billion claims against BEL, of which PRs6 billion were from the Government.

1 Modarbas are finance companies that operate according to Islamic principles of finance, not involving interest.

Appendix 3 29

CHARACTERISTICS OF SUBLOANS

Table A3.1: Distribution of Subloans by Participating Financial Institutions Disbursed Percentage of Item No. Amount ($) Loan Amount Dawood Leasing (DLC) 15 3,102,240 12.64 English Leasing (ELL) 7 873,255 3.56 Network Leasing (NLC) 6 968,615 3.95 Pakistan Industrial and Commercial Leasing (PICL) 42a 4,750,000 19.35 Pakistan Kuwait Investment Co. (PKI) 3 14,852,486 60.51 Total 73 24,546,596 100.00

a This includes two subloans for $19,565 and $172,826, which were disbursed by the Asian Development Bank (ADB) but PICL’s present management could not verify the subprojects at the time of the Operations Evaluation Mission. Moreover, there are discrepancies between ADB’s and PICL’s records as to disbursement amounts of another three subloans. The information here is based on ADB records.

Sources: ADB project files, supplemented by information obtained by the Operations Evaluation Mission.

Table A3.2: Size of Subloans Disbursed Percentage of Item No. Amount ($) Loan Amount $1 million or below 70 9,694,110 39.49 $1 million–$3 million - - $3 million or above 3 14,852,486 60.51 Total 73 24,546,596 100.00

Sources: Asian Development Bank project files, supplemented by information obtained by the Operations Evaluation Mission.

Table A3.3: Maturity of Subloans Disbursed Percentage of Item No. Amount ($) Loan Amount Up to 3 years 49 5,857,480 23.86 Over 3 to 5 years 21 3,836,630 15.63 Over 5 years 3 14,852,486 60.51 Total 73 24,546,596 100.00

Sources: Asian Development Bank project files, supplemented by information obtained by the Operations Evaluation Mission.

30 Appendix 3

Table A3.4: Geographica Distribution of Subloans

Disbursed Percentage of Item No. Amount ($) Loan Amount Baluchistan 1 195,093 0.79 North-West Frontier Province 2 4,972,814 20.6 Punjab 15 5,718,478 23.30 Sindh 55 13,660,211 55.65 Total 73 24,546,596 100.00

a Geographical classification based on location of productive facilities in case of manufacturing companies and office location in case of others.

Sources: Asian Development Bank project files, supplemented by information obtained by the Operations Evaluation Mission.

Table A3.5: Subsector Distribution of Subloans Disbursed Percentage of Item No. Amount ($) Loan Amount Cement 1 40,343 0.16 Chemical/Fertilizer 3 7,479,252 30.47 Food 13 2,089,029 8.51 Information Technology 4 474,294 1.93 Medical 10 420,749 1.71 Oil Refining 1 3,260,870 13.28 Poultry Feeds 1 195,652 0.80 Power/Energy 2 939,484 3.83 Textile 20 7,275,747 29.64 Transport 2 537,772 2.19 Others 16 1,833,404 7.47 Total 73 24,546,596 100.00

Sources: Asian Development Bank project files, supplemented by information obtained by the Operations Evaluation Mission.

Table A3.6: Purpose of Subloans Disbursed Percentage of Item No. Amount ($) Loan Amount New 8 8,503,914 34.64 Expansion 48 14,152,995 57.66 Modernization 17 1,889,687 7.70 Total 73 24,546,596 100.00

Sources: Asian Development Bank project files, supplemented by information obtained by the Operations Evaluation Mission.

Appendix 4 31

OVERVIEW OF SUBPROJECTS

Amount ($) Seq

Date of ADB

Approval

Sub- borrower

Name Location Approved Disbursed Subsector PurposeMaturity (years)

Interest Rate at

Approval (%)

Repayment Performance and Status

A. Dawood Leasing Company Limited

1.

27-Feb-98 D-01 Sindh 376,700 376,700 Food Expansion 3 23.60 Regular and matured

2. 23-Feb-99 D-02 NWFP 625,000 624,988 Textile Expansion 5 22.78 Regular and matured

3. 23-Feb-99 D-03 Balochistan 195,093 195,093 Food Expansion 5 22.06 Default and under litigation

4. 26-Feb-99 D-04 Punjab 185,185 185,185 Others New 5 22.00 Regular and matured

5. 26-Feb-99 D-05 Sindh 55,556 55,556 Food Modernization 3 24.08 Default and under litigation

6. 26-Feb-99 D-06 Sindh 16,667 16,667 Medical Modernization 3 23.00 Regular and matured

7. 26-Feb-99 D-07 Punjab 166,667 166,667 Information Technology Modernization 3 23.66 Prepaid in August 2001

8. 26-Feb-99 D-08 Punjab 224,444 224,444 Others Expansion 3 23.89 Regular and matured

9. 26-Feb-99 D-09 Sindh 31,111 31,111 Others New 3 25.00 Regular and matured

10. 26-Feb-99 D-10 Sindh 22,222 22,222 Others Expansion 4 23.02 Regular and matured

11. 26-Feb-99 D-11 Sindh 44,444 44,444 Textile Expansion 5 21.50 Regular and matured

12. 26-Feb-99 D-12 Punjab 370,370 370,370 Textile Expansion 5 21.00 Regular and matured

13. 26-Feb99 D-13 Sindh 10,274 10,274 Information Technology Expansion 3 23.74 Regular and matured

14. 26-Feb-99 D-14 Sindh 37,778 37,778 Others Expansion 3 22.00 Regular and matured

15. 26-Feb-99 D-15 Sindh 740,741 740,741 Power/ Energy Expansion 3 22.00 Regular and matured

32 Appendix 4

Amount ($) Seq

Date of ADB

Approval

Sub- borrower

Name Location Approved Disbursed Subsector PurposeMaturity (years)

Interest Rate at

Approval (%)

Repayment Performance and Status

B. English Leasing Limited

16.

05-Jul-99 E-01 Sindh 88,657 88,657 Information Technology New 3 25.00 Regular and matured

17. 23-Jun-97 E-02. Punjab 873,255 40,343 Cement Expansion 5 22.00 Decided in litigation

18. 26-Feb-99 E-03. Punjab 260,870 204,366 Textile Modernization 3 24.00 Regular and matured

19. 26-Feb-99 E-04 Punjab 179,374 179,374 Textile Expansion 3 23.00 Regular and matured

20. 16-Mar-99 E-05 Punjab 78,260 78,260 Others Expansion 4 25.00 Regular and matured

21. 16-Jun-99 E-06 Punjab 142,735 142,735 Others Expansion 4 25.00 Regular and matured

22. 30-Jun-99 E-07 Punjab 139,520 139,520 Food Expansion 3 25.00 Regular and matured

C. Network Leasing Corporation Limited

23. 30-Apr-98 N-01 Sindh 175,205 175,205 Others Expansion 3 23.00 Regular and matured

24. 30-Apr-98 N-02 Sindh 145,454 145,454 Textile Expansion 3 19.50 Decided in litigation

25. 07-May-98 N-03 Punjab 215,664 215,664 Chemical/ Fertilizer Expansion 5 20.00 Regular and matured

26. 01-Jul-98 N-04 Punjab 161,383 161,383 Others Expansion 4 20.00 Regular and matured

27. 01-Jul-98 N-05 Sindh 65,909 65,909 Textile Expansion 3 23.00 Regular and matured

28. 24-Sep-98 N-06 Sindh 205,000 205,000 Others Expansion 5 23.00 Regular and matured

D. Pakistan Industrial and Commercial Leasing Limited

29. 11-Sep-98 PI-01 Sindh 198,743 198,743 Power/ Energy Expansion 3 23.63 Regular and matured

30. 01-Oct-98 PI-02 Sindh 180,000 180,000a Textile Modernization 3 22.50 Regular and matured

31. 05-Oct-98 PI-03 Sindh 195,653 175,069a Food Expansion 3 22.00 Regular and matured

Appendix 4 33

Amount ($) Seq

Date of ADB

Approval

Sub- borrower

Name Location Approved Disbursed Subsector PurposeMaturity (years)

Interest Rate at

Approval (%)

Repayment Performance and Status

32. 05-Oct-98 PI-04 Sindh 189,130 189,130 Others New 3 23.78 Default and under litigation

33.

05-Oct-98 PI-05 Sindh 45,652 45,652 Medical Expansion 3 23.00 Regular and matured

34. 05-Oct-98 PI-06 Sindh 91,043 91,043 Textile Modernization 4 21.00 Regular and matured

35. 05-Oct-98 PI-07 Sindh 62,076 62,076 Textile Expansion 3 24.00 Regular and matured

36. 05-Oct-98 PI-08 Sindh 74,348 74,348 Medical Expansion 3 25.00 Regular and matured

37. 05-Oct-98 PI-09 Sindh 39,130 39,130 Medical Expansion 3 24.00 Regular and matured

38. 13-Oct-98 PI-10 Sindh 260,870 260,870 Textile Modernization 5 21.00 Regular and matured

39. 13-Oct-98 PI-11 Sindh 367,826 367,826a Transport Expansion 3 24.00 Casual and matured

40. 14-Oct-98 PI-12 Sindh 195,652 195,652 Poultry Feeds New 3 21.00 Default and under litigation

41. 14-Oct-98 PI-13 Sindh 32,609 32,609 Textile Modernization 3 23.00 Decided in litigation

42. 03-Feb-99 PI-14 Sindh 13,696 13,696 Textile Expansion 3 24.00 Regular and matured

43. 03-Feb-99 PI-15 Sindh 19,565 19,565b Textile Expansion 3 24.00 No information available

44. 03-Feb-99 PI-16 Sindh 45,652 45,652 Textile Expansion 3 24.00 Regular and matured

45. 03-Feb-99 PI-17 Sindh 32,609 32,609 Textile Expansion 3 27.00 Regular and matured

46. 03-Feb-99 PI-18 Sindh 31,043 31,043 Medical Modernization 3 22.50 Regular and matured

47. 03-Feb-99 PI-19 Sindh 12,455 12,455 Medical Modernization 3 25.00 Regular and matured

48. 03-Feb-99 PI-20 Sindh 19,565 19,565 Food New 3 23.45 Casual and matured

49. 03-Feb-99 PI-21 Sindh 16,239 16,239 Food Expansion 3 24.00 Regular and matured

50. 03-Feb-99 PI-22 Sindh 13,043 13,043 Others Expansion 3 25.77 Casual and matured

34 Appendix 4

Amount ($) Seq

Date of ADB

Approval

Sub- borrower

Name Location Approved Disbursed Subsector PurposeMaturity (years)

Interest Rate at

Approval (%)

Repayment Performance and Status

51. 03-Feb-99 PI-23 Sindh 33,913 33,913 Others Expansion 4 25.00 Casual and matured

52.

26-Feb-99 PI-24 Sindh 37,666 37,666 Medical Expansion 3 22.50 Regular and matured

53. 26-Feb-99 PI-25 Sindh 180,739 180,739 Textile Expansion 4 21.00 Regular and matured

54. 26-Feb-99 PI-26 Sindh 208,696 208,696 Information Technology Expansion 3 22.39 Regular and matured

55. 22-Feb-99 PI-27 Sindh 354,199 354,199 Food Expansion 5 22.00 Regular and matured

56. 22-Mar-99 PI-28 Punjab 172,826b 172,826 Transport Expansion 3 23.00 Lease not created

57. 23-Jun-99 PI-29 Sindh 33,647 33,647 Medical Modernization 4 23.00 Regular and matured

58. 23-Jun-99 PI-30 Punjab 176,471 176,471 Textile Modernization 3 25.00 Regular and matured

59. 23-Jun-99 PI-31 Sindh 35,882 35,882 Others Expansion 3 23.00 Regular and matured

60. 23-Jun-99 PI-32 Sindh 550,824 550,824 Food New 3 21.00 Default and under litigation

61. 23-Jun-99 PI-33 Sindh 270,588 270,588 Others Modernization 4 24.00 Regular and matured

62. 23-Jun-99 PI-34 Sindh 58,824 58,824 Food Expansion 3 22.00 Casual and matured

63. 30-Jun-99 PI-35 Sindh 11,767 11,767 Food Modernization 3 21.00 Casual and matured

64. 30-Jun-99 PI-36 Sindh 197,686 197,686 Textile Modernization 3 22.75 Regular and matured

65. 30-Jun-99 PI-37 Sindh 127,201 127,201 Food Expansion 4 24.50 Regular and matured

66. 30-Jun-99 PI-38 Sindh 9,414 9,414 Medical Expansion 3 25.00 Regular and matured

67. 30-Jun-99 PI-39 Sindh 8,472 8,472 Food Expansion 3 24.00 Regular and matured

68. 30-Jun-99 PI-40 Sindh 120,727 120,727 Medical Modernization 3 23.00 Regular and matured

69. 30-Jun-99 PI-41 Sindh 27,525 27,525 Others Modernization 3 24.00 Regular and matured

70. 30-Jun-99 PI-42 Sindh 19,798 19,798 Chemical/ Fertilizer Expansion 3 22.00 Regular and matured

Appendix 4 35

Amount ($) Seq

Date of ADB

Approval

Sub- borrower

Name Location Approved Disbursed Subsector PurposeMaturity (years)

Interest Rate at

Approval (%)

Repayment Performance and Status

E. Pakistan Kuwait Investment Company Private Limited

71.

06-Jun-97 PK-01 Sindh 8,000,000 7,243,790 Chemical/ Fertilizer New 10 19.70

Loan was restructured in 2003 and since then, interest payment has been regular and principal payment has not started.

72. 30-Apr-98 PK-02 NWFP 8,000,000 4,347,826 Textile Expansion 9 20.00

Regular and ongoing. The interest rate scheme was converted to the floating system (based on treasury bill yield) from the fixed rate scheme.

73. 26-May-98 PK-03 Punjab 8,000,000 3,260,870 Oil Refinery Expansion 7 19.45 Loan prepaid in February 2002 due to high interest rate.

Total 34,607,002c 24,546,596

NWFP = Northwest Frontier Province. a The data is based on the Asian Development Bank’s (ADB) disbursement record. b ADB disbursed this amount, but the Pakistan Industrial & Commercial Leasing Limited could not verify this subproject at the time of the Operations Evaluation

Mission (OEM). The information here is based on ADB’s project file. c In addition to this amount, ADB approved/authorized several more subprojects, including 633 subprojects for more than $13 million through the Network Leasing

Corporation, but the disbursement was not made. Sources: ADB project files and OEM.

36 Appendix 5

PROFILE OF FIRST DAWOOD INVESTMENT BANK (FORMERLY DAWOOD LEASING COMPANY LIMITED)

A. Organizational Performance

1. Management and Operations

1. Dawood Leasing Company Limited (DLC) was incorporated in 1994 and began operations in January 1995. The company is listed on the stock exchange and operates through a network of three branches located in Karachi, Lahore, and Islamabad. The Dawood family has been the main sponsor of the company since its inception and also continues to hold DLC’s management. In response to the entry of commercial banks in leasing businesses, DLC diversified its business focus into the capital market, launching a money market mutual fund, underwriting debt and equity issues, and making direct investments in these instruments. It also started housing finance. To formalize the broadened operational scope, DLC in 2003 changed its status from a leasing company to an investment bank, and was renamed First Dawood Investment Bank Limited.

2. Financial Performance

2. The company’s assets grew from PRs340 million at end-1995 to PRs3,980 million at end-2003 (Table A5.1). During this period, the net investment in lease finance as percentage of total assets declined from 66% to 22% as a result of operational diversification. The company remained profitable during FY1995–FY2003 (Table A5.2). The company’s profit in FY2003 was exceptionally high due to PRs221 million surplus on revaluation of its securities portfolio. This resulted in substantial organic growth of its equity in 2003.

3. DLC complied with the financial covenants under the Financial Sector Intermediation Loan (FSIL), requiring maximum debt/equity of 10:1, debt service coverage of at least 1.25, and a pre-tax profit-assets ratio of 1% during FY1995–FY2003. However, the company was not in compliance with the covenant requiring a minimum current ratio of 1.25 during FY2002–FY2003 and it was also short of this level in FY1996. As per the data provided by DLC covering FY1998–FY2003, DLC was in compliance with the financial covenants related to minimum collection ratio and infection ratios during this period (Appendix 1).

B. Subloan Performance

1. Overview

4. The total disbursements to DLC under the FSIL amounted to $3.1 million for financing 15 subprojects. Thirteen subloans for $2.8 million were repaid as per schedule while one subloan for $0.2 million was prepaid by the subborrower. Two subloans for $250,649 had defaulted and went into litigation. The Operations Evaluation Mission (OEM) noted that DLC had been repaying the loan to the Government on schedule, and its outstanding amount was around $2.3 million (PRs165 million).

5. DLC availed itself of foreign exchange (FX) cover from the State Bank of Pakistan, which provided a commitment that it would not raise the FX cover fee above 8.4%. DLC stopped paying the FX cover fee to SBP in 2003 as it resorted to synthetic hedging by purchasing dollar- denominated bonds. At the time of the OEM, DLC was still paying the guarantee and

Appendix 5 37

administration fees to Bankers Equity Limited (BEL). DLC requested the Ministry of Finance to reconsider these financial obligations given that BEL was under liquidation.

2. Profiles of Selected Subprojects

a. D-10 (Media Entertainment Company)

6. D-10 is a leading media entertainment company devoted to the production and distribution of film and television programs since 1946. D-10’s full-time staff strength was 50 including eight women at the time of the OEM. Turnover for the year 2003 was over PRs15.0 million. The company is located in Karachi.

7. The company obtained on lease an apparatus for editing at a fixed interest of 23% for 3 years. The apparatus contributed to improved efficiency in the editing work. At the time of obtaining the lease, the company was unaware of the fact that the lessor DLC was utilizing the FSIL. D-10 borrowed from DLC for the following reasons: (i) D-10’s management personally knew the chairman of DLC, (ii) financing terms offered by DLC were competitive, and (iii) borrowing from leasing companies was generally faster and less cumbersome compared borrowing from with banks. The asset leased is considered a high-tech product with no environmental effect and contributed to the creation of less than five full-time jobs. The lease was fully paid off. D-10 has represented a success story in the industry in the last few decades and started exporting television programs.

b. D-11 (Textile Manufacture)

8. D-11 was incorporated in 1967 and is listed on the stock exchanges in Pakistan. The principal business of the company is the manufacture and sale of cotton and blended yarn. The mill is located in the province of Sindh and has an installed capacity of 47,040 spindles. Staff strength was 980 as of end-September 2003, out of which only four were women.

9. In February 1999, D-11 obtained a lease of PRs4 million for two drawing frames from Japan to improve the quality of its products. The lease carried a fixed interest rate of 21.5% with a tenor of 4 years. The lease has since matured and stands fully paid off.

10. D-11 preferred leasing to a loan as a loan was tax efficient. D-11 selected DLC because of the latter’s reputation and competitiveness of the financing term. D-11 had no knowledge that the lease was being funded by ADB. DLC did not require an environment impact assessment report. At the time of obtaining the lease, D-11’s turnover was over PRs1.1 billion, of which PRs344 million was export sales. The turnover increased up to PRs.1.3 billion in 2003, but export sales decreased to PRs301 million as local market demand picked up. D-11’s export is mainly to Japan; Hong Kong, China; and Republic of Korea. It also sells its product to its associated listed company engaged in weaving, which accounted for about 15% of the total turnover in 2003. The project created five new jobs.

11. D-11 was profitable even in difficult times when cotton was expensive and interest rates were very high. The strength of D-11 has rested on its flexibility to meet specific needs of the buyers. It produces slub yarn and lycra yarn apart from the usual carded and combed yarn. This edge, along with the group’s standing in the local and international market, is the essential factor for the success of D-11.

38 Appendix 5

c. Unsuccessful Subprojects

12. On 23 February 1999, ADB approved the subloan to D-03 (food manufacturer) for PRs10.5 million equivalent for a period of 5 years at a fixed rate of 22.1%. The plant was located in Hub district of Balochistan Province. DLC provided financing for the wafers plant supported under the FSIL. However, the company faced problems due to wheat shortage when it did not get an allocation by the Government at subsidized prices. The company consequently went into working capital problems and defaulted. DLC, together with other lenders, sued the company and the court decreed its liquidation. The OEM noted that DLC expected to recover around 65% of the principal amount on lease from the proceeds of plant sale. It would seek to recover the remaining from the project sponsors who had provided personal guarantees for the loan.

13. On 26 February 1999, ADB approved the lease equivalent to PRs3 million to D-05 (food manufacturer) engaged in tea processing and marketing for a period of 3 years at 24.1%. The company faced difficulties from the very beginning and defaulted. Legal proceedings were pending at the Balochistan High Court in Quetta at the time of the OEM.

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003

267.92 281.60 295.52 305.69 300.63 306.73 313.24 336.37 617.78

57.34 100.66 199.46 241.60 559.74 490.28 562.92 934.65 1,416.2315.19 152.18 168.62 360.29 660.62 732.65 1,181.51 1,074.39 1,943.71

340.45 534.45 663.60 907.58 1,520.99 1,529.66 2,057.67 2,345.41 3,977.73

i. Net fixed assets 12.44 11.22 11.50 17.64 23.80 26.40 25.30 30.17 25.82ii. Net investment in lease finance 225.58 389.03 408.14 434.66 576.09 661.45 735.38 833.41 878.16iii. Others 0.00 0.00 1.65 1.93 47.81 76.68 72.91 409.85 1,115.90

Subtotal 238.02 400.25 421.29 454.23 647.70 764.54 833.58 1,273.42 2,019.87

i. Gross lease/loan receivables 27.79 121.55 212.37 356.98 460.29 456.34 636.80 776.08 939.52Less: Provision for doubtful receivables 0.00 (5.00) (16.50) (26.50) (34.00) 27.05 (44.68) (56.43) (90.23)Net receivables 27.79 116.55 195.87 330.48 426.29 483.39 592.13 719.66 849.28

ii. Cash and other current assets 74.64 17.65 46.45 122.87 447.00 335.83 631.96 352.33 1,108.58Subtotal 102.43 134.20 242.31 453.35 873.29 819.22 1,224.09 1,071.99 1,957.86 Total assets 340.45 534.45 663.60 907.58 1,520.99 1,583.76 2,057.67 2,345.41 3,977.73

Sources: Operations Evaluation Mission and Dawood Leasing Company Limited's annual reports.

Table A5.2: Summary Income Statement of First Dawood Investment Bank Limited (formerly Dawood Leasing Company Limited)

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003Revenues

Lease income 21.19 84.67 121.29 133.36 154.05 171.04 184.58 208.90 216.53Investment income 0.69 0.34 0.21 7.55 8.41 30.13 50.12 53.91 123.59Other income 6.12 4.12 0.46 0.44 0.75 13.25 37.99 16.42 58.10

Total revenues 28.00 89.12 121.96 141.34 163.21 214.42 272.69 279.23 398.22

ExpensesAdministration and operating expenses 8.86 14.45 18.82 22.37 23.57 26.59 26.86 25.43 26.47Financial charges 1.06 23.46 45.23 68.85 99.88 132.93 175.32 200.06 208.38Provision for doubtful receivables and

diminution in value of investment 0.00 5.00 11.50 22.07 4.47 13.25 23.19 20.92 (141.12)Total expenses 9.92 42.91 75.56 113.29 127.92 172.76 225.38 246.41 93.72

Profit before tax 18.09 46.21 46.41 28.06 35.29 41.66 47.32 32.82 304.50Taxation 0.17 1.27 1.24 17.89 15.35 10.55 15.81 10.72 23.64

Net profit after tax 17.92 44.94 45.16 10.17 19.94 31.10 31.51 22.10 280.86

Sources: Operations Evaluation Mission and Dawood Leasing Company Limited's annual reports.

Long-term

Current Assets

AssetsLong-term assets

As of end-June (PRs million)

Table A5.1: Summary Balance Sheet of First Dawood Investment Bank Limited (formerly Dawood Leasing Company Limited)As of end-June (PRs million)

CurrentTotal equity and liabilities

Equity and reservesLiabilities

Appendix 5 39

40 Appendix 6

PROFILE OF ENGLISH LEASING LIMITED A. Organizational Performance

1. Management and Operations 1. A group of individuals established English Leasing Limited (ELL) in 1992. The group had run ELL until 2001 when it sold the equity stake of about 18% to the present chairman, a former senior banker. Soon after the change in management, cases of financial misappropriation by the previous management surfaced. The new management restated the company’s financial statements for FY2000 and FY2001, while charging the previous finance manager with committing fraud. The Securities Exchange Commission of Pakistan (SECP) cancelled ELL’s leasing license in December 2001 because the company had failed to comply with the minimum capital requirement of PRs200 million. However, the previous management prolonged its control of the company by delaying board elections, which were finally held in November 2002 when the new sponsor took control with support from other institutional shareholders of the company. In May 2002, SECP appointed a chartered accountancy firm to investigate ELL’s affairs from July 1998 to December 2001. The firm concluded that the previous management swindled the company resources, resulting in a loss of PRs106 million to ELL. The previous sponsors of ELL were arrested and remain in custody. 2. The current management of ELL has been diversifying its revenue base by expanding its capital market investments as it could no longer write fresh leases after the cancellation of its license in December 2001. At the time of the Operations Evaluation Mission (OEM), the management was also pursuing merger with other companies holding a leasing license.

2. Financial Performance 3. ELL underwent two contrasting phases of financial performance, i.e. the first phase from FY1995 to FY2000 and the second from FY2001 to FY2003 (Tables A6.1 and A62). During the first phase the total assets grew from PRs211 million to PRs395 million, which decreased to PRs218 million at the end of the second phase. ELL remained profitable in the first phase, while making losses due to heavy loan loss provisioning in the second phase. ELL’s revenue increased to PRs35 million in FY2003 from PRs26 million in the previous year, reflecting the better performance of its investment portfolio. 4. ELL complied with the covenant under the Financial Sector Intermediation Loan (FSIL), requiring maximum debt/equity of 10:1, during FY1995–FY2003. ELL complied with the covenant of (i) a minimum current ratio of 1.25 during FY1995–FY2003 with the exception of FY1996, and (ii) a debt service coverage ratio of at least 1.25 except for FY2001–FY2002. ELL could not comply with a minimum pre-tax profit-assets ratio of 1% during FY2001–FY2003. Data pertaining to two covenants, i.e., a gross collection ratio and a portfolio infection rate, are not available (Appendix 1). B. Subloan Performance 1. Overview 5. The total disbursements to ELL under the FSIL amounted to $873,255 for financing seven subprojects. Six loans worth $832,912 were repaid as per schedule, while one loan for $40,343 million was settled through litigation. At the time of the OEM, ELL stopped repayment

Appendix 6

41

to the Government due to its weak financial position,1 while the loan outstanding was around $0.8 million (PRs46.8 million). At the time of the OEM, ELL did not (i) take foreign exchange cover for the outstanding liabilities under the FSIL, and (ii) pay the third-party guarantee and administrative fees to Bankers Equity Limited. 2. Profiles of Selected Subprojects

a. E-03 (Textile Manufacturer)

6. E-03 was incorporated as a public limited company in 1988, constituting a family-based diversified business group. The group had a strong presence in the steel, sugar, and textile industries until the end of the 1990s when the sponsor family embarked in national politics. However, the family member’s downfall in the political arena in 1999 resulted in the group’s dismantling. 7. At the time of the OEM, E-03 manufactured carded and combed yarn in a plant with an installed capacity of 17,280 spindles. After the group was dismantled, E-03 acquired its own laboratory equipment. However, E-03 faced difficulties in securing financing as most financial institutions were concerned about the political adversity that the company potentially faced. Eventually, E-03 was able to secure financing based on a personal relationship between a sponsor of ELL and one E-03 manager. ELL did not require an environmental impact assessment. E-03 fully repaid the subloan on schedule.

8. The project generated employment for 4–5 persons, all males. At the time of the OEM, E-03 had a staff strength of over 500, of whom only 5 were women. The annual turnover of E-03 at the time the lease was obtained was PRs300 million. In 2004 the annual turnover was PRs500 million, but export sales declined from 90% to less than 10% of its total production due to the expanding local market. The management of E-03 indicated its optimistic business prospect to the OEM. b. E-06 (Capacitor Manufacturer) 9. E-06 was established in 1981 as a private limited company. It manufactures various types of capacitors used for power factor improvement. When used with electric machinery and appliances, these capacitors reduce the current, stabilize the voltage, and hence save energy. They are nontoxic and therefore should not have any adverse effect on the environment. During the OEM, E-06 had a 70% share in the local market while being exposed to increasing competition from imports from the People’s Republic of China. Some exports went to Bangladesh, Jordan, Saudi Arabia, and Sri Lanka. The export volume, however, was not substantial. 10. The business relationship between E-06 and ELL started in 1995 when E-06 drew leases from ELL. Satisfied with the manner by which ELL conducted business and after checking out three other leasing companies, E-06 approached ELL again in 1999 when it needed to import machinery from Japan to modernize and expand its production facilities. For this purpose E-06 requested ELL for access to its leasing facility after weighing in the tax advantages of a leasing arrangement over a loan. ELL did not require E-06 to submit an environmental impact assessment. E-06 fully repaid the subloan on schedule.

1 ELL requested the Government for loan rescheduling, but was told to deal with the Asian Development Bank (ADB)

for the request. ELL wrote a letter to ADB in 2003 but did not receive a reply.

42 Appendix 6

11. The subproject did not create any new jobs. During the OEM, E-06 had a staff of 160 of whom 25 were women. E-06 operated a single shift and had no plan to expand its production in the medium term.

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003

111.17 109.78 121.12 125.92 130.50 130.79 88.90 73.90 67.83

46.26 59.68 63.16 82.27 105.61 152.25 124.04 100.48 102.4953.14 97.85 65.49 75.28 98.24 112.30 130.05 104.70 47.22

210.57 267.31 249.77 283.47 334.35 395.34 342.99 279.08 217.54

i. Net fixed assets 7.05 6.42 7.49 8.67 8.40 9.02 7.66 19.05 15.03ii. Net investment in lease finance 99.98 148.43 109.39 152.35 133.57 222.73 165.32 46.66 34.96iii. Others 18.56 17.82 18.56 18.89 20.13 20.28 7.55 7.32 38.53

Subtotal 125.59 172.67 135.44 179.90 162.10 252.03 180.53 73.03 88.53

i. Gross lease/loan receivables 71.66 72.08 85.99 89.51 139.14 83.59 87.98 136.95 91.36Less: Provision for doubtful receivables (0.01) (1.33) (3.97) (3.97) (3.97) (3.97) (21.73) (24.12) (33.00)Net receivables 71.65 70.75 82.01 85.54 135.17 79.62 66.25 112.83 58.36

ii. Cash and other current assets 13.41 23.88 32.31 18.03 37.08 63.69 96.21 93.22 70.65Subtotal 85.06 94.64 114.33 103.57 172.25 143.31 162.46 206.05 129.01 Total assets 210.65 267.31 249.77 283.47 334.34 395.34 342.99 279.08 217.54

Sources: Operations Evaluation Mission and English Leasing Company Limited's annual reports.

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003

17.73 35.34 43.19 48.61 47.17 47.00 39.42 21.52 12.240.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.000.95 1.59 2.06 3.16 4.01 9.63 1.08 4.84 22.63

Total revenues 18.69 36.93 45.25 51.77 51.17 56.63 40.50 26.36 34.88

4.15 8.72 9.44 10.46 11.78 13.89 14.34 13.22 13.397.27 11.81 18.17 18.49 23.33 31.54 29.88 21.30 15.06

2.13 1.72 2.64 0.50 0.00 0.00 35.49 6.69 8.95

Total expenses 13.55 22.25 30.25 29.44 35.10 45.43 79.70 41.22 37.40

5.14 14.68 15.00 22.33 16.07 11.20 (39.20) (14.86) (2.53)0.23 2.08 3.66 1.54 1.48 0.91 2.70 0.13 3.554.91 12.60 11.35 20.79 14.59 10.29 (41.90) (14.99) (6.08)

Sources: Operations Evaluation Mission and English Leasing Limited's annual reports.

Table A6.1: Summary Balance Sheet of English Leasing Limited As of end-June (PRs million)

Current assets

Equity and reservesLiabilities

Long-termCurrent

Total equity and liabilities

AssetsLong-term assets

Table A6.2: Summary Income Statement of English Leasing Limited As of end-June (PRs million)

RevenuesLease incomeInvestment incomeOther income

ExpensesAdministration and operating expenses

Net profit after tax

Financial chargesProvision for doubtful receivables and diminution in value of investment

Profit before taxTaxation

Appendix 6 43

44 Appendix 7

PROFILE OF NETWORK LEASING CORPORATION LIMITED A. Organizational Performance

1. Management and Operations 1. A group of four chartered accountants established Networking Leasing Corporation Limited (NLC) in 1992, supported by some foreign and domestic institutional investors. The company started financing lease operations in 1995 and has been listed on all three stock exchanges of the country. NLC has been a niche player in providing finance to microenterprises and small and medium-size enterprises. NLC started offering operating leases in 2001. At end-2003, NLC had a client base of about 4,000 with an average lease size of PRs150,000. It had 88 employees at end-2003, making it one of the most highly staffed companies in the leasing industry. In response to the entry of commercial banks into the leasing business, NLC formed a subsidiary specializing in microfinance. NLC’s long-term strategy at the time of the Operations Evaluation Mission (OEM) was to merge with this subsidiary making the latter the surviving entity.

2. Financial Performance 2. NLC’s assets grew from PRs115 million at end-FY1995 to PRs981 million at end-FY2003 (Table A7.1). During this period, its net investment in lease finance increased from PRs58 million to PRs352 million. Also in this period, NLC’s equity base more than doubled from PRs102 million to PRs209 million. This was achieved by a PRs75 million rights issue in FY2002 to meet the minimum regulatory capital requirement of PRs200 million for leasing companies. NLC has diversified its earnings assets portfolio by increasing its investments in debt instruments while gradually raising its financial leverage. Aside from the Financial Sector Intermediation Loan (FSIL), NLC borrowed from various international agencies including Swiss Agency for Development and Cooperation, World Bank, and Deutsche Bank. NLC remained profitable during FY1995–FY2003 (Table A7.2). 3. NLC complied with the financial covenants requiring a minimum current ratio of 1.25 and a maximum debt/equity of 10:1 during FY1995–FY2003. A current ratio declined from 7.12 in FY1995 to 1.29 in FY2003. The FY1995 figure, however, is not very representative as it was based on the balance sheet of 6 months after the start of the company’s operations. The company complied with covenants requiring a debt coverage ratio of not less than 1.25 and a pre-tax profit of at least 1% of assets in FY1995–FY2003 with the exception of a FY2001. Data pertaining to two applicable financial covenants, i.e., a gross collection ratio and a portfolio infection rate, are not available (Appendix 1). B. Subloan Performance

1. Overview 4. The total disbursements to NLC under the FSIL amounted to $968,615 for financing six subprojects. Five subloans for $823,161 were repaid as per schedule, while one subloan for $145,454 had gone bad and was under litigation at the time of the OEM. The OEM noted that NLC had been repaying the loan to the Government on schedule, and its outstanding amount was around $0.8 million. NLC took foreign exchange cover for the outstanding liabilities under the FSIL from the State Bank of Pakistan until 2003. At the time of the OEM, NLC continued to pay the guarantee and administration fees to Bankers Equity Limited.

Appendix 7 45

2. Profiles of Selected Subprojects

a. N-03 (Chemical Product Manufacturer)

5. N-03 has been in the chemical manufacturing business for more than 35 years. It is a family-owned business with a production facility in Faisalabad and a liquid conversion facility in Karachi. The main products of the company are sodium silicate and potassium silicate. Sodium silicate is used in manufacturing detergents, soaps, and packaging material. Potassium silicate is primarily used in the drilling industry. N-03 is the only independent manufacturer of these chemicals of high-grade quality in Pakistan. 6. N-03 obtained a lease from NLC in 1998 to acquire a dissolving unit to expand the company’s plant capacity. The expansion involved a higher level of automation than in the previous plant. N-03 borrowed from NLC for the following reasons: (i) D-3 had had good business relationships with NLC before this project, (ii) financing terms offered by NLC were competitive, and (iii) borrowing from NLC was faster and less cumbersome than borrowing from other financial institutions. N-03 knew that the lease facility was supported under the FSIL. The subloan was fully repaid on time. 7. As a result of this project, N-03’s annual turnover increased from PRs250 million in 1999 to around PRs400 million at the time of the OEM. During this period, the number of employees increased from around 80 (no female) to 110 (including 3 females). The OEM noted that the plant had no environmental hazards, and wastewater was recycled within the plant. Recently, N-03 started exporting its products. It exported around $0.2 million worth of potassium silicate to Bangladesh in the past 6 months. During the OEM, N-03 was planning to set up a new plant of 40,000–45,000 tons per annum capacity in Karachi, which would be sufficient to meet the demand for the next 10 years. In addition the company was also exploring the possibility of setting up a liquefaction plant in Dubai. The product would be exported in glass form from Pakistan and would be liquefied and sold in Dubai. b. N-04 (School)

8. N-04 was established in January 1979 in Lahore by a group of women, who committed themselves to quality education aimed at providing a creative alternative to the existing educational facilities in the country. It was incorporated as a private limited company in 1980. The initial focus of N-04 was the promotion of female education. In 1992, a boys’ branch was opened. At the time of the OEM, N-04 had several branches in the city of Lahore as well as Multan, Faisalabad, Karachi, Gujranwala, and Peshawar; had approximately 13,000 students and 1,250 teachers; and was considering opening branches in other major cities of the country. 9. One of the school branches (Gulberg III, Lahore), a beneficiary of the subloan, had 570 female students aged group between 9 and 15 years, and 65 teachers. The branch offers bus service (door-to-door pickup and drop) to students on an optional basis. During the OEM, there were 24 buses in the school fleet, 3 of which are outside Lahore. Roughly 5–7% of the students would be availing of bus services. The charges vary with area at PRs600–PRs1,400 per month. N-04 leased two buses from NLC, and repaid them on time. The motivation for leasing was the tax advantages. Usually, the buses are sold out within 2–3 years and replaced by new ones. The lease facility was for $161,383 to mature in 4 years with an interest rate at approval equal to 20%.

46 Appendix 7

c. Unsuccessful Subprojects

24. On 30 April 1998, ADB approved the lease equivalent to PRs6.4 million to N-02 (textile manufacturer), which was in exports. The lease carried a rate of 19.5% and a term of 3 years. The company incurred losses due mainly to inexperienced management, higher prices of cotton, competition from other Asian countries, and sharp increases in the euro (as the total costing was made in dollars). Eventually, NLC got its leased assets back. The sale proceeds covered the total outstanding overdue.

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003

102.48 102.54 112.45 110.56 113.18 113.34 118.94 205.43 209.17

5.70 44.36 45.75 94.72 181.59 203.71 302.42 326.00 404.796.62 20.99 25.39 30.51 43.60 179.42 228.61 364.54 367.10

114.81 167.89 183.59 235.79 338.38 496.47 649.97 895.97 981.06

i. Net fixed assets 3.64 12.68 13.12 16.10 15.66 14.10 47.03 58.99 75.71ii. Net investment in lease finance 58.19 94.43 92.46 112.51 156.12 217.67 262.70 293.07 352.47iii. Others 5.79 5.04 3.38 1.67 16.91 16.13 53.50 73.38 80.51

Subtotal 67.63 112.15 108.96 130.27 188.69 247.90 363.22 425.44 508.69

i. Gross lease/loan receivables 11.81 31.83 54.52 75.73 111.33 138.95 197.91 247.07 271.85Less: Provision for doubtful receivables 0.00 (0.63) (1.10) (1.88) (2.33) (2.34) (8.75) (9.02) (10.17)Net receivables 11.81 31.20 53.42 73.85 109.00 136.61 189.16 238.05 261.68

ii. Cash and other current assets 35.38 24.54 21.21 31.67 40.68 111.96 97.60 232.48 210.70Subtotal 47.18 55.74 74.63 105.51 149.68 248.57 286.75 470.53 472.38 Total assets 114.81 167.89 183.59 235.79 338.38 496.47 649.97 895.97 981.06

Sources: Operations Evaluation Mission and Network Leasing Corporation Limited's annual reports.

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003

1.50 19.65 29.48 35.14 45.26 59.93 83.96 87.85 90.150.00 0.00 0.00 0.00 0.00 2.66 5.75 10.52 43.845.73 3.53 2.19 2.30 1.99 5.97 7.65 5.24 6.41

Total revenues 7.23 23.18 31.66 37.43 47.25 68.56 97.36 103.61 140.40

3.86 11.06 14.77 18.48 17.05 21.68 25.48 28.30 39.430.01 1.27 6.20 9.71 21.18 35.73 63.65 55.26 75.64

0.00 0.63 0.47 0.88 0.85 1.08 7.11 9.23 3.05

Total expenses 3.87 12.96 21.44 29.07 39.08 58.48 96.23 92.78 118.12

3.36 10.22 10.22 8.37 8.17 10.08 1.13 10.83 22.270.87 0.16 0.31 0.26 5.55 2.43 (4.48) (0.66) 1.032.48 10.06 9.91 8.10 2.63 7.65 5.61 11.48 21.25

Sources: Operations Evaluation Mission and Network Leasing Corporation Limited's annual reports.

Net profit after tax

Administration and operating expensesFinancial chargesProvision for doubtful receivables and diminution in value of investment

Profit before tax

Investment incomeOther income

Expenses

Taxation

As of end-June (PRs million)

RevenuesLease income

Current assets

AssetsLong-term assets

Table A7.2: Summary Income Statement of Network Leasing Corporation Limited

Table A7.1: Summary Balance Sheet of Network Leasing Corporation LimitedAs of end-June (PRs million)

CurrentTotal equity and liabilities

Equity and reservesLiabilities

Long-term

Appendix 7 47

48 Appendix 8

PROFILE OF PAKISTAN INDUSTRIAL AND COMMERCIAL LEASING LIMITED A. Organizational Performance

1. Management and Operations 1. The Prudential Group established Pakistan Industrial and Commercial Leasing Limited (PICL) in 1987 as the first private sector leasing company in Pakistan. PICL is principally engaged in lease financing through a network of three branches in Karachi, Lahore, and Islamabad. The Prudential Group grew into a diverse financial sector conglomerate by the mid-1990s, but its involvement in various fraudulent activities surfaced toward the end of the 1990s. The Government launched criminal investigations against the group’s management, and the head of the Prudential Group was an absconder at the time of the Operations Evaluation Mission (OEM). 2. In 2001, the Prudential Group sold the controlling stake in PICL to the present sponsor—a United Kingdom-based group, owned by individuals of Pakistani origin. The new sponsors changed the entire management of the company and replaced the company’s auditors after discovering glaring financial irregularities in the company. The core problems were gross underreporting of nonperforming leases, very low bad debt provisions, and extreme disregard for risk management. The current management has been pursuing expeditious recovery of bad leases through restructuring and liquidation.

2. Financial Performance 3. PICL underwent two contrasting phases of financial performance: the first phase showing expansion in FY1995–FY2000 and the second phase of contraction in FY2001–FY2004 (Tables A.8.1 and A8.2).1 During the first phase, the total assets grew from PRs653 million to PRs1,145 million, but decreased to PRs520 million at the end of the second phase. PICL’s cumulative profits during the first phase amounted to PRs98.4 million. However, the aggregate losses in the second phase amounted to PRs254 million, wiping out the entire equity of the company. PICL managed to recover and/or regularize some bad loans, resulting in net reversals in provisions of a total of PRs45 million during FY2003–FY2004. Nonetheless, the company’s total revenues amounted to PRs33.4 million in FY2004, still insufficient to meet even the financial charges of PRs45.3 million. The latest balance sheet for FY2004 presents a very weak financial position with an equity amounting to negative PRs27.4 million and an outstanding debt of PRs353 million. PICL needs substantial equity injections to remain viable. 3. PICL complied with the minimum current ratio requirement of 1.25 during FY1995–FY2003, but not in FY2004. PICL did not comply with the financial covenants on (i) a debt/equity ratio after FY2002, and (ii) a debt coverage ratio and a pre-tax profit-assets ratio since FY2001. Data pertaining to two applicable financial covenants i.e., a gross collection ratio and a portfolio infection rate, were not available (Appendix 1).

1 OEM considered highly doubtful the quality of the FY1995–FY2000 financial statements prepared by the previous

management.

Appendix 8

49

B. Subloan Performance 1. Overview 4. The total disbursements to PICL under the Financial Sector Intermediation Loan (FSIL) amounted to $4.7 million for financing 42 subprojects.2 By the time the OEM was fielded, 36 subloans totaling $3.6 million3 had been repaid; one subloan for $32,609 had defaulted and a court decision was made; and three subloans totaling $1.0 million had not performed and were under litigation. At the time of the OEM, the outstanding amount of loan payable by PICL to the Government was PRs258.3 million. The OEM could not verify if PICL continued to pay the third-party guarantee and administration fees to Bankers Equity Limited.

2. Profiles of Selected Subprojects

a. PI-01 (Power Supplier) 5. PI-01 is a public limited unlisted company established in 1994. The company is an independent power producer (IPP) that supplies the power requirements of the group companies with an installed capacity of 6 megawatts. The plant is located in Muzzafargarh district in the Punjab Province. 6. In the late 1990s, the country suffered from an acute shortage of electric power that brought difficulties to the industry sector. The adverse effect was especially telling on the textile sector, which operated in three shifts, 364 days a year. There were long hours of power outages on account of load sharing/management. As a temporary solution, several groups of companies put up their own small power plants. PI-01 did the same with a 635 kilowatts/hour gas-fired generator that was financed by a lease of to $198,743 from PICL in 1998. PI-01’s objective was to supply electricity to its affiliated companies. PI-01 recognized the subloan was supported under the FSIL. PI-01 found the lease terms to be competitive and processing time short. P-01 repaid the subloan on schedule. 7. The project generated employment for an additional three persons and increased business turnover by about 10%. Total turnover of the company was PRs55 million at the time the lease was obtained. The volume increased to PRs165 million in 2003 after additional generators were put up, financed by other leasing companies. The project helped improve the quality of the PI-01’s affiliated companies’ products.

b. PI-36 (Textile Manufacture) 8. PI-36 was incorporated as a public limited company and is listed on the Karachi and Lahore stock exchanges. It manufactures and sells yarn with an installed capacity of 19,200 spindles. On the average, 80% of PI-36’s output is exported to Hong Kong, China; Indonesia, Republic of Korea, and Malaysia. 9. In 1999, PI-36 obtained lease financing from PICL to replace some machines with newer models. PI-36 recognized that the lease was supported under the FSIL. PI-36 found PICL’s procedures to be expeditious. The new assets did not pose any environmental risk, and thus

2 The current management of PICL cannot verify two subloans totaling $192,391. Moreover, the disbursement

amounts for three other loans in PICL’s record are not consistent with the Asian Development Bank’s record. 3 Excluding the two leases for $192,391, which PICL could not verify (foofnote 2).

50 Appendix 8

PICL did not request submission of an environment impact assessment report. Because it valued its relationship with PICL, PI-36 did not attempt to renegotiate the terms of the lease even when market interest rates went down. PI-36 fully repaid the subloan on schedule. The project did not create any new jobs, nor did it increase business turnover. It did however improve the yarn winding process and removed production bottlenecks. The staff strength of the company on 30 September 2003 was 684 working three shifts for 364 days a year. c. PI-41 (Advertisement Agency) 10. PI-41 was established by two brothers in 1953 as a private limited company. Its principal business is to provide advertising services through the electronic and print media. In 1993 it marked a milestone when it linked up with an internationally renowned advertising agency. It has since grown to become one of the country’s largest advertising agencies and has remained in that position for two decades. It was a recipient of the best performance award in the field of advertising for 10 consecutive years. Today, the two founding brothers serve as PI-41’s chairman and managing director. 11. In 1999, PI-41 found it necessary to look for financing arrangements for the purchase of computers and vehicles for its marketing staff. It opted to avail of a lease facility instead of a loan because of tax considerations and also to keep its working capital line limits unencumbered. PI-41 reported that its application for a lease facility was expeditiously processed by PICL. PI-41 found PICL’s policy of imposing the penalty for late payments too rigid. For this reason it stopped business relationships with PICL after the full repayment of the subloan. The assets leased were for modernization and did not contribute to job creation. At the time of the OEM, the total number of PI-41’s employees was 200, of whom 10% were female.

d. Unsuccessful Subprojects

12. On 5 October 1998, ADB authorized PI-04’s application for lease for $189,130 through PICL. The company was into retail sales with a chain of department superstores in Karachi and Lahore. Due to the drop in sales aggravated by difficulties in securing working capital finance, PI-04 defaulted in December 1999. PICL filed a recovery suit in August 2000. This was still pending at the time of the OEM. 13. On 14 October 1998, ADB authorized a lease for $195,652 to PI-12, a poultry feeds company. The company was in trouble from the early stage of its repayment. The lease was approved by PICL's previous management and no follow-up was made for recovery in the beginning. The lease was rescheduled in June 2000 and the period was enhanced from 24 quarters to 50 quarters. The present management, after taking over control of PICL, filed a recovery suit in February 2002, which was decided in PICL’s favor in May 2002. However, the execution application was pending at the time of the OEM. 14. In October 1998, ADB authorized a lease for $32,609 to PI-13, a textile manufacturing company. The lease started encountering problems from March 2000. The directors reportedly fled the country in July 2000 and the factory has since closed. PICL filed a recovery suit in September 2000 and an application to the High Court, for repossession of the leased assets was approved in May 2002. PICL repossessed the assets and sold them in the market in August 2002. Part of the proceeds was used to settle the overdues. 15. On 23 June 1999, ADB authorized a lease for $550,821 to PI-32, a flour mill. The company defaulted on its second payment. The lease was approved by the previous

Appendix 8

51

management and no follow-up was made for recovery in the beginning. The lease was rescheduled in April 2000, and the period was enhanced from 26 quarters to 45 quarters. The present management, after taking over control of PICL, filed a recovery suit in January 2002, which was decided in PICL’s favor in March 2002.

Table A8.1: Summary Balance Sheet of Pakistan Industrial and Commercial Leasing Limited As of end-June (PRs million)

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

143.95 147.06 169.10 194.21 214.34 229.94 143.32 17.16 (18.41) (27.42)

302.99 264.21 309.11 381.81 531.83 673.33 661.67 559.73 421.19 353.03205.81 185.76 194.51 215.14 220.00 242.72 197.38 209.83 201.21 194.12652.75 597.02 672.72 791.16 966.17 1,145.99 1,002.36 786.72 604.00 519.72

i Net fixed assets 6.28 5.84 5.98 7.92 6.08 5.93 6.93 14.71 10.63 11.28ii Net investment in lease finance 281.34 266.81 245.83 400.34 461.60 507.30 250.04 261.64 194.34 174.56iii Others 25.20 29.41 28.71 26.78 33.82 30.99 32.90 84.75 97.17 107.82

Subtotal 312.82 302.07 280.52 435.05 501.50 544.21 289.87 361.10 302.15 293.66

i. Gross lease/loan receivables 281.67 270.88 359.92 334.88 411.39 488.12 687.06 423.32 312.96 230.37Less: Provision for doubtful receivables (13.25) (18.25) (35.86) (49.76) (64.66) (88.50) (91.37) (152.35) (150.56) (123.79)Net receivables 268.42 252.63 324.06 285.12 346.73 399.62 595.70 270.97 162.40 106.58

ii. Cash and other current assets 71.51 42.33 68.14 70.99 117.94 202.15 116.79 154.65 139.45 119.49Subtotal 339.93 294.95 392.20 356.11 464.67 601.77 712.49 425.62 301.85 226.07 Total assets 652.75 597.02 672.72 791.16 966.17 1,145.99 1,002.36 786.72 604.00 519.72

Sources: Operations Evaluation Mission and Pakistan Industrial and Commercial Leasing Limited's annual reports.

Table A8.2: Summary Income Statement of Pakistan Industrial and Commercial Leasing Limited As of end-June (PRs million)

Item 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

97.37 92.60 106.52 117.54 125.71 143.35 82.32 100.82 42.52 20.530.86 1.64 1.52 2.31 2.31 2.31 1.94 1.51 0.00 0.00

10.99 5.87 4.25 7.81 10.21 21.86 11.14 6.19 14.05 12.92Total revenues 109.23 100.11 112.30 127.66 138.23 167.51 95.39 108.52 56.57 33.44

12.05 16.31 19.05 22.25 23.57 24.41 29.01 41.92 37.05 35.1267.14 62.37 52.30 63.91 78.04 101.66 97.86 85.66 60.13 45.30

12.95 5.00 17.61 15.08 14.90 23.84 50.82 101.72 (6.24) (38.51)

Total expenses 92.13 83.67 88.95 101.24 116.51 149.91 177.68 229.30 90.93 41.91

17.10 16.44 23.35 26.42 21.72 17.60 (82.29) (120.78) (34.36) (8.47)4.71 13.34 1.30 1.31 1.60 2.00 4.34 1.70 1.21 0.55

12.38 3.10 22.05 25.11 20.13 15.60 (86.62) (122.48) (35.57) (9.01)

Sources: Operations Evaluation Mission and Pakistan Industrial and Commercial Leasing Limited's annual reports.

Long-term assets

Equity and reservesLiabilities

Long-termCurrent

Total equity and liabilities

Assets

RevenuesLease income

Current assets

Investment incomeOther income

ExpensesAdministration and operating expenses

Net profit after tax

Financial chargesProvision for doubtful receivables and diminution in value of investments

Profit before taxTaxation

52 Appendix 8

Appendix 9 53

PROFILE OF PAKISTAN-KUWAIT INVESTMENT COMPANY (PRIVATE) LIMITED A. Organizational Performance

1. Organization, Management, and Operations 1. Established in 1979 with an initial capital of PRs250 million, Pakistan-Kuwait Investment Company (Private) Limited (PKI) is a joint venture between the Government of Pakistan and the Government of Kuwait. Each country has 50% shareholding and equal representation on PKI’s six-member board. PKI is classified as a development financial institution (DFI) falling under the regulatory domain of the State Bank of Pakistan. As of December 2003, PKI was the largest DFI in the country in terms of total equity. 2. The company’s business focus has been shifting over the years in response to opportunities available at different times and under changing macroeconomic conditions. Corporate finance was the predominant focus of PKI’s business until the late 1980s and then it shifted to swap deposit schemes from the 1990s to mid-1998, taking advantage of the opportunity offered by foreign exchange (FX) circular number 45 (FE-45).1 The FE-45 window was closed when the Government froze the FX deposits after conducting nuclear tests in May 1998. Thereafter, PKI shifted its strategic focus from conventional corporate lending to asset management, stock brokerage, and small and medium-size enterprise credits.

2. Financial Performance 3. PKI’s total assets grew from PRs13.0 billion at end-FY1995 to PRs35.9 billion at end-FY1997, due to an increased investment in Government securities and lending to public sector companies (Tables A9.1 and A9.2). A significant increase in FX deposits through the FE-45 window, on the liabilities side, matched the growth of assets. The closure of the FE-45 window in 1998 resulted in significant contraction of PKI’s assets during FY1998–FY2000, with partial recovery during FY2001–FY2003 due to the increased portfolio of equity investment. PKI remained profitable during FY1995–FY2003. Substantial profits during FY2002–FY2003 reflected the robust capital market performance. This led to substantial organic growth in its equity, and reserves increased from PRs4.1 billion at end-FY2001 to PRs9.3 billion at end-FY2003. PKI largely complied with the applicable financial covenants under the Financial Sector Intermediation Loan (FSIL) during FY1995–FY2003 (Appendix 1). B. Subloan Performance 1. Overview 4. The total disbursements to PKI under the FSIL amounted to $14.8 million for financing three subprojects. The first subloan approved was for $7.2 million to PK-01. The company failed to meet financial obligation in 2000, and the subloan was restructured in 2003. At the time of the Operations Evaluation Mission (OEM), there was no arrear in PK-01’s interest payment while its amortization had not yet started. The second subloan was to PK-02 for $4.3 million. 1 Under this scheme, PKI, like many other foreign financial institutions in the country, raised foreign currency

deposits from institutional investors abroad and swapped the foreign currency with SBP at a forward cover fee ranging from 6% to 8%. The rupee liquidity thus generated was either invested in government treasury-bills or lent to public sector companies. High domestic interest rates offered a decent positive spread even if rupee liquidity was invested in T-bills. A large part of the swap deposits was repaid and remaining amounts were subject to forced rescheduling. The decline in PKI’s assets after 1997 reflects the repayment of rescheduled FE-45 deposits.

54 Appendix 9

Subsequently, PKI approved the conversion of the interest rate from the fixed to floating scheme based on 6-months treasury bill yield, and no arrears in interest payments were evident at the time of the OEM. The OEM could not verify the outstanding amount of this subloan. The third subloan was to PK-03 for $3.3 million. This was prepaid by PK-03 as the sharp decline in interest rates provided the opportunity for cheaper refinancing. PKI prepaid the loan to the Government in March 2003 when the outstanding amount was $13.0 million. PKI did not obtain formal FX cover but managed it internally by purchasing dollars in the open market and swapping them into Pakistan rupees. The third-party guarantee requirement was not applicable to PKI as 50% of its shares were owned by the Pakistani Government.

2. Profiles of Subprojects

a. PK-01 (Fertilizer Manufacturer) 5. PK-01 was established in 1993 to own and manage a fertilizer plant. It currently produces annually 400,000 tons (around 30% of the country’s demand) of high-quality diammonium phosphate (DAP) and 600,000 tons of urea. The key inputs of DAP are phosphoric acid and ammonia. All phosphoric acid is imported while ammonia is produced from natural gas. 6. At the onset of the project, the Government guaranteed the floor price of DAP at $250/ton and agreed to supply natural gas at a subsidized price. On this basis, PK-01 built the DAP plant financed by the ADB loan through PKI for $7.24 million. In addition, PK-01 also built plants for urea and ammonia production. The operations of the DAP plant started in January 2000, delayed by 19 months because of labor problems in ports of the supplier country. This delay resulted in substantial cost overrun. The project ran into problems from the early stage: (i) the Government did not supply enough natural gas and even when it did, the pressure was low; (ii) the ammonia plant (second-hand) did not work well; (iii) the international price of DAP went down to around $160/ton, and the Government did not discharge its duty on the guaranteed price; (iv) the price of phosphoric acid went up to around $160/ton. As a result, PK-01 incurred losses of PRs3.2 billion in 2000 and PRs3.4 billion in 2001. The DAP plant shut down in September 2001, and suspended its debt obligation to the creditors. 7. PK-01 entered into discussions with the Government on debt restructuring. In June 2002 the following were agreed upon: (i) the sponsors were to inject PRs5 billion equity up-front; (ii) the Government was to inject PRs5 billion grants over a period of 7 years; (iii) the Government was to take over the loans from bilateral export credit agencies (which were rescheduled at the Paris Club), while PK-01 was to repay PRs10 billion to the Government over a period of 10 years with interest rate equivalent to 1-year treasury bill (T-bill) rate; (iv) the Commonwealth Development Corporation converted its loans into equity (₤2.5 million); and (iv) PK-01 domestic syndicated loan was rescheduled and its interest rate was cut from 17% to the prevailing T-bill rate. As a result, PK-01’s total liabilities were reduced from PRs22 billion to PRs13 billion, and its average interest rate was reduced from 17% to 1%. Subsequently, PK-01 changed its corporate name. 8. In 2003, PK-01 resumed its DAP operations and started interest payments to the creditors. PK-01 recently increased the production capacity of its ammonia plant and established a joint venture phosphoric acid plant in Morocco. At the time of the OEM, phosphate acid was $167/ton while the international price for DAP was $272/ton. PK-01 noted that the breakeven DAP price was around $227/ton.

Appendix 9 55

b. PK-02 (Textile Manufacturer) 9. PK-02 was established in 1990 in Haripur district of North-West Frontier Province as a joint venture with Japanese and Korean corporations. It produces and sells polyester staple. PK-02 is the largest synthetic fiber manufacturing complex in the country and has over 40% market share. As of 30 June 2003, out of a total turnover of PRs18 billion, PRs16 billion was from production of polyester and the rest from acrylic fiber. 10. The establishment of the acrylic fiber plant in 1999 required an investment of PRs3 billion. For financing of the imported plant and machinery, a lease was obtained from the Dawood Leasing Company Limited and a long-term loan from PKI and other lenders. The acrylic plant generated employment for 300–400 employees directly and over 400 jobs indirectly. Only a few women work at offices and none at the plant site. 11. When commercial production started, it could not operate at optimal production level because of stiff competition from Central Asian countries. The lower-than-expected sales and high interest charges worsened the financial position of the company. Initially, the experience was very discouraging, but shifting the group’s focus from the domestic to the export market, worked out well for the company. About 40% of acrylic fiber production was exported to United Kingdom, France, Spain, Morocco, Italy, Syria, Turkey, Egypt, and Iran. The domestic market conditions for acrylic products have improved since 2003; hence acrylic production started earning decent profits.

c. PK-03 (Oil Refinery)

12. PK-03 was incorporated as a private limited company in November 1978. It was subsequently converted into a public limited company in June 1979 and is listed on the three stock exchanges of the country. PK-03 is the pioneer in crude oil refining in the country with its operations dating back to 1922. It is one of three refineries in Pakistan and the first refinery in South Asia. Its plants have gradually expanded to meet the ever-increasing demand for its products. PK-03’s products include premium motor gasoline, high-speed diesel, kerosene, furnace oil, jet fuels, light diesel oil, naphtha, and liquefied petroleum gas. The total turnover of PK-03 for the year ending June 2004 was over PRs25.4 billion. 13. To expand and upgrade existing facilities, the management decided to add a heavy crude unit of 10,000 barrel per day (bpd) and a catalytic reformer of 5,000 bpd, requiring a capital outlay of PRs2 billion, which would produce lead-free 100 octane as against the then requirement of 87 octane, later enhanced to 90 octane. PKI with other lenders financed this expansion. PKI did not require an environment impact assessment. As market interest rates started declining, PK-03 requested PKI to lower the interest rate. But PKI could not accept PK-03’s proposed terms. As a result, PK-03 prepaid the loan in February 2002. PK-03 also prepaid similar fixed rate loans to other financial institutions. 14. This project created about 50 new jobs, all for men. The expansion was a success and improved the sales of PK-03 in local and international markets. About 8% of the total turnover is from export sales. PK-03 was first to produce low-sulfur furnace and diesel and first to produce low-lead premium gasoline direct from the refining process in 1999. The sector is growing and so is PK-03. It is going for value addition and has expansion plans to upgrade its furnace oil-refining capabilities.

Item 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

1,992.31 2,268.21 2,650.31 3,181.56 3,319.89 3,870.34 3,968.83 4,082.39 7,131.92 9,318.28

29.91 2,734.67 3,952.11 4,422.26 10,101.88 4,975.73 3,502.15 3,236.58 1,167.43 2,301.095,570.30 7,948.77 13,297.62 28,343.33 7,746.79 2,573.70 2,411.28 3,467.89 5,836.24 4,934.947,592.51 12,951.65 19,900.04 35,947.15 21,168.56 11,419.77 9,882.26 10,786.86 14,135.58 16,554.31

i. Net fixed assets 49.15 46.29 44.85 47.45 58.17 63.65 60.53 52.87 65.20 73.49ii. Net investment in lease finance 277.58 2,482.77 3,946.26 4,364.78 10,660.33 3,631.42 2,199.90 2,267.70 2,383.13 1,344.60iii. Others 489.84 907.76 639.18 645.49 678.06 627.31 466.78 442.99 1,201.20 910.10

Subtotal 816.57 3,436.82 4,630.29 5,057.72 11,396.57 4,322.39 2,727.21 2,763.56 3,649.52 2,328.19

i. Gross lease/loan receivables 4,468.15 6,707.48 10,256.03 24,070.08 3,931.83 2,270.70 2,412.82 2,219.83 918.69 763.19Less: Provision for doubtful receivables (48.24) (39.92) (39.92) (80.57) (69.02) (75.13) (98.10) (68.41) (221.40) (188.29)Net receivables 4,419.91 6,667.56 10,216.11 23,989.51 3,862.80 2,195.57 2,314.72 2,151.42 697.29 574.90

ii. Cash and other current assets 2,356.03 2,847.27 5,053.64 6,899.92 5,909.19 4,901.81 4,840.32 5,871.88 9,788.78 13,651.22Subtotal 6,775.94 9,514.83 15,269.75 30,889.43 9,771.99 7,097.38 7,155.05 8,023.30 10,486.06 14,226.12 Total assets 7,592.51 12,951.65 19,900.04 35,947.15 21,168.56 11,419.77 9,882.26 10,786.86 14,135.58 16,554.31

Sources: Operations Evaluation Mission and Pakistan Kuwait Investment Company Private Limited's annual reports.

Item 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

47.53 195.70 595.77 824.95 1,235.95 1,423.27 575.75 549.79 532.83 156.89503.74 971.11 1,559.77 2,887.38 3,246.14 651.34 574.02 622.93 710.62 653.88424.15 158.43 296.32 557.04 396.36 386.68 689.67 948.51 998.08 2,701.28

Total revenues 975.41 1,325.25 2,451.85 4,269.38 4,878.46 2,461.30 1,839.44 2,121.23 2,241.53 3,512.06

34.08 47.45 57.90 74.52 82.66 141.38 137.27 134.93 194.78 275.97304.98 857.46 1,837.03 3,312.77 4,032.15 1,877.96 1,017.25 1,002.71 542.79 217.26

(4.16) (5.56) 24.81 75.85 475.32 (378.75) 330.63 612.95 (826.04) (15.95) Total expenses 334.90 899.35 1,919.75 3,463.13 4,590.13 1,640.59 1,485.15 1,750.59 (88.47) 477.28

640.52 425.90 532.11 806.24 288.33 820.71 354.29 370.65 2,330.00 3,034.770.00 0.00 0.00 0.00 0.00 20.26 55.79 57.09 202.72 204.86

640.52 425.90 532.11 806.24 288.33 800.45 298.50 313.55 2,127.28 2,829.91

Sources: Operations Evaluation Mission and Pakistan Kuwait Investment Company Private Limited's annual reports.

Current Assets

Total equity and liabilities

AssetsLong-term assets

LiabilitiesLong-termCurrent

Table A9.1: Summary Balance Sheet of Pakistan Kuwait Investment Company (Private) Limited for the year ending 31 December (PRs million)

Equity and reserves

Table A9.2: Summary Income Statement of Pakistan Kuwait Investment Company (Private) Limited for the year ending 31 December (PRs million)

RevenuesLease income/income on financingInvestment incomeOther income

ExpensesAdministration and operating expenses

Net profit after tax

Financial chargesProvision for doubtful receivables and diminution in value of investment

Profit before taxTaxation

56 Appendix 9

Appendix 10 57

POLICY MATRIX

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

Macroeconomic

Fiscal cost of SBP operations • Minimum SBP lending rate to FI of no more than 3 percentage points below average T-bill rate. (Complied with)

• Promote ability of private

markets to provide FX risk coverage of medium-term loans. (Partly complied with)

• Minimum SBP lending rate to FI at least equal to T-bill rate. (Complied with)

• SBP significantly streamlined its refinancing programs (to support concessional bank loans to targeted sectors) during FSIL implementation. The measure was also supported under the World Bank’s BSAL as well as a series of IMF programs.

• SBP’s discount rate was lowered to 7.5% in 2002. Since

then, this rate average has remained the same and constantly higher than T-bill rate.

• The interest rate of SBP’s refinance under the Export

Finance Scheme has been raised and is currently linked with average T-bill rate.

• SBP withdrew in June 1994 from providing short-term

cover for trade and short-term loans, and FX risk cover for medium-term loans in 1994 while encouraging banks to offer risk cover. This measure was also supported under the IMF ESAF implemented from 1997 to 2000. However, no commercial bank responded except the state-owned National Bank of Pakistan, which introduced the scheme to support exporters and importers. To date, the FX forward/swap market has not fully developed.

Monetary/credit management

• Complete shift from CDR to indirect methods. (Complied with)

• SBP abolished CDR in September 1995. Since then, credit to the private sector has been through market-based instruments such as open market operations with occasional changes in cash reserve requirement, discount rate, and repo rate. This measure was also supported under a series of IMF programs.

58 Appendix 10

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

Foreign exchange deposits • Price foreign exchange

cover to reduce attractiveness of FED. (Complied with)

• SBP progressively raised FX cover fees on FEDs during 1996–1997 to restrain the rapid increase of FED. In the aftermath of the nuclear detonation in May 1998, the country had to face international sanctions that led to freezing of FX accounts and stringent austerity and exchange control mechanism, leading to abolition of the FED scheme. Subsequently, a new FED was introduced. Under the new scheme, banks are allowed to extend FX loans to domestic borrowers unlike in the old scheme, which imposed the placement requirement at SBP.

Sectoral/Institutional

Level playing field

• Carry out a study and, on the basis of the recommendations thereof, develop and implement a plan for regulating FIs by activity and, in particular, prescribe liquidity ratios for NBFIs compatible with those applied to banks as regards foreign exchange and other deposits. (Complied with)

• Review the implementation of the plan agreed upon during the first interim review and agree on taking further necessary action to narrow down differences in income taxation of financial and nonfinancial firms. (Complied with)

• The Government has decided to reduce the income tax for financial institutions as per following schedule:

Year Financial

Institutions

(%)

Public company other than financial

institutions (%)

Private company other than a banking company

(%) 2003 47 35 43 2004 44 35 41 2005 41 35 39 2006 38 35 37 2007 35 35 35

Prudential regulations • Define minimum capitalization of banks in relation to risk-weighted assets and develop a program to achieve compliance. (Complied with)

• Define minimum capitalization of NBFIs in relation to risk- weighted assets and develop a program to achieve compliance. (Partly complied with)

• SBP adopted the Basle system of defining minimum capital requirements in December 1997. Under the new rule, all banks operating in Pakistan were required to maintain capital and unencumbered general reserves, the value of which is not less than 8% of the risk-weighted assets. This measure was also supported under BSAL and ESAF.

• In 1997, leasing companies were required to raise the minimum capital to PRs200 million by 30 October 1999. The last date for compliance was later extended to 30 June 2001. This measure was supported under the CMDP.

Appendix 10 59

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

• SECP issued NBFC Rules of 2003, requiring the

following separate tiers of minimum equity in respect of the following forms of business:

Item Amount

(PRs million)

1 Investment finance services 300

2 Leasing 200

3 Venture capital investment 5 ( for a venture capital company)

4 Discounting services 200

5 Investment advisory and asset management services

30

6 Housing finance services 100

• SECP is planning to introduce the risk-weighted capital

adequacy requirement for NBFCs.

Insurance sector • Increase minimum capital for general and life insurance companies. (Complied with)

• Further reduce required reinsurance with PIC. (Complied with)

• The minimum paid-up capital for new domestic life insurance company was raised from PRs30 million to PRs100 million, and that for general insurance companies from PRs80 million during FSIL implementation.

• Minimum capital was further increased to PRs150

million for life insurance and PRs80 million for general insurance.

• Required reinsurance with PIC was reduced from 20%

to 10% during FSIL implementation.

60 Appendix 10

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

• Empower controller of

insurance to regulate state-owned companies. (Not applicable)

• Based on the review of

options study, decide modalities for restructuring of State Life/PIC. (Complied with)

• Review the exercise of rate-settling by Insurance Association of Pakistan with a view to phasing out the system. (OEM could not independently verify if an exercise was carried out)

• Initiate programs for

restructuring State Life and PIC. (Partly complied with)

• Under TA 2825-PAK,a the study on insurance regulatory framework was conducted, and the draft Pakistan Insurance Regulatory Authority Bill was prepared. The draft Bill envisaged the establishment of an independent insurance regulator outside of MOC. Following extensive consultation with ADB and other aid agencies, the Government decided to make SECP responsible for regulating the insurance industry. Consequent to the policy decision, the SEC Act 1997 was amended in October 2000 to transfer the function of Administration of the law of Insurance from MOC to SECP. The Office of Controller of Insurance under MOC was abolished in the same year.

• Under TA 2866-PAK,b in-depth studies of state-owned

PIC and NIC were conducted.

• Based on the above study, PIC and NIC were incorporated as public limited companies in March 2000. PIC was then renamed as the Pakistan Reinsurance Company. Since then, the Board of these Companies has been reconstituted with experienced personnel from the private sector. These measures were supported under CMDP.

• Restructuring of State Life Insurance Corporation is

being pursued under Loan 1955-PAK: Financial (Nonbank) Markets Governance Program.c

Promote long-term finance • Government to review

desirability of issuing long-term variable rate debt instruments. (Complied with)

• Initiate the action program. (Complied with)

• In June 1998, the Government issued 3-month, 6-month, and 1-year T-bills in discount form to replace the existing 6-month federal bonds. To date, the Government has issued long-term bonds with maturities of 3–20 years.

• Draw an action program in the light of the review. (Complied with)

Appendix 10 61

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

Securities markets • Reduce National Investment

Trust (NIT) privileged access to new issues in a phased manner. (Complied with)

• Complete a study of the possibility of creating a regulatory environment to facilitate trading of commodities, foreign exchange, stock futures. (Complied with)

• NIT’s privileged access to new issues ended during FSIL implementation. Moreover, the Government announced exemption from tax on income of private sector mutual funds through the Finance Act 1997, supported under the CMDP.

• National Commodities and Exchange Limited has been

incorporated and is expected to be operational soon.

• Stock futures are traded at the stock exchanges.

• Take measures to promote the establishment of investor protection funds. (Complied with)

• Regulate insider trading. (Complied with)

• Each stock exchange established investor protection and clearinghouse protection schemes during FSIL implementation. This measure was supported under the CMDP.

• SECP issued Insider Trading Guidelines, 2001,

supported under the CMDP and TA Loan 1577-PAK(SF).d

• Take measures to promote

incorporation of individual members and ensure that individuals and corporate members have adequate capital. (Complied with)

• The Government granted tax exemption on capital gains levied on individual members on transfer of such membership to a corporate entity. Tax exemption was allowed for the period from 1 July 1998 to 30 July 1999 and from 1 July 2000 to 30 July 2001. This measure was supported under the CMDP.

• TA 2393-PAKe helped to redefine the minimum capital

requirement and other criteria for the members. These were reflected in (i) Members’ Agents and Traders (Eligibility Standards) Rules 2001, (ii) Stock Exchange Members (Inspection of Books and Record) Rules 2001, (iii) Amendments in Securities and Exchange Rules (Not Capital Balance Requirement), and (iv) Broker Agents Registration Rules 2000. These rules were supported under the CMDP.

62 Appendix 10

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

• Enhance disclosure of

information. (Complied with) • SECP has made disclosure of quarterly accounts

mandated for listed companies supported under the CMDP.

• Under TA Loan 1577-PAK(SF),d the study on OTC debt

market was conducted.

• Study the desirability of establishing an OTC equities market. (Complied with)

• Karachi Stock Exchange introduced OTC market rules in January 2003.

• Commence operations of securities regulation wing. (Complied with)

• Enforcement Wing at SECP was established in 1998.

NBFIs • Complete study of long-term lending problems. (Complied with)

• Complete study of DFIs.

(Complied with)

• Commence execution of DFI action plans. (Complied with)

• The study on DFIs was conducted under BSAL. • To improve corporate governance of state-owned DFIs,

the Government replaced their boards and management during FSIL implementation. In January 1997, SBP required the new management of DFIs to tighten lending policies and implementation action programs approved by SBP. This measure was also supported under BSAL.

Strengthening loan recovery • Take measures to implement the first phase of the reforms recommended by the Task Force (e.g., completion of work appointments and procedures committees). (Complied with)

• Continue reform program (e.g., carry out recommendations of Task Force follow-up committees). (Complied with)

• Through the enactment of the Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act of 1997, two parallel systems of bank loan recovery courts were unified. This measure was supported also under BSAL and ESAF.

• The Banking Companies Act of 1997 was replaced by

The Financial Institutions (Recovery of Finances) Ordinance, 2001. The Ordinance adequately covers shortcomings in the Act of 1997 relating to repossession and sale of property.

Appendix 10 63

Policy Area

Policy Requirements per First Interim Review First Quarter 1996

(Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

Capital Market

Corporate Law Authority (CLA)

• Formulate program for overall restructuring of CLA to enhance its functions and operational efficiency. (Complied with)

• Implement the program according to phased schedule. (Complied with)

• CLA has been completely revamped and an independent body (SECP) was created on 22 December 1997. SECP started operations on 1 January 1999.

• Under the CMDP, detailed policy measures were

identified and supported to (i) strengthen SECP as a regulatory body, and (ii) modernize the supportive legislation to improve enforcement by SECP. These measures were largely implemented by end of 2001.

• TA 2393-PAKe and TA Loan 1577-PAK(SF)d

significantly contributed to the institutional strengthening of SECP.

Mutual fund industry • Complete amendment of

legislation. (Complied with) • Review the mutual fund

industry with focus on ICP and NIT. (Complied with)

• Review adequacy in legislative amendments. (Complied with)

• Formulate and implement an

action program for enhancing efficiency in the mutual fund industry. (Complied with)

• SECP Act 1997 gave SECP responsibility for regulating all mutual funds. This measure was supported under the CMDP. Under TA 2393-PAK,e remaining legal and regulating issues in the mutual fund industry were reviewed.

• Under TA 2865-PAK,f strategy and an action plan for

privatizing the asset management business of NIT and ICT were prepared.

• Under the CMDP, detailed policy measures for the

restructuring of NIT and ICT were identified and implemented. Privatization of the ICPs mutual funds was carried out in 2002–2003. Privatization of NIT’s fund is currently under way.

Venture capital • Formulate and bring into

effect policy, rules, and guidelines applicable to the venture capital industry. (Complied with)

• Review the adequacy of policy, rules, and guidelines. (Complied with)

• The Venture Capital Companies and Venture Capital Fund Rules were issued in 2001.

• New rules were formulated under NBFC Rules 2003.

64 Appendix 10

Policy Area

Policy Requirements per First Interim Review

First Quarter 1996 (Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

Credit rating agency • Formulate and bring into

effect policies and rules, applicable to credit rating business. (Complied with)

• Review the adequacy of policies and rules. (Complied with)

• The Credit Rating Companies Rules was issued in 1995. Since then, two credit rating agencies have been established. All the corporate bonds are now required to be rated before public issue.

Leasing industry resource base

• Undertake a study on ways to expand the resource base of the leasing industry, including an exploration of the scope for developing a market for securitized lease receivables. (Complied with)

• Formulate and implement an action plan for expanding the resource base of the leasing industry. (Complied with)

• The study on the leasing industry was conducted under TA 2393-PAK.e In line with the recommendation of the study. The Government (i) increased capital requirement for leasing companies; (ii) opened the leasing business to banks, modarbas, and investment banks; and (iii) issued the Leasing Companies Rules of 2001. These measures were supported under the CMDP.

• SEC issued the Companies (Asset-Backed

Securitization) Rules in 1999. • Instruments like term finance certificates have played a

role in expanding the resource base of the leasing companies. Moreover, permission to eligible leasing companies to mobilize deposits on certain conditions and participation in the inter bank money market transactions has helped them mobilize funds.

Stock exchanges • Undertake a study to review

the overall functioning of the stock market, scope for automating and linking the operations of three stock exchanges, further enhancing stock exchange management and improving the listing and information disclosure rules. (Complied with)

• Formulate and implement an action plan to enhance the transparency and efficacy of the stock market. (Complied with)

• The study on the stock market was conducted under TA 2393-PAK.e The TA also helped initiate a number of reforms enhancing the transparency and efficiency of the stock market, including (i) automating trading at securities and exchanges; (ii) introducing the T + 38 settlement system; (iii) establishing and operating the Central Depository Company; (iv) transforming CLA into SECP under the SECP Act 1997; (v) strengthening the margin requirement for securities lending; (vi) disallowing blank sales; (vii) setting up a market surveillance wing at SECP; (viii) restructuring the Boards of SEs to allow at least 40% representation of nonmember professionals and, with SECP approval, appointment of independent managing directors;

Appendix 10 65

Policy Area

Policy Requirements per First Interim Review

First Quarter 1996 (Compliance Status per OEM)

Policy Requirements per Second Interim Review

First Quarter 1997 (Compliance Status per OEM) OEM Remarks

(ix) issuing brokers registration rules and registration

guidelines, including on insider trading; (x) setting up the national clearing and settlement system; and (xi) issuing a corporate governance code.

• Under the CMDP, detailed policy measures were

identified and implemented to (i) strengthen stock market governance, institutions, regulation, and supervision; and (ii) modernize the security market infrastructure. These measures were largely implemented by end of 2001.

ADB = Asian Development Bank, BSAL = Banking Sector Adjustment Loan, CDR = credit to deposit ratio, CMDP = Capital Market Development Program, DFI = development finance institution, ESAF = Enhanced Structural Adjustment Facility, FED = foreign exchange deposit, FI = financial institution, FSIL = Financial Sector Intermediation Loan, FX = foreign exchange, ICP = Investment Corporation of Pakistan Limited, IMF = International Monetary Fund, MOC = Ministry of Commerce, NBFC = nonbanking finance companies, NBFI = nonbank financial institutions, NIC = National Insurance Corporation, OEM = Operations Evaluation Mission, OTC = over-the-counter, PIC = Pakistan Insurance Corporation, SBP = State Bank of Pakistan, SEC = Securities and Exchange, SECP = Securities and Exchange Commission of Pakistan, T- Bill = Treasury Bill. a ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Capital Market and Insurance Law Reform. Manila (for $100,000, approved on 14 July 1997). b ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Reform of the Insurance Industry. Manila (for $700,000, approved on 15 September 1997). c ADB. 2002. Report and Recommendation of the President to the Board of Directors on Proposed Loans and Guarantees to Pakistan for the Financial (Nonbank)

Markets and Governance Program. Manila (for $260 million, approved on 5 December 2002). d ADB. 1997. Report and Recommendation of the President to the Board of Directors on Proposed Loans to the Islamic Republic of Pakistan for the Capital Markets

Development Program. Manila (Technical Assistance Loan for Capacity Enhancement of the Securities Market [for $5 million, approved on 6 November 1997]). e ADB. 1995. Technical Assistance to the Islamic Republic of Pakistan for Capital Market Development. Manila (for $865,000, approved on 7 September 1995). f ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Restructuring of Public Sector Mutual Fund. Manila (for $800,000, approved on 15 September

1997). Source: Operations Evaluation Mission.

66 Appendix 11

STATISTICAL DATA

Table A11.1: Benchmark Interest Rates (%)

SBP Discount 6-Month T-Bill Export Financing Month End Rate Yielda Scheme

Jun-94 15.0 10.80 13.00 Jun-95 15.0 12.60 13.00 Jun-96 17.0 15.10 13.00 Jun-97 19.0 16.30 13.00 Jun-98 18.0 15.40 11.00 Jun-99 13.0 10.70 8.00

Jun-2000 11.0 7.20 8.00 Jun-01 14.0 12.50 10.50 Jun-02 9.0 6.50 8.00 Jun-03 7.5 1.70 3.50 Jun-04 7.5 2.20 3.50

SBP = State Bank of Pakistan, T-Bill = treasury bill. a Simple average of auction cut-off yields for the month. Sources: State Bank of Pakistan. Various years. Statistical Bulletins. Islamabad.

Table A11.2: Banking Sector Spreads (%)

Year to December Yield on Earning

Assetsa Cost of Fundsb Net Interest

Margin 1991 10.1 5.8 4.3 1992 9.8 5.3 4.5 1993 11.0 6.2 4.8 1994 10.9 6.3 4.6 1995 11.8 6.9 4.9 1996 11.2 7.4 3.8 1997 13.5 8.3 5.2 1998 13.8 8.5 5.3 1999 13.0 7.4 5.6 2000 11.2 6.6 4.6 2001 11.2 6.0 5.2 2002 9.0 4.3 4.7 2003 6.1 2.0 4.1

a Interest income/(advances + investment + money at call). b Interest expense/(deposits + borrowings).

Source: State Bank of Pakistan. 2003. Banking Sector Review. Islamabad.

Appendix 11 67

Table A11.3: Financial Sector Assets (PRs billion, unless otherwise specified)

As at Year Enda 1995 1996 1997 1998 1999 2000b 2001 2002 2003 Scheduled Banks 1,118.1 1,275.0 1,436.5 1,556.3 1,654.0 1,807.6 1,942.3 2,223.2 2,545.9

Public Sector Banks 610.4 656.5 696.9 789.3 844.1 902.0 946.5 877.6 963.1Domestic Private Banks 265.5 313.4 373.4 405.5 448.7 513.5 565.9 967.5 1,211.6Foreign Banks 152.5 212.6 268.9 263.3 252.6 280.6 323.7 279.6 271.2Specialized Banks 89.7 92.5 97.3 98.2 108.6 111.5 106.2 98.5 100.0

DFIs 113.5 125.4 159.5 131.5 103.4 91.5 61.1 68.7 79.2Investment Banks 30.5 36.8 41.7 45.9 48.7 41.5 28.0 27.0 34.4Leasing Companies 20.4 27.4 31.4 33.0 35.5 40.9 48.0 46.2 45.8Modarbasc 12.8 12.7 13.9 15.2 14.8 15.4 15.5 17.5 16.1Housing Finance Companies 19.4 20.2 20.4 21.3 21.5 22.3 23.6 22.4 21.5Discount Houses 0.8 1.0 1.5 1.6 1.6 1.8 1.4 1.5 2.0Venture Capitals 0.1 0.1 0.6 1.3 1.3 1.0 0.4 0.3 0.9 Total (As of GDP)

1,315.7(70.0%)

1,498.6(70.9%)

1,705.5(70.2%)

1,806.1(67.4%)

1,880.9(64.0%)

2,022.0(53.3%)

2,120.3(50.9%)

2,406.8(54.7%)

2,745.70(57.0%)

GDP = gross domestic product, DFI = development finance institution. a Year end for scheduled banks is December while that for other financial institutions is June. b The Government rebased GDP in FY2004 with retrospective effect from FY2000. Consequently, the GDP for FY2000 increased by 20.5%. c Modarbas are finance companies that operate according to Islamic principles of finance, not involving interest. Sources: State Bank of Pakistan. 2002–2003. Financial Sector Assessment. Karachi; Ministry of Finance. 2003–2004. Economic Survey of Pakistan. Islamabad.

Table A11.4: Capital Market Dataa

Year Market Annual No. of Average Ending Capitalization Turnover Listed No. of Daily Volume June KSE-100 PRs million % of GDP (PRs billion) Companies IPOs (shares)

1994 2,331 405,797 25.9 — 676 51 6,468,0251995 1,607 485,580 25.8 — 742 60 9,470,9961996 1,703 371,323 17.6 — 783 38 22,851,5081997 1,566 491,881 20.3 — 782 10 33,873,0271998 880 258,394 9.6 — 778 2 63,774,0071999 1,055 287,885 9.8 — 769 0 103,418,1772000b 1,521 394,446 10.4 — 762 3 192,740,8222001 1,366 341,796 8.2 1,073 759 2 118,228,0442002 1,770 411,576 9.3 805 725 5 119,720,2472003 3,402 755,766 15.7 2,266 702 2 214,393,4862004 5,279 1,421,584 26.0 5,538 — 11 553,774,263

— = not available, GDP = gross domestic product, IPO = initial public offering, KSE = Karachi Stock Exchange, no. = number, PRs = Pakistan rupees. a The data reflects Karachi Stock Exchange only. b The Government rebased GDP in fiscal year (FY) 2004 with retrospective effect from FY2000. Consequently, GDP for FY2000 increased by 20.5%. Source: Karachi Stock Exchange.

Table A11.5: Banking Sector Credita (%)

Year Ending June Total Bank Credit/GDPb Bank Credit to

MarketingSector/GDPb 1994 — 38.5 — 8.3 1995 — 36.6 — 8.5 1996 — 36.8 — 8.8 1997 — 38.3 — 9.1 1998 — 40.1 — 10.2 1999 — 38.0 — 11.4 2000 28.9 34.9 8.6 10.4 2001 28.2 34.3 9.2 11.2 2002 30.9 36.5 9.0 10.6 2003 33.7 39.9 9.5 11.2 2004 36.8 — 11.2 —

— = not available , GDP = gross domestic product. a The Government rebased GDP in FY2004 with retrospective effect from fiscal year (FY) 2000. Consequently, the GDP for FY2000

increased by 20.5%. b Left columns reflect revaluation of the GDP in FY2004 while right columns do not reflect the revaluation.

Sources: State Bank of Pakistan. Various years. Statistical Bulletins. Islamabad; Ministry of Finance. 2003–2004. Economic Survey of Pakistan. Islamabad.

Table A11.6: Pakistan’s Exportsa

Year Ending June Total Exports (PRs million) Exports of Manufacturing Products/GDP (%)b

1994 205,499 — 10.5 1995 251,173 — 10.3 1996 294,741 — 10.6 1997 325,313 — 11.3 1998 373,160 — 10.9 1999 390,342 — 10.4 2000 443,678 8.5 11.5 2001 539,070 9.4 13.3 2002 560,947 9.5 12.6 2003 652,294 10.6 13.4 2004 709,036 10.2 —

— = not available, GDP = gross domestic product, PRs = Pakistan rupees. a The Government rebased GDP in fiscal year (FY) 2004 with retrospective effect from FY2000. Consequently, the GDP for FY2000 increased by 20.5%. b Left columns reflect revaluation of the GDP in FY2004 while right columns do not reflect the revaluation.

Source: Ministry of Finance of Pakistan. 2003–2004. Economic Survey of Pakistan. Islamabad.

68 Appendix 11

MANAGEMENT RESPONSE ON THE PROJECT PERFORMANCE AUDIT REPORT ON THE FINANCIAL SECTOR INTERMEDIATION LOAN IN PAKISTAN

(Loan 1371-PAK)

On 9 September 2005, the Director General, Operations Evaluation Department, received the following response from the Managing Director General on behalf of Management:

1. Management finds the report well prepared. The report correctly questions a number of design features of the project, which mirrors the design of a parallel intervention of the World Bank. We agree that a program loan would have been the right instrument rather than a project loan based on a credit line with a program of policy actions addressing broad sector issues. Also, "shortage of funds" does not seem to correctly reflect the rationale for the loan project. It should have been the distortions in the financial system and the need of the economy for a resilient financial sector, as shown in the policy matrix. Such a shift in the articulation would have highlighted that a program loan would have been the right modality. 2. As stated in the report, the policy matrix was not backed by a loan releasing the loan amount based on the Government's performance and the credit line provided under the loan was disconnected to the more important policy reform agenda. While we agree that this constitutes a design weakness, we believe that the policy matrix sets out very important reform issues, which helped set the stage for the important and very successful financial sector reforms that Pakistan implemented since 1997 with the support of the IMF, World Bank, and ADB. The reform agenda set out under the policy matrix was highly relevant (and not irrelevant as stated in the report) and was successfully implemented. Management also notes Operations Evaluation Mission’s (OEM) confirmation that most of the loan’s policy actions were complied (40 out of 45 fully complied, 3 partly complied). 3. We agree that the relevance of the credit line in this context was weak and that the credit line did not have a significant impact on financial intermediation and private sector activity. Factors such as (i) lacking mechanism to mitigate the foreign exchange risk and (ii) unattractive pricing of ADB's pool-based rate led to the low utilization of the credit line. 4. With regards to the report’s two recommended follow-up actions directed to the Government (Ministry of Finance), ADB will have a course of dialogues with the Government through its Pakistan Resident Mission (PRM).