How does Pakistan’s auto industry contribute to its balance of payment crisis?

The first four months of the current fiscal year have seen a cumulative automotive demand of 59,402 cars sold. This is 46% lower than the 109,238 units sold over the same period in the previous year based on the data provided by the Pakistan Automotive Manufacturers Association. 

So what happened? Very briefly put, the dip in demand for cars has been very deliberately managed by the government.  And there has only been one agenda behind managing this demand: Pakistan’s dwindling foreign exchange reserves. 

What do cars have to do with Forex reserves, and how has the government managed to curtail the number of new cars in the market? The matter goes deep to the root of how Pakistan’s automobile industry is set up. Entirely based on imports, the prices of and demand for cars in the country are directly linked to the rupee-dollar parity. And in the latest crisis, the handiest tool at the disposal of the country’s finance czars has been the State Bank of Pakistan (SBP). 

What happened this year? 

In May this year, the central bank issued a circular stating that it now possessed administrative oversight over the import of completely-knocked down (CKD) units of cars being imported into the country. In Pakistan, no cars are locally manufactured. So where do all the cars come from? They are either imported in completely assembled form — what are known as ‘Completely Built Units (CBUs)’, or as ‘Completely Knocked Down (CKDs)’. Most cars that get imported are CKDs which are then assembled at local factories and sent out to the market. 

This is where the SBP comes in. The SBP’s announcement regarding CKD imports came only a day after the government  imposed an import ban on luxury items in an attempt to stem foreign exchange outflows. While cars were not a part of the ‘luxury’ items banned by the government, they did come under scrutiny from the SBP in a much subtler manner. 

Essentially, the central bank told car companies in Pakistan that they needed to seek permission before performing transactions in dollars for the import of CKD (completely-knocked-down) units of cars. This meant that auto assemblers in the country will now need express permission from the SBP to assemble them in the country. 

Through this permission, the SBP was now able to control how many cars were being imported and how many dollars were outflowing. This became the cudgel that the State Bank now uses against the automotive industry in an attempt to provide life support to Pakistan’s dwindling current account position. 

And while this was still not part of the import ban, a sector that constituted about 15% of Pakistan’s large-scale manufacturing, according to the Pakistan Economic Survey 2021-22, was thrown into the same conversation as imported luxury goods. 

The Government rescinded the ban in August, and opted instead to utilise other measures to curb imports. Imported automobiles in particular saw a blanket increase in duties as a means to deter their consumption. However, there was no conversation about the curbs on CKD kits at all. 

If silence is golden then any onlooker could surmise that the domestic automotive sector had been deemed a far bigger problem child in terms of Pakistan’s balance of payment crisis. Profit seeks to explain why one of Pakistan’s largest industrial sectors has such a toxic relationship with our balance of payments. 

Problematic beginnings 

“One of the very first textbooks I ever read said the following, there are two ways to produce cars.” Dr Ali Hasanain, Associate Professor at LUMS, told Profit. “One way is to set up an engine plant, a body shop, manufacture tyres, and put it all together in your country. The other is to grow rice and wheat, send them to Japan in ships, and those ships will magically convert those into automobiles.” Hasanain continued. 

Pakistan chose the former of the two options, and the reason for that boils down to the belief in import substitution as a means to conserve Pakistan’s foreign exchange reserves. How does this work? 

“With CKDs you can preserve foreign exchange to the extent that you are adding value between a CKD, and a completely built-up (CBU) unit.” Dr Ishrat Hussain, former Governor State Bank of Pakistan, told Profit. “CKDs also have the tendency to enable import substitution as imports start to disappear and are replaced by local counterparts.” Hussain continued. 

So how did the automotive sector, created to conserve foreign exchange, end up bleeding Pakistan’s precious foreign exchange? 

Tryst with deletion standards 

“Producing automobiles in Pakistan is inefficient is because we don’t have that industrial capacity or selahiyat to produce these things more efficiently than developed countries which have a more mature industrial base than us.” Hasanain told Profit. 

However, the Government of Pakistan persisted and supported the sector by nurturing it in a protectionist environment. The Auto Industry Development and Export Policy (AIDEP 2021-26) reveals that the Big 3 of Suzuki, Toyota, and Honda have achieved upwards of 50% in terms of deletion across the lionshare of their portfolio.  

But if localisation levels are this high, then is the Government of Pakistan an idiot for doing what it has done? The devil is in the details, and the fault in Pakistan’s deletion standards lies in their construction. Pakistan’s deletion standards account for the number of parts that have been localised and not the value of the vehicle that has been localised. Automotive companies are cognisant of this loophole and exploited to its maximum potential. 

“Localisation has not been a successful policy given that the main part, the engine, is still imported.” Dr. Aadil Nakhoda. Assistant Professor at IBA, tells Profit. 

“What happened was, because we lacked the capability to build cars in Pakistan, we made the floor mats and other minor accessories here, but we ended up importing the major inputs.” Hasanain told Profit. 

This situation gives rise to the more expensive parts of domestic cars still being imported. Realistically deletion levels are far lower than the ones advertised as part of AIDEP. 

Furthermore, “CKDs are dependent upon imported parts and accessories.” Nakhoda tells Profit. Pakistan’s deletion methodology does not account for the imported inputs being used in domestic inputs. If accounted for, net deletion levels would probably plummet even lower. 

Wrapping up 

“Let’s assume we could buy a CBU for $10,000. So the parts for equivalent CKD may be let’s say for $9,000. The CKD has saved $1,000 in terms of a foreign exchange, but this saving comes at an efficiency cost.” Hasanain told Profit. 

What is the efficiency cost? The efficiency cost Hasanain tells Profit is firstly the likely higher overall cost (exceeding $10,000) the domestic customer would have to pay to obtain the vehicle. However, more importantly, it is the opportunity cost that Pakistan could have done with that $9,000 instead of importing a CKD kit. 

“Now suppose we said, let’s kill the Auto industry and make whatever we could produce more efficiently more, e.g. toy manufacturing. By throwing more resources into whatever we are good at doing, we generate more dollars to buy CBUs with, and have money left over to play with, on both our foreign accounts and overall growth.” Hasanain tells Profit. 

This opportunity cost is important because Pakistan has to obtain foreign currency from some source in order to import these kits to begin with. In the absence of net localisation levels, it is likely that, complemented with the fuel cost of actually running all these cars, that in net terms the domestic automotive industry is in reality a drain on our foreign exchange reserves. 

Even if the Government and the Engineering Development Board disagree with such an assessment, the State Bank likely agrees with it. Why else would it restrict the activities of one particular sector in the economy if that sector was actually a valuable vehicle (no pun intended) for obtaining foreign exchange reserves at such a crucial junction (no pun intended again)?