Mutual Fund Structures

There are 11 categories of mutual funds according to the NBFI regulations formulated by the Pakistani SEC in 2009. The categories are equity, asset allocation, index tracker, capital protected, balanced, income, money market, fund of funds, exchange traded funds, and commodities. Each category can also have a Shari'ah-compliant version (Shariah-compliant funds are considered one category), making it a total of 11 categories. Exchange traded funds and commodities are recent entrants to the list, with a means to broaden the investment avenues available to asset management companies.

While money market, income, and equity funds remain the most popular and represent the largest segment of the industry's AUM, asset management companies have recently digressed into newer fund types such as index funds, commodity funds, and fund of funds, allowing investors to choose from a broader range of investment alternatives.

Exchange Traded Funds

The SEC approved the regulations for exchange traded funds (ETFs) in March 2012. Although asset management companies have launched funds for all categories of mutual funds, ETFs are the only category for which no fund currently exists in Pakistan. At present, the only way for an investor to invest in ETFs is through investing in mutual funds of the asset management companies that invest in international ETFs. The slow takeoff of ETFs in Pakistan can primarily be attributed to the legal and structural complexities of an ETF setup. It involves multiple new counterparts, such as authorized participants and brokers, the roles of whom also differ compared to the existing structure of mutual funds.

In the case of Shari'ah-compliant ETFs, the Islamic aspects—in terms of the role of the parties, investment mechanisms, and avenues—are further considerations that have acted as obstacles in the launch of an ETF. Moreover, the complexity of the product concept to an individual investor has given rise to the perception that ETFs are mainly for institutional clients, which is expected to limit the investor base of the product in Pakistan. Presently, with majority of frontier markets, including Pakistan, showing steady stock market growth, ETFs in Pakistan are expected to be a major investment attraction for local and international investors. In this respect, some asset management companies in Pakistan are exploring a launch of ETFs in the near future to broaden their investment portfolios.

Endowment Funds

Endowment funds exist primarily for the field of education in Pakistan; each province of Pakistan has its own education endowment fund to enable students to apply for scholarships at different universities. Moreover, many private institutions have their own endowment funds to promote higher education. One of the latest initiatives in this was the signing of a memorandum of association by the Higher Education Commission with the Education in Pakistan Foundation for the establishment of the Advancement Endowment Fund and the Student Endowment Fund.

An Islamic endowment fund is not a very common phenomenon in Pakistan. However, institutional investors of endowment funds are moving toward Islamic assets to diversify their investments and portfolios.

Banking Assets

Banking assets and deposits have consistently grown over the years, to PKR9.8 trillion and PKR7.3 trillion, respectively, as of December 31, 2012. The year-to-year growth in assets in 2012 was 19.5 percent. Because of the increasing risk averseness of the banking sector and little or no demand for credit in the private sector, the commercial banks have largely relied on investment in government securities to park funds generated from deposits. From a peak of 14 percent about 30 months ago, the prime (discount) rate has been reduced to 9 percent by the central bank, State Bank, as a major component of its expansionary monetary policy. Lately, however, increasing money supply and inflation have resulted in an increase in the discount rate to 10 percent as of December 31, 2013.

The Islamic banking sector has shown a tremendous annual growth of around 30 percent since the inception of the first licensed Islamic bank in Pakistan in 2002. As of December 31, 2012, Islamic banking assets stood at PKR836.5 billion, and deposits reached PKR706.5 billion. Islamic banking deposits currently make up around 10 percent of the total deposits of the industry (see Table 22.2).

Financial Reporting Standards

Pakistan announced that it was going to adopt international accounting standards in 1974, shortly after they were created. In the first stage of compliance, Pakistan made it voluntary for all companies to adopt international accounting standards. Most of these standards have been adopted, and the Institute of Chartered Accountants of Pakistan is working closely on a regular basis to adopt any new standards announced.

Pakistan is currently completing a full adoption of the International Financial Reporting Standards (IFRS) through a three-tier structure. In tier 1, public interest companies, such as listed companies and financial institutions, had to be in compliance with the IFRS by December 2009. In tier 2, medium-sized enterprises must follow the accounting and financial reporting framework and standards for medium-sized entities. In tier 3, small entities must follow the accounting and financial reporting framework and standards for small-sized entities.

On November 16, 2011, an IFRS seminar was held in Karachi to highlight the new accounting standards, which started in January 2013.

Tax Legislation

The tax-to-GDP ratio in Pakistan has often been quoted as being one of the lowest in the world, hovering around 9 percent for fiscal year 2013. Apart from the taxes charged by the federal government through the Federal Board of Revenue, as listed below, each province also has its own revenue board that charges various taxes. Common examples are a sales tax on services, a motor vehicle tax, a property tax, and an entertainment tax.

Capital gains tax is also applicable on listed securities in Pakistan. This was implemented in April 2012, with 10 percent being levied if securities are sold within 6 months of purchase and 8 percent if they are sold after 6 months but before 12 months. Total collection for fiscal year 2013 hovered at PKR1.25 billion.

Direct Taxation

Income tax is regulated under the Income Tax Ordinance of 2001 and the Income Tax Rules of 2002. It is an annual charge on taxable income, income subject to separate charge, and income subject to final tax of a person for a tax year. For the ongoing fiscal year 2014, the tax rate on corporations has been reduced from 35 to 34 percent, whereas the tax rate for individuals varies depending on the level of income. Thus the marginal tax rate starts from zero and goes up to 30 percent for salaried individuals and 35 percent for self-employed (nonsalaried) individuals.

Pakistani customs was established under the Customs Act of 1969 and is regulated under this as well as under the Customs Rule of 2001.

Indirect Taxation

Sales tax in Pakistan is regulated under the Sales Tax Act of 1990. It is levied on the sale and supply of goods and services and on goods imported into Pakistan by the federal government.

The government has recently introduced a version of the earlier abolished wealth tax, which is basically a tax on assets. It is applicable to all income tax–paying individuals at the rate of 0.5 percent of their net assets over PKR1 million. The objective of the levy is to generate funds for providing support and relief to the needy and the poor.

This newly introduced levy is widely criticized because it has the potential to slow down the economy and could enhance the already sizable informal economy, in which individuals underdeclare their net assets to minimize payment. It is also criticized because Muslims, who constitute more than 96 precent of the population, are already subject to a 2.5 percent zakat every year on their accumulated wealth to fund a system of poverty alleviation and support for the needy.

Tax Incentives and Exemptions

There are several geographical areas of Pakistan that are economically backward. To promote investment activity in such areas, an income tax holiday is provided for a certain period of time, such as 8 or 10 years. In addition, there is an exemption on income earned on agriculture, which has existed for a long time because of a strong agricultural lobby in Pakistan.

On the capital markets front, the government incentivizes investments in voluntary pension funds by providing tax reduction as long as no withdrawal is made before retirement (60 years or older) or 25 years from the date of first participation in such funds, whichever is earlier. Investments in collective investment schemes also enjoy tax breaks in the form of a step-down incentive structure.

Recently the government announced a number of tax incentives and exemptions. These are explained next.

Other Tax Issues

One of the major outstanding tax issues in Pakistan is the low tax-to-GDP ratio prevailing in the country. This is best judged by the fact that in a country of more than 190 million people, only 768,000 people pay income tax, and taxes are only 8 to 9 percent of the GDP.

Conclusion

There are several outstanding tax issues that must be addressed: increasing the incidence of direct taxes instead of relying heavily on indirect taxes, broadening the tax net to make all sectors of the economy contribute tax revenue, and increasing the tax-to-GDP ratio by bringing the informal sector into the tax net. The country is expected to move toward such reforms as a result of IMF conditions for a long-term loan. Introduction of e-filing and reform of the Federal Board of Revenue to streamline tax filing are other important steps.

In terms of accounting, Pakistani companies are following international accounting standards, and the disclosure standards are generally very high. This is very positive for international investors, since they rely heavily on the quality of disclosures in their financial statements to make their investment decisions, be they portfolio investments or direct investments.

Products

Microfinance banks and institutions in Pakistan offer a number of lending and deposit products to the needy. The Islamic microfinance product offering comprises the following products:

• Interest-free financing
• Deposit accounts
• Interest-free financial services to start small businesses
• Enterprise development training and programs
• Business start-up grants and consultancies
• Market linkages through exposure visits and exhibitions
• Strengthened community governance

The conventional microfinance industry also offers variants of the above products.

Demand

As previously noted, retail and microfinance is slowly gaining traction in Pakistan. Mobile banking is picking up pace. Phone users clearly outnumber banking customers: The country has a mobile phone density of 73 percent but a banking density of under 18 percent.

A significant part of the untapped banking segment is therefore a valuable opportunity for the microfinance segment, because even though people do require banking services, they are unable to access them because of their rural locations or because the individuals do not fulfill the bank financing and deposit criteria. Hence, branchless banking has emerged as a fast-growing sector that has brought under it a large number of telecommunication and banking companies. Currently, 10 banks are operating branchless banking services, with more to come. Of these 10, 3 are microfinance banks that operate branchless banking services: U Microfinance Bank, Tameer Microfinance Bank, and Wasila Microfinance Bank.

Opportunities

After the recent elections, the finance minister stated that one of the key objectives of the new government would be poverty alleviation, and he identified microfinance specifically as being one of the most effective instruments of poverty reduction. This is because of the potential of microfinance institutions to encourage financial inclusion, particularly in those segments of society that have had nothing to do with banking.

Another opportunity is the branchless banking model, which though at present has yet to fully realize its potential. A biometric payment system has just been initiated in Pakistan as a test. In addition, government-to-people payments are gaining momentum and are being expanded to promote branchless banking to the target market. All these payment and disbursement facilities are great opportunities for the branchless banking sector and also for the microfinance sector, because the target market is the same.

Initiatives for Financial Inclusion

The different modes currently being used by Islamic microfinance institutions are salam, istisna, musharaka, murabahah, and ijarah. However, there are other modes that are not being widely used by microfinance institutions, such as takaful and waqf.

The waqf model can be used to create a charity pool for the needy and create a credit line for them. Loans on the concept of qard hasan will be given to the needy with no expectation of repayment. Such a model will alleviate poverty and create a charitable culture in the country along the lines of Islam.

Takaful is the Islamic variant of conventional insurance. It is presently in an infancy stage in Pakistan and is mainly offered in the area of health. Currently, takaful is provided only for inpatient health care. This service can be broadened to include outpatient health care as well, to help low-income groups, who are often at a disadvantage because the cost of missing a day's work is quite large.

Another welcome initiative is the growth of Islamic banking. Individuals who previously did not use conventional banking for socioreligious reasons may be more comfortable using Islamic banking and Islamic microfinancing as alternatives.

A number of initiatives have been taken by State Bank to develop the microfinance sector. The bank has established a consultative group on branchless banking to examine and overcome the challenges of the microfinance sector. Also, banks have been asked to expand ATM access to increase the reach of financial services. A financial inclusion program has been initiated to promote the microfinance sector, consisting of initiatives such as microfinance credit guarantees and credit guarantee schemes for small and rural borrowers.

Restructuring has occurred within the microfinance sector to foster growth. Rozgar Microfinance has been converted into a nationwide microfinance bank and acquired by Pakistan Telecommunications. It too will launch a branchless banking platform to offer financial services. Other similar changes are being made to enhance the microfinance sector.

In the areas of Islamic microfinance, there is an increased membership in the Pakistan Microfinance Network, an Islamic microfinance working group, which is an indication that the recognition of Islamic microfinance is picking up pace in Pakistan. The aim of the working group is to enable the providers of Islamic microfinance to offer more varied and valuable Islamic microfinance services.

Risk Management

The objective of risk management in takaful is to protect the tabarru fund, a participant's investment amount, and the shareholders' fund. This is necessary in order to meet claims and expenses of the fund incurred by the takaful operator, to increase the participant's investment by generating profitable returns on it, and to meet any participant claims. To achieve these objectives, the three key areas of risk management in takaful are Shari'ah compliance, asset management capabilities, and human resources.

Shari'ah compliance is the core of the risk management framework. The takaful models, products, fee structures, investment avenues, and surplus sharing must ensure full adherence to Shari'ah at all times. Shari'ah compliance in investments is mandatory to ensure that the funds from the waqf pool are given to Shari'ah-compliant sources only. Any element of noncompliance in investments is purified through charity. Shari'ah screening in an ongoing activity that plays an important role in identifying the permissible investment avenues for the waqf pool funds to be invested in assets and investment management is another area where expertise and Shari'ah knowledge are essential to manage the risk in the takaful business. The primary challenge that takaful operators face is a limited investment base because of Shari'ah constraints. This often means lower-return investments, less scope for product innovation, and increased liquidity risk. Re-takaful at high premium rates is also often a challenge that takaful operators face. The expertise of takaful operators and a competent and talented human resources team is essential to meet these challenges and turn them into opportunities. More takaful professionals and Shari'ah scholars could uplift the industry and bring in more creativity and innovation.

Regulatory Issues

There are a number of regulatory challenges for the takaful industry. First, there is no separate division of government that looks after the takaful industry. There is a need for an institution that solely monitors the takaful sector—that helps in opening new takaful companies, conducting research, providing guidance, facilitating re-takaful, and providing the necessary consultancy by the industry. Islamic banking and the takaful industry are interdependent, but the growth and scope of Islamic banking has well surpassed the growth of the takaful industry. An independent institution that governs the takaful industry solely will help it develop.

Further issues that stand as challenges for the takaful industry are high capital requirement for both general and family takaful. The regulatory restriction that conventional insurance companies cannot open takaful windows also restricts the growth of the industry.

Conclusion

Growth potential for the takaful industry is immense, given a growing population, the weak law-and-order situation in Pakistan, and a growing business and corporate sector. Opportunities exist to convert globally practiced microinsurance into a Shari'ah-compliant variant and to take part in the SEC's effort to develop crop and livestock insurance. Regulatory support is essential to develop the industry further.

Currently, on the developing side, the SEC is considering establishing a Shari'ah advisory board that will ensure the compliance of regulated entities. The Takaful Rules of 2012 have also been approved by the policy board whereby conventional insurance companies can now apply for opening takaful windows. However, some takaful companies have gone to court against it and have requested a stay order.

Asset-Backed Sukuk

Sukuk is an Islamic certificate of investment. Sukuk is usually asset-backed; that is, it represents co-ownership of productive resources known as the underlying assets. Because income to sukuk holders is generated by trading or real investment rather than mere lending, sukuk holders earn profit rather than interest. As co-owners of productive assets, sukuk holders face the risks of ownership. In particular, they face the risk that their assets might not generate profits or might even incur losses. They also face the risk that the assets might be damaged or destroyed completely.

Asset-backed securities represent the real form of securitization, since they expose the sukuk investors to the real value and risk of the underlying asset. Under this structure, investors can expect only the returns from the cash flow of the underlying assets. Asset-backed sukuk would require the owner of the asset to sell the asset on a true-sale concept to the sukuk issuers without having any purchase undertaken in case the asset fails to generate the expected income to the sukuk investors.

However, some sukuk is structured as non asset–based—for example murabahah sukuk—and thus are nontradable. Specific Shari'ah requirements have to be fulfilled for sukuk to be tradable.

The Globalization of Sukuk

The sukuk industry has emerged as one of the main components of the Islamic financial system and has increasingly become an integral subset of the international financial system (see Figures 22.3, 22.4 and 22.5).

Global Sovereign Sukuk

A prominent theme in the sukuk arena that carried through from 2010 to 2012 was the increasingly diverse range of countries that have looked to sovereign issuance as a method of financing, with approximately 86 percent of total sukuk issuances being from sovereign entities. Since the inception of the sukuk market, the value of sovereign sukuk issued cumulatively as of the end of December 2012 stood at US$194 billion, with US$80.2 billion issued in 2012 alone (see Figure 22.6).

Major highlights of the global soverign sukuk issuances are as follows:

• Qatar launched its nine-year sovereign sukuk in July 2012, a US$4 billion ijarah issue. The sukuk program was oversubscribed, highlighting the strong global demand for Islamic sovereign papers.
• Bahrain remained active in the sukuk market, with a US$750 million sukuk in June 2012, which elicited US$1.8 billion of demand.
• Malaysia and Saudi Arabia have been the frontrunners in the issuance of sovereign sukuk, with Malaysian-issued sukuk totaling US$63 billion and Saudi Arabian issued sukuk totaling US$10.5 billion.
• Egypt aims to issue its debut US$12 billion sovereign sukuk early in 2014, which could help ease pressure on its public finances.
• The Turkish government issued a US$1.5 billion Islamic bond in 2012, which drew heavy bids totaling about US$7.5 billion from global investors.
• A $75 million Islamic bond issue by the Development Bank of Kazakhstan in 2012 was the first sukuk issued in the former Soviet Union.

Corporate Sukuk

Sukuk can be used as an ideal alternative for fulfilling funding requirements by the public as well as the private sector. The Pakistani market has excess funds, which can be tapped through the issue of listed Term Finance Certificates (TFCs) Corporate sukuk provides investors with risk-return opportunities not provided by bank deposits or government bonds. The average oversubscription of public offers is 54 percent, which clearly indicates that the demand for these securities exceeds the supply.

Banks and other financial institutions also prefer the issuance of sukuk when providing financing to corporations because their high tradability and liquidity. The listed sukuk can actively be traded in the secondary market and thus can provide additional avenues of investment for retail clients and the general public.

In Pakistan, the first Islamic sukuk was issued in 2002, when Sitara Chemicals Industries issued its musharaka term finance certificate. However, it was after 2005 that the corporate sukuk market started growing at a healthy rate, with prestigious corporations and conglomerates issuing sukuk to arrange funds for their short- and long-term funding requirements. Recently, power companies KAPCO and HUBCO have been actively involved in issuing sukuk to meet their financing needs.

As of the end of December 2012, privately placed sukuk totaling PKR577,911 million have been issued in the domestic market, and growth of the domestic sukuk market is expected to follow this trend in the near future.

The Debt Market

The debt market is vital for the economy as a means of meeting the financial requirements of the corporate sector. As of March 31, 2013, a total of 131 corporate debt securities were outstanding, valued at PKR613.37 billion. During July 2012 to March 2013, three issues of listed debt instruments were offered to the general public, and six debt securities were issued through private placement.

The SEC, along with credit rating agencies, State Bank, and the National Clearing Company of Pakistan are all working toward the development of the debt market so as to provide the corporate sector a wider mode for fulfilling its financial requirements. Some of the recent measures that have been taken to develop the country's debt market are as follows:

• To develop the Islamic debt market, a draft of sukuk regulations is in the final stages.
• The SEC has prescribed debt securities trustee regulations under which 15 debt securities trustees have been granted registration.
• The existing framework of the credit rating agencies is being revamped to enable them to help develop the debt market of the country. In this respect, a committee composed of members of the SEC, the credit rating agencies, and State Bank are reviewing and improving the regulatory framework.
• A separate set of regulations for the debt securities is being developed to encourage the listing of debt securities.
• Steps have been taken to facilitate the settlement of trading in debt securities listed on the OTC segment of stock exchanges.
• Models for valuation of debt securities have been implemented, and steps are being taken for the application of a uniform pricing mechanism in the Shari'ah-compliant sector of the debt market as well.

The Money Market

Pakistan has been pursuing an expansionary monetary policy since July 2011, slashing the discount rate by 5 percent, from 14 percent to the recent 9 percent (currently increased to 10 percent). Since the monetary easing has started, the yield of long-term government bonds has come down by 300–460 basis points from the tenure of 2–10 years. The successive rate cuts were primarily led by slowing inflation, low private sector investment, and a widening fiscal deficit. Although the objective of monetary easing was to encourage private sector investment, lending was restricted to working capital requirements, mostly because of energy issues and law-and-order deterioration. Those who gained from the discount rate cuts were mainly the government, which could now borrow at lower rates, and commercial banks, funds, and corporate entities, through capital gains on long-term government bonds.

The overall economic and political state of the economy is expected to improve with the recent smooth political transition. This is a reasonable expectation, given various ongoing developments such as the government reentering into the IMF to ease the external account; an energy policy to curb the energy crisis of the country; the Federal Board of Revenue optimistically expecting to meet its fiscal year 2014 target of PKR2.4 trillion; and the inflow of outstanding privatization proceeds of Pakistan Telecom shares from Etisalat (Emirates Telecommunication Corporation) and the auction of 3G spectrum (third generation of mobile telecommunications technology), expected to come along with fund support from the United States and the Asian Development Bank. All these factors point to a better recovery for Pakistan and mean that slight monetary tightening can be expected in the new fiscal year.

The Stock Market

KSE-100, the key benchmark index, has shown stellar performance over the last four years with a compound annual growth rate (CAGR) return of more than 40 percent, and the last fiscal year was especially exceptional: KSE-100 was up by more than 50 percent and was declared one of the best-performing markets in the world. A number of factors have contributed to this upward spike in the stock market performance: the revamping of the capital gains tax rules, an expansionary monetary policy of State Bank to cut the discount rate in the wake of falling inflation, demutualization of the stock exchanges, heavy foreign inflow, and the recent smooth political transition.

The optimistic sentiments of the general public for an improvement in the overall economic and political state of the country was well reflected in the index after the general election, which resulted in power being transferred from one democratic regime to another for the first time in Pakistan. Figure 22.7 shows the performance of the benchmark index KSE-100 since 2005.

The Karachi Meezan Index

In 2008, the first Islamic asset management company of Pakistan, Al Meezan Investment Management, collaborated with KSE-100 to develop the first Shari'ah-compliant index, the Karachi Meezan Index (KMI-30), aimed at tracking 30 Shari'ah-compliant equity stocks. The index is a means to help Shari'ah-conscious investors identify halal equity investments and enable them to measure the performance of their investments against the benchmark index. Evaluating the performance of KMI-30 against KSE-100, Table 22.4 shows that KMI-30 has consistently outperformed KSE-100 after being adjusted for dollars to provide a clearer picture of the returns.

In the past 10 years, KSE-100 has provided an annual return of 22 percent to its investors in rupee terms, but in dollar terms the annual return was 14 percent.

Conclusion

The SEC is on its way to bringing about further changes and reforms to the capital markets of Pakistan. Among these changes are the following: to introduce post-demutualization reforms to take the stock exchange forward in the demutualized setup; to establish a central country party for clearance and settlement; to develop the commodities market; to develop the Islamic capital market; to establish a broker's association and an SME exchange to allow fundraising for SMEs through initial public offerings and secondary trading.

Standardization of Shari'ah Supervisory Boards

Islamic banks and financial institutions in Pakistan either have their own Shari'ah supervisory boards or have access to known Shari'ah supervisory boards. In this regard, efforts are being made at the regulatory level to bring some uniformity in the Shari'ah guidelines by having centralized boards. State Bank already has such a Shari'ah board, and the SEC is in process of forming one of its own. The SEC has also issued guidelines on Shari'ah compliance for mudaraba companies in an effort to streamline their own Shari'ah guidelines.

Shari'ah supervisory boards in Pakistan are sometimes aided by dedicated departments that monitor compliance with the guidelines issued by the Shari'ah board and by a Shari'ah advisor of the financial institution who oversees day-to-day matters of the institution. In this regard, the Shari'ah compliance department acts as an internal auditing and compliance department.

The Shari'ah-compliance department also issues draft instructions for Shari'ah compliance covering regulations in areas such as appointment, duties, responsibilities, and reports of the Shari'ah advisor; conflict resolution in Shari'ah rulings; permissible modes of financing and investment; essentials of Islamic modes of financing; use of charity funds; introduction of new products and services; and schedules of service charges.

Draft guidelines for Shari'ah compliance also cover areas like internal Shari'ah compliance, internal Shari'ah auditing, investment in shares, policies for profit distribution with profit and loss sharing (PLS) account holders, and financial reporting and general disclosure requirements. Finalization of these instructions and guidelines will further contribute to the process of standardizing practices in the respective areas.

Conclusion

Despite the existing issues, Islamic finance is a flourishing industry. As it matures, differences in standardization can be expected to be resolved.

Also, as the industry grows, increasing note should be taken by the regulator of the differences and perceived differences among various institutions. Steps in the right direction, such as the proposed introduction of a central Shari'ah board for the SEC, would increase transparency.

Proposed changes by the SEC in light of international best practices, if implemented, can also encourage institutions to further invest in expanding their distribution and/or diversifying into related product offerings. All of these positive regulatory changes could foster increased economic activity.