Why Do Pakistani Firms Stay Small?

The Missing Middle Problem

Pakistan's private sector exhibits a distinctive pattern that development economists call "the missing middle." The country has many small firms and a handful of large conglomerates, but relatively few medium-sized enterprises filling the gap. This matters because medium-sized firms are typically the engines of job creation and export growth in developing economies.

The problem is not simply a snapshot of Pakistan's firm distribution at one point in time. It is a dynamic phenomenon: Pakistani firms do not grow as they age. According to analysis of firm-level data, a young formal firm under ten years old is approximately the same size as a firm that has been operating for 20-25 years.^[3]

This stagnation contrasts sharply with the growth trajectories seen in comparator countries. In well-functioning markets, firms either grow and become more productive or they exit, releasing resources to more efficient competitors. In Pakistan, firms appear to neither grow nor exit at expected rates.

Declining Private Investment

One symptom of Pakistan's firm dynamics problem is the steady erosion of private investment. World Bank data shows that private gross fixed capital formation has trended downward over the past two decades.^[1]

During the 2000s, private investment averaged 13.0% of GDP.^[1] The decade saw a peak of 14.5% in 2006, coinciding with a period of relatively strong economic growth.^[1]

The 2010s brought a marked decline. Private investment fell to an average of 11.2% of GDP over the decade, beginning at 11.8% in 2010 and remaining roughly flat through 2019.^[1]

The COVID-19 pandemic and subsequent economic instability pushed private investment even lower. By 2023, private investment had fallen to just 10.0% of GDP, the lowest level in the available time series.^[1]

This decline matters because private investment is the primary mechanism through which firms expand capacity, adopt new technologies, and create jobs. A sustained fall in private investment suggests that Pakistani firms are choosing to remain small rather than grow.

Small Exporters in a Competitive World

Pakistan's firm size problem becomes especially visible when examining exporters. Exporting requires significant scale: firms must meet international quality standards, navigate foreign regulations, and absorb the risks of currency fluctuations and shipping delays. Larger firms are generally better positioned to handle these challenges.

Data from the World Bank's Exporter Dynamics Database reveals a persistent gap between Pakistani exporters and their regional peers. In 2010, the average Pakistani exporting firm shipped goods worth $1.28 million. The average Bangladeshi exporter shipped $2.58 million, roughly twice as much.^[2]

This gap widened over time. By 2014, the average Bangladeshi exporter reached $3.79 million in annual exports.^[2] While comparable 2014 data for Pakistan is not available in the database, the earlier trend suggests that Pakistani exporters failed to keep pace with their competitors.

The implications are significant. Smaller export values per firm suggest that Pakistan's exporters may lack the scale to compete effectively in global markets, invest in quality improvements, or negotiate favorable terms with international buyers.

Entry, Exit, and Creative Destruction

A healthy market economy features constant churning: new firms enter, successful ones grow, and unproductive ones exit. Economists call this process "creative destruction." It reallocates resources from less productive to more productive uses, driving overall economic growth.

Pakistan's firm dynamics suggest that this creative destruction process is impaired.

The World Bank's Exporter Dynamics Database provides data on export market entry rates. For Pakistan, the average entry rate from 2006 to 2010 was approximately 27%.^[2] Bangladesh showed similar rates, averaging around 26% from 2006 to 2014.^[2]

However, both countries lagged significantly behind Mexico, where the average entry rate exceeded 35% during 2001-2011.^[2]

Lower entry rates mean fewer new exporters are emerging to challenge incumbents. Combined with low exit rates, this suggests that the reallocation process that drives productivity growth in other economies is weaker in Pakistan.

Important methodological note: Entry rate definitions vary across sources. The World Bank Exporter Dynamics Database measures the share of new exporters in total exporters. Some studies use alternative definitions that may produce different figures. Cross-source comparisons should be made with caution.

The Zombie Firm Problem

Perhaps the most striking symptom of Pakistan's firm dynamics problem is the prevalence of "zombie firms," companies that have been persistently loss-making for three or more consecutive years yet continue to operate.

According to analysis of Pakistan's top 500 firms by revenue, more than 11% qualify as zombie firms.^[3] This is roughly twice the rate observed in aspirational comparator countries like Indonesia, Mexico, Turkey, and Vietnam.^[3]

The ownership structure of these firms provides clues about why they persist. State-owned enterprises and family-owned firms show zombie rates exceeding 20%, compared to just 5-10% for foreign-owned firms and non-family domestic firms.^[3]

This pattern suggests that soft budget constraints may be at work. State-owned firms may receive implicit government support that allows them to survive despite persistent losses. Family conglomerates may cross-subsidize failing businesses using profits from other group companies. In both cases, firms that would exit in a competitive market instead continue operating, absorbing capital, labor, and market share that could flow to more productive competitors.

The annual cost is substantial. By one estimate, approximately $3 billion in short-term bank credit flows to zombie firms each year.^[3] This credit could otherwise finance working capital for growing firms, new market entrants, or productive investments.

Confidence note: The zombie firm claims are derived from analysis of Orbis database firm-level data as reported in the World Bank's Swimming in Sand Country Economic Memorandum. Independent verification would require access to the underlying Orbis database, which was not available for this analysis.

The Protection Trap

Pakistan's tariff structure may inadvertently discourage firms from growing and exporting. The country has among the highest levels of tariff cascading in the world, meaning that protection rates increase as products move up the value chain.^[3]

This protection pattern has measurable effects on firm behavior. Firms in highly protected sectors (those enjoying effective protection rates above 100%) export only about 1.3% of their revenue.^[3] Firms in sectors with lower protection export roughly 13% of revenue, ten times as much.^[3]

For the largest firms (those with 1,000 or more employees), the pattern is even starker. Large firms in protected sectors export just 2.9% of revenue, compared to 27% for large firms in non-protected sectors.^[3]

The economics are straightforward. High tariff protection makes domestic sales artificially profitable by shielding firms from foreign competition. This reduces the incentive to invest in the capabilities needed to compete internationally: quality systems, export marketing, and the scale economies that come with serving larger markets.

In effect, protection allows firms to remain small and domestically focused rather than growing to achieve the scale needed for international competitiveness.

The Smaller Revenue Base

The size differential between Pakistani firms and their regional peers extends beyond exports. Analysis of the top 500 firms by revenue across countries reveals a striking pattern.

According to the Swimming in Sand analysis, 51.6% of Pakistan's top 500 firms have annual revenues below $50 million.^[3] In aspirational comparator countries (Indonesia, Mexico, Turkey, and Vietnam), only about 25% of top 500 firms fall in this revenue category.^[3]

This means that even among Pakistan's largest companies, the average firm is substantially smaller than similarly ranked firms in countries Pakistan aspires to emulate. The top 500 in Pakistan are roughly equivalent to smaller companies in other economies.

This size disadvantage matters because firm size correlates with productivity, export capacity, R&D investment, and ability to adopt new technologies. Smaller firms have fewer resources to invest in innovation, less bargaining power with suppliers and customers, and reduced capacity to attract skilled workers.

Implications for Economic Growth

Pakistan's firm dynamics challenge has direct implications for the country's long-term economic growth prospects.

Economies grow when resources flow from less productive to more productive uses. When unproductive firms persist while new entrants face barriers, this reallocation process stalls. When firms fail to grow as they age, they never achieve the scale economies that drive productivity improvements.

The decline in private investment suggests that Pakistani entrepreneurs and business owners see limited returns from expanding their operations. Whether due to macroeconomic instability, policy uncertainty, credit constraints, or the artificial profitability of protected domestic markets, firms are choosing to stay small.

Breaking this pattern likely requires action on multiple fronts: resolving zombie firms through improved bankruptcy processes and harder budget constraints; reducing tariff protection to create incentives for export-oriented growth; improving the business environment to encourage new entry and investment; and reforming credit markets to direct financing toward productive firms rather than politically connected incumbents.