Moody's eyes 'stable outlook' for banking system

Moody's Investors Service said the robust funding and liquidity and close links with the sovereign underpin stable outlook for the Pakistan banking system over the next 12-18 months.

Moody's in its latest report "Banking System Outlook - Pakistan", stated that high interest rates, government's narrow revenue base and heavy debt burden coupled with substantial structural constraints to economic and export competitiveness will weigh on economic growth.

Real GDP growth will remain below potential at 2.9 percent in 2020, with inflation and interest rates remaining high. "We expect real GDP growth of just 2.9 percent for the fiscal year ending June 2020, down from 3.3 percent in 2019 and 5.5 percent in 2018. Interest rates have increased by 7.5 percentage points since January 2018," states the report.

Operating conditions are improving but will remain difficult. Economic activity will be supported by ongoing infrastructure projects, improvements in power generation and domestic security and by terms of trade gains. In addition, rupee depreciation will likely lift private investment from low levels.

Economic growth will remain subdued, nonetheless, primarily due to high interest rates (policy rate at 13.25 percent). The government's heavy borrowing needs will also absorb bank lending at the expense of the private sector, hurting business and consumer confidence as well as private-sector debt repayment.

Investments in energy infrastructure projects under the China-Pakistan Economic Corridor (CPEC), coupled with improvements in domestic security, have reduced some of the country's long-term economic constraints and have potential to boost private-sector activity. Nonetheless, Moody's expects the tight monetary conditions to keep economic activity subdued near term.

Macroeconomic policy effectiveness is rising aided by increased central bank independence that will be enshrined in a new State Bank of Pakistan (SBP) Act. Other reforms include gradually addressing the long-standing problem of circular debt with a goal of eliminating it by the end of 2020.

The country still faces challenges, including substantial structural constraints to economic and export competitiveness. The government's narrow revenue base and heavy debt burden limits fiscal flexibility and also hampers development spending. High interest rates, coupled with the challenges noted above, will weigh on economic growth.

Despite the challenges, the exchange rate has stabilized since June 2019 and markets expect the State Bank of Pakistan (SBP) to lower policy rates over the next few years.

High exposure to government securities (40 percent of assets) link banks' credit profiles to that of the sovereign. Moody's expects nonperforming loans (NPLs) to rise slightly as a result of high interest rates and banks' troubled foreign operations. NPLs stood at a high 8.8 percent of gross loans as of September 2019, although risks are mitigated by the fact that banks' loan portfolios only make up 37 percent of total assets. The government is working on laws to improve NPL recovery.

Capital is modest and will remain stable. Sector-wide reported Tier 1 capital ratios stood at 14.2 percent, but it adjusts these by raising risk weights on government securities to 100 percent from zero percent to reflect risks associated with the sovereign's B3 credit rating. The adjustment reduces the ratio to a more modest 7 percent.

Moody's expects banks to keep capital ratios steady by reining in dividend payouts, issuing Tier I or Tier II capital instruments or through other capital optimization measures.

Profits will increase slightly but remain below historical levels. Higher net interest margins (on the back of higher interest rates and government bond yields) and estimated 10 percent credit growth will boost revenue, compensating for rising provisioning needs, ongoing pressures at banks' overseas operations and higher costs.

Customer deposits make up around 69 percent of total assets, and it is expected these to grow by over 12 percent this year, providing banks with plentiful low-cost funding. Cash and bank placements account for around 12 percent of total assets, while another 40 percent of assets are invested in government securities-with around 64 percent in T-Bills, which can be repo'ed with the central bank - offering sound liquidity. Market funding increased to 23 percent of assets as of September 2019, mainly in the form of repo facilities, used for "carry trades", which expose banks to additional credit and interest rate risks.

Moody's expects the government to remain willing to support at least the systemically important banks in case of need, but its ability to do so is limited by fiscal challenges reflected in its B3 rating.

Weaker economic growth that would undermine banks' business generation and loan quality, any deterioration in the sovereign credit profile would have a direct credit impact on banks could change outlook to negative.

Operating conditions for banks are improving, aided by infrastructure investment, increased power supply and a pick-up in exports. The IMF programme is overseeing fiscal and structural reforms.

The banks hold large quantities of Pakistani government debt that link their credit profiles to that of the government. Financial inclusion efforts and remittance inflows provide robust funding. Capital buffers are modest and problem loans may rise since economic growth will remain below potential.

Further sustained improvements including economic growth in line with the country's potential (around 5 percent), competitiveness gains and robust foreign investment would open up business opportunities for banks and strengthen the sovereign credit profile.

Government initiatives under the National Financial Inclusion Strategy will promote loan growth, but high interest rates and banks' risk-averse stance will add restraints.

The SBP accelerated its monetary tightening following a rise in inflation, while allowing the rupee to depreciate by around 35 percent against the US dollar. Positively, it is noted that the exchange rate has stabilized in recent months and appears to have found a near-term equilibrium, while long-term interest rates have fallen below short-term interest rates, indicating that markets expect SBP to lower policy rates over the next few years.

Moody's expects private-sector lending to grow by around 10 percent in 2020. High interest rates and banks' more risk-averse stance will be partly offset by initiatives to deepen financial inclusion, as per the National Financial Inclusion Strategy (NFIS).

Some of the NFIS initiatives include a targeted 25 percent market share for Islamic banking, with revised Shari'ah government framework and initiatives to facilitate liquidity management. Islamic banking assets accounted for 13.8 percent share of banking assets as of September 2019; authorities aim for SME lending to increase to around 17 percent of private-sector credit by 2023 by providing an enabling regulatory framework and improving the ease of doing business; initiatives to increase agricultural finance (targeting disbursements of Rs1.8 trillion by 2023 and 6 million borrowers); facilitate digitalisation; enhance depositor base, targeting 65 million active accounts and 55 percent of GDP; and increase housing finance through regulatory and tax incentives, and via concessionary financing.

Pakistani banks are highly exposed to the B3-rated Pakistan sovereign through holdings of government securities and lending. This links their creditworthiness with that of the government, whose credit profile has improved in recent months. Pakistani banks hold government securities worth Rs 8.7 trillion, a sum equivalent to 6.9x their Tier 1 capital at the end of September 2019. Including lending to the government and public-sector entities, the exposure rises to 8.8x of Tier 1 capital.

"We expect government exposure to remain high over our outlook horizon because Pakistani banks will remain the main source of financing for the government. We expect the government's commitment to stop borrowing from the central bank to increase government reliance on banks for meeting its financing needs", Moody's added.

Interest rates at over 13 percent compromise the capacity of borrowers to repay their loans, and the banks face difficulties in their overseas operations, particularly in the Gulf. High concentrations of loans to single borrowers and to specific sectors (e.g. agribusiness, sugar and energy sectors) also hide risks.

During the first nine months of 2019, the system-wide return on assets was 1.4 percent, with Islamic banks contributing 26 percent (up from 17 percent in 2018). The banks' earnings generating capacity has deteriorated over the past three or four years, hurt by narrowing net interest margins, lower gains on sales of securities and in the value of investments, reduced dividend income, and a rise in expenses (including extraordinary costs, such as increased pension costs).

We expect net profit to rise in 2020, a result of stronger net interest income thanks to higher interest rates and government bond yields. Profitability will remain constrained nonetheless by subdued trading gains and dividend income. The extension of a 4 percent special taxation imposed on banks up to 2021 will also bite, as will rising costs as a result of investments to strengthen compliance and security infrastructure, higher minimum staff pension payments (of Rs8,000 a month, with a 5 percent annual increase), and an expected rise in loan-loss provisioning costs.

Deposits will remain the primary source of funding for Pakistani banks over our outlook period, supported by initiatives to deepen financial inclusion and banking penetration, as well as a high level of remittances from Pakistani emigrant workers.

The potential introduction of a Treasury Single Account (TSA), where government deposits are held at the SBP, could lead to some deposit outflows from banks. Market funding increased to 23 percent of assets as of September 2019. This was mainly in the form of inter-bank and SBP repo facilities, used for "carry trades" (i.e. buying government bonds funded by short-term borrowing). Although risks are relatively contained from a liquidity perspective, such activities expose banks to additional credit and interest rate risks.

"We expect Pakistani banks to maintain comfortable liquidity buffers, with core liquid assets (cash and bank placements) accounting for 12 percent of assets as of September 2019, complemented by the banks' investments in government securities (40 percent of total assets)", maintained the report.

Around 64 percent of the government securities are Treasury bills, which are accepted by the SBP as collateral for repo funding.

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