Moody's maintains B3 stable rating

Moody's Investors Service has maintained Pakistan's (B3 stable) rating but warned that the government's very narrow revenue base restricts fiscal flexibility and weighs on debt affordability, while the rising level of external debt exposes the country's finances to sharp currency depreciations.
Moody's in its annual credit analysis titled "Pakistan's credit profile balances robust growth against high government debt, fragile external payments position", states that "Very Low (-)" assessment of Pakistan's fiscal strength reflects the country's narrow revenue base, which hinders debt affordability and increases the debt burden. In particular, Pakistan's limited tax base restricts its fiscal space, while low savings and shallow capital markets hinder stable domestic financing of sizable budget deficits. Credit challenges include the country's high general government debt burden and low debt affordability, weak physical and social infrastructure weighing on economic competitiveness, and increasingly vulnerable external payments position, and high political risk.
Moody's further maintains that there would be "ongoing pressure on Pakistan's foreign exchange reserves, arising from the country's large refinancing needs and its widening current account deficit. Foreign exchange reserves fell to $10.2 billion as of the end of March 2018, down 42% from their June 2016 peak, and are now slightly above $11 billion after a loan disbursement from a Chinese bank.
The lower level of reserves is likely to push Pakistan's External Vulnerability Indicator (EVI) to 115.1 in fiscal 2019, above 100 for the first time since fiscal 2015, when the EVI was 148.8. Pakistan's debt structure somewhat mitigates this risk, as only a quarter of the repayments (principal plus interest) are due to Eurobond and Sukuk holders, with another quarter or so due to commercial banks. More than 50% of repayments are due to multilateral or bilateral sources, where the likelihood of refinancing is significantly higher. Eurobond and Sukuk repayments amount to around 13 percent of reserves for fiscal 2019 - including commercial loans would raise the percentage to 30 percent.
The credit profile of Pakistan (B3 stable) is supported by the country's strong growth performance and potential, a relatively large - though low-income - economy, and an improved track record of reforms that started under its 2013-16 International Monetary Fund (IMF) programme. These strengths have been accompanied by greater transparency and lower levels of inflation and inflation volatility.
Moody's points out that there is potential for a further strengthening in Pakistan's growth beyond Moody's current expectations, because successful implementation of CPEC can transform the Pakistani economy by removing infrastructure bottlenecks and stimulating both foreign and domestic investment. However, fiscal costs related to the project could raise Pakistan's debt burden more rapidly and significantly than Moody's expects, and persistently high levels of imports could develop into greater external vulnerability.
According to Moody's assessment Pakistan's economic strength as "Moderate (+)" reflects the large size of the economy and high real GDP growth, balanced against very low global competitiveness and low income levels that indicate a limited capacity to absorb shocks.
Over the next 3-5 years, CPEC has the potential to significantly improve Pakistan's competitiveness and raise potential GDP growth, by relieving supply-side constraints and catalyzing private sector investment. A gradual economic impact, though full implementation of projects over the next few years could have a greater effect than expectations. On the other hand, project implementation could be slower than envisage or less effective at generating productivity gains. Like many of its South Asian neighbors, Pakistan is vulnerable to climate change risk. The magnitude and dispersion of seasonal monsoon rainfall continues to influence agricultural sector growth and rural household consumption. As a result, both droughts and floods can create economic and social costs for the sovereign.
Moody's maintains economic activity remains robust, supported by CPEC-related investment and strong domestic demand Pakistan's GDP growth has accelerated following the launch of CPEC with China (A1 stable) in 2015 and the successful completion of its three-year Extended Fund Facility program with the IMF in September 2016. Greater macroeconomic stability aided by the IMF program and increased investment flows because of CPEC have spurred higher levels of private consumption and gross fixed capital formation (GFCF).
Moody's expects real GDP growth to rise further to 5.8 percent in fiscal year 2018, ending 30 June 2018, from 5.4 percent and 4.6 percent in fiscal 2017 and fiscal 2016 respectively, better than the median 2017 growth of 3.8 percent among B-rated peers.
Growth drivers include the continuing recovery in the agricultural sector, aided by an increase in credit disbursements and more favorable weather conditions, robust activity in large-scale manufacturing because of improved energy availability and capacity expansions associated with CPEC, and higher remittance inflows, which rose 3.9% in the first ten months of fiscal 2018 compared with the same period of 2017, after having contracted in fiscal 2017. With the growth drivers largely intact, it is expected GDP growth to remain around similar levels in fiscal 2019, at 5.6 percent.
With a nominal GDP of $305 billion in fiscal 2017, Pakistan is the third-largest economy among sovereigns in the B-rating range, after Argentina (B2 stable) and Nigeria (B2 stable).
The relatively large size of the economy affords some resilience to local or sector-specific shocks, providing some credit support. However, the very low level of real GDP per capita of around $5,000 on a purchasing price parity (PPP) basis ranks within the bottom 15th percentile of Moody's rated sovereigns, which constrains the country's credit profile relative to peers.
Global competitiveness remains low, hampered by weak infrastructure and institutions. Also weighing on Pakistan's economic strength is its weak global competitiveness.
The Ministry of Planning, Development and Reforms estimates that around 12,000 megawatts (MW) of power supply has been added to Pakistan's electrical grid over the last five years - aided by CPEC in recent years - and an additional 20,000 MW will come online over the next three years. Authorities expect Pakistan to have a power surplus when all projects are complete.
Moody's expect the successful implementation of CPEC to gradually reduce supply-side bottlenecks and raise Pakistan's growth potential and economic competitiveness. However, low levels of government effectiveness, coupled with fiscal and external account challenges, could result in delays in execution.
Ensuring the security of projects also remains key, given that China has previously indicated that it would not hesitate to withdraw financial support from projects that may be vulnerable to terrorist activities.
As of April 2018, the total projected value of CPEC-related investments was approximately $62 billion (20% of fiscal 2017 GDP), of which nearly half ($28 billion) were "early harvest" projects, which the government intends to finish by the end of fiscal 2018. The remainder of the investments will occur through 2030 and beyond. Total spending on CPEC for fiscal 2019 is projected by the Ministry of Finance to be around 9.2% of GDP, with the private sector funding the energy projects and the government budgeting around 3.9% of GDP for the infrastructure projects.
Pakistan's institutional strength is set at "Very Low (+)", above the indicative score of "Very Low (-)". This reflects the country's performance under the 2013-16 IMF programme, which has contributed to greater central bank autonomy and stronger prospects for monetary policy credibility and effectiveness. Nonetheless, since completion of the program and ahead of general elections expected in July 2018, reform progress has slowed. Moody's overall assessment also reflects Pakistan's low rankings on the Worldwide Governance Indicators (WGI) and institutional constraints that limit fiscal and structural reforms.
Low WGI scores relative to peers reveal very weak institutional framework WGI scores, namely on government effectiveness, rule of law, and control of corruption, inform our assessment of institutional strength. Pakistan ranks very low in all three categories relative to B-rated peers and lags behind regional peers such as Sri Lanka (B1 negative), but its scores are in line with Bangladesh's. Pakistan's WGI scores also continue to rank below the 20th percentile among the sovereigns we rate, although government effectiveness has increased since 2014.
Progress in reforms reflected in improving business sentiment, but momentum has slowed. Significant progress in areas such as monetary policy credibility and energy infrastructure has spurred greater business confidence, with international companies announcing investment plans, often undertaking joint ventures with local companies. Recent announcements have been concentrated in the auto sector, with Hyundai (Baa1 stable), Kia Motors (Baa1 stable) and Renault (Baa3 positive) announcing investment in car assembly and production plants, and Daimler (A2 stable) announcing that it would make Mercedes-Benz trucks in Pakistan.
However, the broader reform momentum has slowed ahead of this year's general election, which is expected to take place in July 2018. Fiscal deficits have widened again, though slightly, and little progress has been made in SOE privatization.
In particular, loss-making SOEs could require resources from the government's budget over the coming years. The IMF estimated in its March 2018 post-program monitoring report that the combined accumulated losses at SOEs, including the state-owned airline and steel mill, have risen to around Rs 1.2 trillion (3.9% of fiscal 2017 GDP), while new payment arrears from power distribution companies have also increased. This compares to total losses across all SOEs of Rs 652.5 billion as of fiscal 2016 (2.2% of fiscal 2016 GDP).
Since November 2015, the State Bank of Pakistan (SBP) has been given greater autonomy in its pursuit of price stability, while the creation of a new Monetary Policy Committee (MPC) - which allows a more independent monetary policy decision-making process - has contributed to the anchoring of inflation expectations. Despite strong domestic demand, higher oil prices, and two episodes of currency depreciation amounting to approximately 10% in total, inflation has remained stable between 3.5% and 5% in fiscal 2018, below the SBP's target of 6%.
Moody's expect inflation to average 4.5% in fiscal 2018 and remain relatively contained in fiscal 2019, rising marginally to 5.5%. Risks are nevertheless skewed toward higher than expected inflation, as oil prices - which are typically passed through to the consumer in Pakistan - have continued to rise, and there may be further rounds of currency depreciation by the SBP to reduce import demand. However, the SBP also preemptively raised its policy rate by 25 basis points in January 2018, having gauged the potential for strong domestic demand to push inflation higher. With monetary policy tilted toward tightening, further rate hikes would offset some of the upward pressure on inflation.
Compared with the "Very Low (-)" median, Pakistan's debt burden is modestly smaller when expressed in terms of its GDP, given the large size of the economy in nominal terms. When expressed as a percentage of general government revenue, the debt burden is larger, reflecting the shallow revenue base from which the government draws. The material foreign currency portion of outstanding general government debt (about 30% of total debt) also exposes the government's balance sheet to sharp currency depreciations.
The government's fiscal deficit widened slightly in fiscal 2017 to 5.6 percent of GDP from 4.4 percent in fiscal 2016. Higher development spending - in large part due to CPEC-related infrastructure projects - coupled with lower than expected government revenue growth pushed the deficit wider.
Since the start of fiscal 2018, revenue has rebounded strongly, rising nearly 20% for the first six months of the fiscal year compared with the year-earlier period. Moody's expects the fiscal deficit to remain around 5.5% of GDP, given continued increases in development spending, which rose over 23% in the first six months of fiscal 2018 from the same period of the previous fiscal year. For fiscal 2019, we are forecasting a slight narrowing of the deficit to 5.0% of GDP, in line with the government's recently introduced budget.
Government's fiscal 2019 budget continues to focus on development spending, aims to raise tax compliance. The government's fiscal 2019 budget, which was approved by parliament in May 2018, will continue to allocate more spending to infrastructure and CPEC-related projects. Out of an outlay of Rs 5.9 trillion for fiscal 2019 (10.7% increase from the revised fiscal 2018 budget), Rs 1.2 trillion has been allocated to development expenditure - 8.5% higher than the revised fiscal 2018 budget and accounting for close to 20% of the total outlay.
The Federal Public Sector Development Programme (PSDP) accounts for approximately 90% of total development expenditure, of which over 60% includes infrastructure and CPEC-related spending. PSDP has tripled in size since fiscal 2013. The government also announced a number of measures alongside the fiscal 2019 budget, aimed at improving tax compliance. However, Moody's says that the potential for slippage given the untested effectiveness of some of these measures on increasing compliance or expanding the tax base.
General government revenue was equivalent to 15.5% of GDP in fiscal 2017, which is one of the lowest among similarly rated peers. This reflects Pakistan's narrow tax base, driven by a very low level of per capita income, but also a high level of tax exemptions, along with weak tax compliance and enforcement.
In a country of more than 200 million people, only 1.4 million filed income tax returns, of which approximately 990,000 paid taxes, according to the government's latest estimate for fiscal 2017.
Revenue performance remains weak and some of the government's recent tax generation measures are, in our view, more likely to produce one-off gains rather than generate sustainable sources of revenue. An example is the government's three-month tax amnesty scheme announced in April 2018 - the first to target undeclared foreign assets, which accounting firm AF Ferguson estimates at around $150 billion (25% of our fiscal 2018 GDP forecast).
It could increase government revenue between 0.3% and 1.0% of GDP, the impact is likely to be one-off, and the success of the scheme depends on residents' willingness to declare their assets and their expectation for future tax amnesty schemes with similar incentives.
At 68.1% of GDP as of fiscal 2017, the government's debt stock is higher than the 57.5% median for B-rated sovereigns. Although the Fiscal Responsibility and Debt Limitation (FRDL) Act requires the government to limit public debt to 60% of GDP until fiscal 2018 and targets a further reduction to 50% of GDP over the following 15 years, we see limited prospects for meaningful adherence to the act over the next 2-3 years.
The moderately large and rising share of foreign currency borrowing further exposes the sovereign credit profile to sharp currency depreciations. The increase in the government's debt burden since fiscal 2016 has been due to higher external debt, borrowed partly to fund the country's balance of payments deficit. External borrowing had increased to 31.1% of total debt at the end of March 2018, from 28.4% at the end of fiscal 2016.
Moody's assess Pakistan's susceptibility to event risk to be "High", driven by domestic and geopolitical political risk, and government liquidity risk, stemming from the government's large rollover requirements.
Moody's assessment of Pakistan's political risk at "High" reflects a strong probability of an escalation of violent terrorism or tensions between the different branches of the government, which would threaten political stability and divert essential policy and economic resources.
Pakistan has experienced frequent changes in its political leadership and a long history of coups and strife between the executive, judiciary and military. No prime minister has ever completed a term in office, although the outgoing PML-N government - whose term finishes end-May 2018 - would be the second consecutive democratically elected body to finish a full five-year term.
The frequency of terrorist attacks in Pakistan also dampens economic sentiment and deters investment, particularly foreign direct investment. Violent and/or disruptive events, in particular, have the potential to derail growth and limit policy effectiveness if the country shifts its attention and limited resources away from economic development toward national security and emergency response.
Authorities have invested significant resources to increase national security over the past few years, and the number of terrorist incidents has fallen by about 60% from its 2013 peak. The ongoing, often violent, border dispute with India over Kashmir, adds another dimension to geopolitical risk. We do not expect the general election, due to be held in late July 2018, to yield significant surprises in terms of the broader direction of macroeconomic and/or national security policies.
Pakistan's government liquidity risk is set at "High", above the indicative score of "Medium (-)". Sizable fiscal deficits and reliance on short-term debt have contributed to very high gross borrowing requirements.
At an estimated 33.4% of GDP, Pakistan's gross borrowing requirement in fiscal 2018 is the fourth largest among all rated sovereigns, after Japan (A1 stable), Egypt (B3 stable) and Bahrain (B1 negative), and higher than most similarly rated peers.
The government's large gross borrowing needs are partly due to its large and rising stock of short-term Treasury bills, which have to be frequently rolled over.
Short-term Treasury bills amounted to 19% of gross government debt (or close to 12% of estimated fiscal 2018 GDP) as at the end of 2017. While the Treasury bills are denominated in local currency, which mitigates rollover risk as long as domestic banks are well funded and have capacity to lend to the government, the large amount of short-term debt raises the government's exposure to interest rate risk. In fact, expectations of higher policy rates on the back of strong domestic demand and rising inflation have reduced banks' appetite for longer-term debt instruments.
The approximately 31% of debt denominated in foreign currency as of the end of 2017 also exposes the sovereign to marked changes in refinancing costs should the local currency weaken abruptly. The share of foreign currency debt is within the 20%-35% range specified in the government's Medium Term Debt Management Strategy for fiscal 2016 to fiscal 2019.
Moody's assess Pakistan's banking sector risk to be "Very Low (+)", as the relatively small size of the banking system and adequate capital levels and funding liquidity limit contingent liabilities to the sovereign.
With total domestic banking system assets of about 57% of GDP as of the end of fiscal 2017, the size of Pakistan's banking system is relatively small. Banks are well capitalized, with an average Tier-1 capital ratio of 12.9% as of the end of calendar 2017 that exceeds the regulatory requirement of 7.5% and well-funded, with an average loan-to-deposit ratio of 54%. Nonperforming loans have also declined on average to 8.4% of total loans as of the end of 2017 from a peak of 16.7% in the third quarter of 2011, reducing the risk to bank capital, and, ultimately, the sovereign credit profile.
One source of weakness relates to the large holdings of securities and government-related loans by banks. Pakistani banks' holdings of government securities increased to an estimated 44% of total assets or 7.5 times the system's Tier 1 capital as of the end of 2017, while loans to government agencies and state-owned companies amounted to a further 8.5% of assets and 1.5 times capital. It is expected that this exposure to increase further, given the government's sizable fiscal deficit and limited alternative sources of domestic capital.
Pakistan's external vulnerability risk score is adjusted to "Medium", above the indicative score of "Low", as external pressures have been building since the country's IMF programme finished in 2016.
The country's foreign exchange reserves have also declined markedly. We expect Pakistan's current account deficit to widen to 4.6% in fiscal 2018 and remain around 4.4% in fiscal 2019. This compares to an average deficit of around 1.3% in 2013-16, when Pakistan was under the IMF programme.
With foreign direct inflows stable at around 1.1% of GDP, Pakistan's basic deficit is likely to hover around 3.5% of GDP in fiscal 2018-19. Strong import growth, due primarily to import-intensive CPEC projects, and bolstered by higher fuel imports and robust household demand for luxury goods such as cars, has been the main driver of the widening deficit. We expect import growth to slow slightly in fiscal 2019, as CPEC transitions from energy projects to infrastructure projects and the establishment of SEZs, which are less import intensive.
A strong rebound in exports - up around 16% in fiscal 2018 to date - and the lagged impact of currency depreciation and higher regulatory duties to curtail nonessential imports would also provide support on the margins. Remittances contracted in fiscal 2017, driven mainly by weak economic conditions in Saudi Arabia, but are now growing at around 4% year-on-year.