Credit profile challenges identified: real GDP growth to slow to 4.3 percent: Moody''s

The credit profile of Pakistan (B3 negative) reflects the sovereign''s high external vulnerability, weak debt affordability, and very low global competitiveness, says Moody''s Investors Service.
Moody''s in its latest report "Pakistan''s credit profile reflects domestic and external challenges", has projected that real GDP growth in Pakistan would slow to 4.3 in fiscal 2019 (ending June 2019) and fiscal 2020 from 5.8% in fiscal 2018 in part due to policy measures taken to address the external imbalance.
The International Monetary Fund (IMF) has already revised downward the GDP growth to 4 percent for Pakistan from its earlier projection of 5.8 percent while Asian Development Bank (ADB) and World Bank (WB) have projected a growth rate of 4.8 percent for the current fiscal year 2018-19.
Significant external pressures driven by wider current-account deficits have reduced foreign-currency reserves, which are unlikely to be replenished in the near term unless capital inflows increase substantially.
While Pakistan''s public external debt repayments are modest, low reserve adequacy threatens the ability of the government to finance the balance of payments deficit and roll over external debt at affordable costs.
Moody''s conclusions are included in its just-released annual credit analysis "Government of Pakistan - B3 negative". This analysis elaborates on Pakistan''s credit profile in terms of economic strength, moderate (+); institutional strength, very low (+); fiscal strength, very low (-); and susceptibility to event risk, high, which are the four main analytic factors in Moody''s Sovereign Bond Rating Methodology.
Moody''s assessment of Pakistan''s susceptibility to event risk is driven by external vulnerability risk. Current-account deficits will remain wider relative to 2013-16 levels, with near-term prospects for a marked and sustained reversal unlikely unless goods imports contract sharply.
Absent significant capital inflows, the coverage of foreign-exchange reserves for goods and services imports will remain below two months, below the minimum adequacy level of three months recommended by the International Monetary Fund.
The government''s narrow revenue base restricts fiscal flexibility and weighs on debt affordability, while its debt burden has increased in recent years.
At around 72% of GDP as of the end of fiscal 2018, the government''s debt stock is higher than the 58% median for B-rated sovereigns, and Moody''s expects the burden to rise further and peak at around 76% of GDP in fiscal 2020 - in part because of currency depreciation - before gradually declining as the twin deficits gradually narrow.
The moderate but rising level of external government debt also exposes the country''s finances to sharp currency depreciations.
Nevertheless, longer-term economic prospects remain robust, in part because of improvements in power supply, infrastructure and national security that have raised the country''s growth prospects and hence business confidence.
In particular, infrastructure investments and the significant increase in power supply, including through projects under the China-Pakistan Economic Corridor (CPEC), which are already helping with growth, will address some of Pakistan''s long-term economic constraints and strengthen its growth potential.
Further institutional reforms planned by the new government, if effectively implemented, will also bolster institutional strength, which has increased in recent years with greater central bank autonomy and monetary policy effectiveness. However, the reforms will be challenging for any government to navigate because of the country''s large bureaucracy and complex federal-provincial politics and administrative arrangements.
With a nominal GDP of $311 billion as of fiscal 2018, 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, very low GDP per capita of slightly over $5,000 on a purchasing price parity (PPP) basis ranks within the bottom 15th percentile of our rated sovereigns, which constrains the country''s credit profile compared with peers by limiting its shock absorption capacity.
To address the external imbalance, policymakers have tightened domestic monetary conditions by allowing the Pakistani rupee to depreciate by around 30% over five episodes since the beginning of December 2017 and raising policy rates by 425 basis points, tightened fiscal policy, and imposed regulatory duties on imports of nonessential goods.
Total investment under CPEC amounted to about $18 billion as of the end of fiscal 2018 (around 6% of fiscal 2018 GDP), split between $11.5 billion in power sector projects under the independent power producers (IPP) scheme, which is taken on by the private sector, and $6.5 billion in public sector infrastructure projects. This compares with official estimates of a total projected value of $46 billion under the "early harvest" phase, and $62 billion for the entire project.
CPEC-related power supply has already started to come online, and will continue to enter the country''s electrical grid over the next decade, mostly in the next two to three years. 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 and an additional 20,000MW will come online over the next three years, mainly from CPEC-related IPPs. This additional capacity will allow Pakistan to have a power surplus as soon as the end of fiscal 2021, after accounting for long-standing grid connectivity issues that result in lower power supply, which the authorities are aiming to address.
However, the long-term success of CPEC also depends on the potential for the project to create new economic value chains and generate productivity gains, which would lift Pakistan''s growth potential further. The authorities are now focusing on the second phase of CPEC (the first phase being power and infrastructure, including Gwadar port), which involves investments in special economic zones (SEZs) to raise the manufacturing capacity of Pakistan.
Global competitiveness remains low, hampered by infrastructure, institutional constraints and quality of human capital Pakistan''s global competitiveness remains low compared with peers.
We expect CPEC to ease some supply-side constraints, but relatively weak human capital and institutional constraints will continue to weigh on Pakistan''s economic competitiveness, at least over the next few years.
Meanwhile, institutional reforms, which the government has also set sights on, will be challenging for any government to navigate because of the country''s large bureaucracy, complex federal-provincial politics and administrative arrangements.
Our "Very Low (+)" institutional strength score for Pakistan reflects its very low rankings on the Worldwide Governance Indicators for government effectiveness, rule of law and control of corruption. The score is set above the indicative of "Very Low (-)" to take into account institutional improvements in recent years and prospects for further reforms.
Greater central bank autonomy, including the creation of an independent Monetary Policy Committee, has fostered monetary policy credibility and effectiveness and lowered inflation volatility. Economic policies and reforms have also started to filter through into higher manufacturing and export activity and stronger business sentiment, albeit from low levels.
We expect the reform momentum to continue - although it slowed after the completion of the 2013-16 IMF program - as international finance institutions (IFIs) such as ADB, World Bank (IBRD, Aaa stable) and the IMF are providing policy and technical assistance. Other countries with a "Very Low (+)" score for institutional strength include Belize (B3 stable), Kyrgyz Republic (B2 Stable) and Uganda (B2 stable).
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, but its scores are in line with Bangladesh''s. Pakistan''s WGI scores also rank below the 20th percentile among the sovereigns we rate, although the scores have largely increased since 2011-13.
The average inflation in fiscal 2018 fell to 3.8%, below the government''s target of 6%, mainly because of lower food prices. Given the sharp depreciation of the rupee since December 2017 and higher electricity and gas tariffs, we expect inflation to rise to an average of 7% over fiscal 2019 before moderating to an average of 6.5% in fiscal 2020.
The 425 basis points in monetary policy tightening delivered by SBP in 2018 was in part driven by the central bank''s expectation of higher inflation, which lends credibility to its policy framework.
The SBP also announced in December 2017 its decision to let the value of the rupee reflect demand and supply in the foreign-exchange market. The currency depreciations over the past 12 months are in largely line with the new exchange rate regime, although currency interventions have continued to prevent excess currency volatility. Given the ongoing supply-demand imbalance for US dollars because of the current-account deficit and the shallow foreign-exchange market in Pakistan, we expect further pressure on the rupee and on foreign-exchange reserves. We also see room for further monetary policy tightening with inflation potentially rising further, and as interest rates remain around average levels compared with the past two decades.
Combined accumulated cumulated losses at SOEs, including Pakistan International Airlines and Pakistan Steel Mills, have risen to around Rs 1.2 trillion as of the end of June 2018 (3.6% of fiscal 2018 GDP), compared with total losses across all SOEs of around Rs 650 billion as of fiscal 2016 (2.2% of fiscal 2016 GDP). The state-owned power sector has also re-accumulated debt of around Rs 660 billion (1.9% of fiscal 2018 GDP) - commonly referred to as "circular debt" - after having cleared them in the 2013-16 IMF program, because of lower tariffs charged by the distribution companies relative to the price they pay for the power through power purchase agreements, transmission losses that reduce the amount of electricity that can be sold, and nonpayment by customers.
Our "Very Low (-)" assessment of Pakistan''s fiscal strength is driven by the government''s very narrow revenue base, which hinders debt affordability, reduces fiscal flexibility given ongoing infrastructure and social spending needs, and increases the debt burden. The country''s revenue-generation capacity, as measured by government revenue as a percent of GDP, is among the lowest within our rated universe. The foreign-currency portion of outstanding general government debt, while not large at around 35% of total government debt, also exposes the government''s balance sheet to foreign exchange risks.
The government''s fiscal deficit widened to 6.4% of GDP in fiscal 2018 from 5.6% in fiscal 2017. The fiscal 2018 outturn was worse than we had expected because of higher current expenditure and lower-than-budgeted government revenue intake, both the result of budgetary measures ahead of the general election in July 2018. The slippage was also largely at the provincial level because the provinces are constitutionally allotted 57.5% of total government revenue and therefore account for more than half of total government spending.
While election-year impact is one-off, we expect the fiscal deficit to remain around 5.0%-5.4% over fiscal 2019 and fiscal 2020, given still-large development spending needs due to ongoing implementation of infrastructure projects and higher interest payments. In particular, interest payments are set to increase as frequent rollovers of the government''s Treasury bills will transmit higher domestic interest rates to the government''s finances.
By comparison, the new government is targeting a deficit of 5.1% for fiscal 2019 in its "mini-budget" that was presented in September 2018, after its election in July. The mini-budget envisages lower development spending and additional revenue measures relative to the pre-election budget for fiscal 2019, which the government has said would have resulted in a deficit of 6.5%-7.0% of GDP.
At an estimated 72.1% of GDP as of the end of fiscal 2018, the government''s debt stock is higher than the 58.4% median for B-rated sovereigns. We expect the government debt burden to rise further and peak at around 76% of GDP in fiscal 2020 - in part because of currency depreciation - before gradually declining as the twin deficits gradually narrow. Pakistan''s foreign currency-denominated debt is not particularly large compared with peers. However, the share of foreign-currency debt has increased because of foreign-currency borrowing for infrastructure projects and to finance the balance of payments deficit. The rising share of foreign-currency debt exposes the government to sharp local currency depreciations, which has crystallized over the past 12 months. That said, the structure of external debt mitigates roll-over and debt affordability risks on the government''s foreign-currency obligations. Over three-fourths of the government''s external borrowings are due to multilateral and bilateral sources, which are typically borrowed on concessional terms with very long maturities and significant grace periods.
We assess Pakistan''s susceptibility to event risk to be "High", driven by external vulnerability risk, as external pressures continue to weigh on the country''s foreign-exchange reserve adequacy. Political risk and government liquidity risk also challenge the credit profile, while banking sector risks are relatively benign. Political risk: High (-) Our assessment of Pakistan''s political risk at "High (-)" reflects a moderate probability of a high impact scenario involving tensions between the different branches of the government, which could threaten political stability and divert essential policy and economic resources, or an escalation of terrorism, which could dampen economic sentiment and deter investment.
Pakistan''s government liquidity risk is set at "High (-)", above the indicative score of "Moderate (-)", to reflect the magnitude of the sovereign''s gross borrowing requirements, which are among the highest in our rated universe, and potentially rising share of external debt given government borrowing to finance the country''s current-account deficit.
Sizable fiscal deficits and the reliance on short-term debt, in particular Treasury bills issued domestically, have contributed to very high gross borrowing requirements. At an estimated 34.7% of GDP, Pakistan''s gross borrowing requirement in fiscal 2019 will be the third largest among all rated sovereigns, after Japan (A1 stable) and Egypt (B3 positive), and higher than most similarly rated peers.
The stock of short-term Treasury bills, which have to be frequently rolled over, has increased and amounted to 38.6% of gross government debt (or close to 12% of forecast fiscal 2019 GDP) as of the end of September 2018. While the Treasury bills are denominated in local currency, which mitigates roll over 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. Any increase in domestic interest rates would quickly transmit into higher borrowing costs for the government, which would further weaken debt affordability. Expectations for higher interest rates given still-strong domestic demand, rising inflation, and efforts by policymakers to curb import demand have reduced banks'' appetite for longer-term debt instruments.
With total banking system assets of about 50% of GDP as of the end of September 2018, the size of Pakistan''s banking system is relatively small. Banks are well-funded by deposits - the average loan/deposit ratio is 55% - with limited reliance on market or foreign funding. We expect efforts to deepen financial inclusion and remittance inflows to support continued growth in bank deposits. At an average Tier-1 capital adequacy ratio of 13.2% as of the end of September 2018, bank capitalization levels are well above the regulatory requirement of 7.5%. Nonperforming loans (NPLs) have also declined on average to 8.0% of total loans as of the end of September 2018 from a peak of 16.7% in the third quarter of 2011, while NPLs net of provisioning was 1.2% of net advances, reducing the risk to bank capital and, ultimately, the sovereign credit profile. The operating environment for banks nevertheless remains challenging, given the rupee depreciation, higher interest rates and our expectation for growth to slow, in addition to structural issues relating to the availability of information on borrowers and concentration risk. However, banks have limited foreign-currency exposure, with foreign-currency loans amounting to 7.5% of total assets, given strict exposure limits imposed by SBP. Domestic interest rates also remain below their 20-year average, which limit default risk, barring a sharp deceleration in economic activity. Higher interest rates would benefit banks'' net interest margins.
We expect Pakistan''s current-account deficit to narrow slightly, in part as a result of the policy measures, to 4.7% in fiscal 2019 and 4.1% in fiscal 2020, from the wider-than-expected deficit of 6.1% in fiscal 2018. The gradual transition to and government focus on the second phase of CPEC - which involves private sector investment in Pakistan''s industry and will have lower import content relative to power projects - will also keep import growth contained. Increased remittances are a further bright spot, having picked up post-election and are up 15% year on year over the first four months of fiscal 2019.
Foreign-exchange reserves fell to $7.5 billion as of the end of October 2018, down nearly 60% from their June 2016 peak. The import cover of foreign-exchange reserves has consequently fallen to around 1.5 months, below the IMF''s recommended minimum adequacy level of three months. Pakistan''s External Vulnerability Indicator (EVI4) reading has also risen above 170% for fiscal 2019, from 84% for fiscal 2018, pointing to a marked reduction in the coverage of total external debt of the economy due over fiscal 2019 by foreign-exchange reserves.
The recent arrangement with Saudi Arabia (A1 stable) amounting to $6 billion in balance of payments support - split between deposits with the SBP and a deferred payment facility for oil imports - partly reduces this risk.
Separate arrangements may be possible with other countries including China and the United Arab Emirates (Aa2 stable). Ongoing negotiations with the IMF for a new program, if successful, would also bolster foreign-exchange reserves and lower external vulnerability risk.
Pakistan''s debt structure slightly mitigates the risk of low reserve adequacy. Only a quarter of the repayments (principal plus interest) are due to Eurobond and Sukuk holders, with about another quarter due to commercial banks. More than 50% of repayments are owed to multilateral or bilateral sources, where the likelihood refinancing is significantly higher. Eurobond and Sukuk repayments for the remainder of fiscal 2019 amount to around 15% of reserves as of the end of fiscal 2018 - including commercial loans would raise the percentage to around 40%.