Moody's Investors Service (Moody's) has affirmed the government of Pakistan B3 rating and senior unsecured ratings, but cautioned that domestic politics, stalling of the government's post-IMF programme reform agenda and geopolitical risk may continue to represent a significant constraint on the rating.
The report added that large fiscal deficits and a reliance on short-term debt have contributed to very high gross borrowing requirements. At about 32 percent of GDP, Pakistan's projected gross borrowing need for 2017 is one of the highest among rated sovereigns. With nearly 31 percent of outstanding government debt in foreign currency in fiscal year 2016, Pakistan is exposed to marked changes in the cost of refinancing debt, should the local currency weaken abruptly.
In addition, debt affordability metrics, which include interest payments as a percentage of revenues and GDP, are very weak for Pakistan relative to its peer group. At around 28 percent of revenues in 2016, Pakistan spends nearly three times as much revenue on interest payments as the median of B-rated sovereigns at about 10 percent.
Foreign exchange reserve buffers have increased nearly fourfold since the onset of the IMF programme and cover more than the full amount of external debt payments; they are still low in relation to current account payments and have been declining since their recent peak around September 2016. As of April 2017, import coverage had fallen from a high of about five months in mid-2016 to below four months. This is only slightly above the IMF's three-month minimum adequacy level.
At 67.6 percent of GDP in fiscal year 2016, the government's debt burden is materially higher than the B-rated median of 52.6 percent. Moody's expects the debt burden to remain broadly stable over the next two years.
The report states that Moody's would view a stalling of the government's post- International Monetary Fund (IMF) program reform agenda, including revenue reforms and the strengthening of monetary policy and central bank independence, to be credit negative. Any material widening of the fiscal deficit, renewed weakening of the external payments position, loss of multilateral/bilateral financial support, or significant escalation in political tensions would also weigh on Pakistan's credit profile.
Pakistan's medium-term growth outlook is strong, supported by the China-Pakistan Economic Corridor (CPEC) project to address critical infrastructure constraints, and the continuing effects of macro-stability-enhancing reforms started under the IMF's Extended Fund Facility (EFF) program.
However, the government's debt burden is high and fiscal deficits remain relatively wide, driven by a narrow revenue base that also restricts development spending. In addition, foreign exchange reserve adequacy, albeit stronger than a few years ago, would still be vulnerable to any significant increase in imports. The decision to maintain the stable outlook on Pakistan's B3 rating reflects broadly balanced risks related to these two sets of factors.
Concurrently, Moody's has affirmed the B3 foreign currency senior unsecured ratings for the second Pakistan International Sukuk Co Ltd and the third Pakistan international Sukuk co. ltd.
Pakistan's Ba3 local currency bond and deposit ceilings remain unchanged. The B2 foreign currency bond ceiling and the Caa1 foreign currency deposit ceiling are also unchanged. These ceilings act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country.
From a macroeconomic stability perspective, the IMF program succeeded in fostering fiscal deficit reduction, more rigorous inflation management and the rebuilding of foreign exchange reserves. While further progress will be challenging, as fiscal metrics remain weak and reserve adequacy is relatively fragile, our baseline assumption is that the steps that the authorities have taken in the last 3-4 years will not be reversed. Continued government commitment to reform implementation will help to reinforce fiscal and monetary discipline, preserving recent macroeconomic stability gains.
Moody's expects that real GDP growth will rise to 6 percent over the next few years, as the economic benefits of the CPEC gradually materialize and past policy reforms continue to support economic potential. The CPEC will increase Pakistan's competitiveness and lift potential GDP growth by relieving supply-side constraints, particularly in power and transport infrastructure, and by catalyzing private sector investment.
However, security related issues and a weak track record of public project implementation suggest the pace of project execution will be relatively slow. Therefore, while the CPEC will support Pakistan's credit profile, Moody's expects the economic impact to materialize more slowly than the government envisions, resulting in real GDP growth closer to 5.5 percent over the next two years, compared to government forecasts for 6 percent growth in fiscal year 2018, rising to 7 percent by fiscal year 2020. Despite relatively robust GDP growth, weak government revenue generation poses fiscal constraints. It limits growth potential by curbing the government's capacity to spend on physical and social infrastructure development.
General government revenues were equivalent to only 15.5 percent of GDP in fiscal year 2016, lower than most of Pakistan's rating peers. This reflects the government's narrow tax base, linked to very low per-capita incomes, along with weak tax compliance and administration, despite some improvements related to IMF program reforms.
Further fiscal consolidation, after the deficit narrowed to 4.4% of GDP in fiscal year 2016 from 8.1 percent of GDP in fiscal year 2013, will be challenging. The government had set fiscal deficit targets of 3.8 percent of GDP for fiscal year 2017 and 3.5 percent for fiscal year 2018. However, despite relatively disciplined spending, revenue collection has fallen short of the target in the first half of this fiscal year. As a result, in June 2017, the government revised its fiscal year 2017 and fiscal year 2018 deficit targets to 4.2 percent and 4.1 percent of GDP, respectively.
Moody's expects the fiscal deficit to widen to about 4.7 percent of GDP in fiscal year 2017 and 5 percent in fiscal year 2018 despite the government's intention to advance fiscal consolidation. The government's revenue projections for fiscal year 2018 are based on GDP growth projections that Moody's considers to be optimistic.
Development spending - particularly related to CPEC power infrastructure investments - combined with political pressure ahead of the 2018 general election to maintain power subsidies, which are currently budgeted for about Rs 103 billion, will weigh on the public finances.
Pakistan has benefited from lower global oil prices, but the uptick in prices last year, combined with an increase in imported CPEC capital goods, widened the trade deficit. In addition, worker remittance inflows from abroad, which amount to nearly 7 percent of GDP, have declined. As a result, the current account deficit has widened and external pressures are building. Moody's expects the current account deficit to grow to about 2.7 percent of GDP in fiscal year 2017 and 2.9 percent in fiscal year 2018 from 1.2 percent in fiscal year 2016.
In response to mounting external pressure, in March 2017, the central bank introduced a 100 percent cash margin requirement on certain imported consumer goods. On July 5, 2017, after nearly two years of stability, the Pakistani rupee depreciated by about 3 percent following foreign exchange market intervention by the central bank. The intervention responded to mounting external pressures and deterioration of export competitiveness, following persistent real effective exchange rate appreciation. The Pakistani rupee has retraced much of its recent depreciation.
Greater exchange rate flexibility would contribute to a more durable accumulation of foreign exchange reserves over time, which would help to strengthen external buffers and export competitiveness. The resulting reduction in external vulnerabilities would support Pakistan's credit profile. However, while Moody's believes this to be the central bank's medium-term objective, it expects any shift in exchange rate management to be gradual, as the government will likely want to avoid abrupt currency and other price movements, in particular in advance of the 2018 general election.
Support from multilateral and bilateral lenders has bolstered Pakistan's foreign currency reserves and progress on economic reforms, and there is potential for further strengthening in growth and policy effectiveness beyond Moody's current expectations. The successful implementation of the CPEC project has the potential to transform the Pakistani economy by removing infrastructure bottlenecks, and stimulating both foreign and domestic investment.
However, downside risks also exist. In particular, the economic benefits of CPEC are still highly uncertain and power supply may continue to constrain growth to a greater extent than Moody's currently envisages. Moreover, the fiscal costs related to the project and, more generally, development spending could raise Pakistan's debt burden more rapidly and significantly than the rating agency expects. In addition, recent indications of renewed increases in external pressure could develop into greater external vulnerability.