NEW YORK (NNI): Moody’s Investors Service has affirmed the Government of Pakistan’s B3 issuer and senior unsecured ratings, and maintained a stable outlook.
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 macrostability-enhancing reforms started under the International Monetary Fund (IMF)’s Extended Fund Facility (EFF) program in 2013-16.
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. Domestic politics and geopolitical risk also continue to represent a significant constraint on the rating.
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 Int’l 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.
The outlook for growth has strengthened as a result of increased macroeconomic stability due to reforms started during the three-year IMF EFF program and following the launch of the CPEC project in 2015.
In the fiscal year ended June 2016 (FY2016), real Gross Domestic Product (GDP) growth reached 4.5 percent, up from 4.1 percent in both FY2015 and FY2014. Moody’s expects such growth rates to be maintained or exceeded in the next few years. By contrast, the median rate of growth for B-rated sovereigns was just 2.7 percent in 2016.
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 towards 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 6.0 percent growth in FY2018, rising to 7.0 percent by FY2020.
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 FY2016, 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.
At 67.6 percent of GDP in FY2016, 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.
Further fiscal consolidation, after the deficit narrowed to 4.4 percent of GDP in FY2016 from 8.1 percent of GDP in FY2013, will be challenging. The government had set fiscal deficit targets of 3.8 percent of GDP for FY2017 and 3.5 percent for FY2018.
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 FY2017 and FY2018 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 FY2017 and 5.0 percent in FY2018 despite the government’s intention to advance fiscal consolidation.
The government’s revenue projections for FY2018 are based on GDP growth projections that we consider to be optimistic. Meanwhile, 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.
Large fiscal deficits and a reliance on short-term debt have also contributed to very high gross borrowing requirements. At about 32.0 percent of GDP, Pakistan’s projected gross borrowing need for 2017 is one of the highest among rated sovereigns. Meanwhile, with nearly 31 percent of outstanding government debt in foreign currency in FY2016, 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.
Although foreign exchange reserve buffers have increased nearly fourfold since the onset of the IMF program 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.
As a net oil importer, 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 7.0 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 FY2017 and 2.9 percent in FY2018 from 1.2 percent in FY2016.
In response to mounting external pressure, in March 2017, the central bank introduced a 100 percent cash margin requirement on certain imported consumer goods. Meanwhile, 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, we expect 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.
The stable outlook represents our expectation of balanced upside and downside risks to the sovereign credit profile. 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 our current expectations.
Meanwhile, 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 we currently envisage.
Moreover, the fiscal costs related to the project and, more generally, development spending could raise Pakistan’s debt burden more rapidly and significantly than we expect.
In addition, recent indications of renewed increases in external pressure could develop into greater external vulnerability.
Meanwhile, political event risk remains high in Pakistan, due to recurrent terrorist attacks.