Moody’s changes Pakistan's ratings outlook from stable to negative

SINGAPORE: Moody’s on Wednesday changed the outlook on Pakistan’s rating to negative from stable but affirmed the B3 debt ratings, considered as being speculative and a high credit risk.   

The decision to change the outlook to negative is driven by heightened external vulnerability risk. Foreign exchange reserves have fallen to low levels and, absent significant capital inflows, and will not be replenished over the next 12-18 months. Low reserve adequacy threatens continued access to external financing at moderate costs, in turn potentially raising government liquidity risks.

The ratings agency said the decision to affirm the B3 rating reflects Pakistan’s robust growth potential, supported by ongoing improvements in energy supply and physical infrastructure, which are likely to raise economic competitiveness over time.

These credit strengths balance the fragile external payments position and very weak government debt affordability owing to low revenue generation capacity.

Concurrently, Moody’s also affirmed the B3 foreign currency senior unsecured ratings for the second and third Pakistan International Sukuk, considered direct obligations of the government of Pakistan.

Furthermore, 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.

The short-term foreign currency bond and deposit ceilings remain unchanged at not-prime. These ceilings act as a cap on the ratings that can be assigned to the obligations of other entities in the country.

Foreign exchange reserves to fall further

The ratings agency expects Pakistan’s external account to remain under significant pressure. Foreign exchange reserves will likely fall further from already low levels due to imports, while external debt payments due will weaken from currently adequate levels.

In turn, higher foreign currency borrowing needs, in combination with the low levels of foreign exchange buffers, risks weighing on the ability of the government to access external financing at moderate costs.

First, external vulnerability risks are related to sizeable current account deficit, which Moody’s expect will only narrow slightly to around 4-4.3% of GDP over the next few years, after an expected 4.6% in fiscal year 2018 compared to an average deficit of around 1.5% between FY2014 and FY2016.

Furthermore, continued growth in imports of goods, driven by demand for capital goods under the China-Pakistan Economic Corridor (CPEC) project, higher fuel prices and robust household consumption, will prevent a significant narrowing of the current account deficit.

Although goods exports have picked up since the start of 2018, growing around 10-15% per year, they will not be enough to narrow the trade gap. As a result, unless capital inflows increase significantly, Moody’s does not expect official foreign exchange reserves to replenish from their current low levels.

Stable foreign direct investment (FDI) inflows have not kept pace with the increased outflows driven by trade. As of end-May 2018, official foreign exchange reserves were around $10 billion, down more than 40% from their October 2016 peak and sufficient to cover just two months of imports.

Import cover of reserves to fall to around 1.7 months

Moody’s projects that the import cover of reserves will likely fall to around 1.7-1.8 months over the next fiscal year, below the adequacy level of three months generally recommended by the International Monetary Fund.

The agency expects the government’s tax amnesty scheme, which expires in June 2018, to have a modest impact of around $2-3 billion in foreign exchange inflows.

Second, the coverage by foreign exchange reserves of external debt payments due is weakening, pointing to further external vulnerability risks.

With a significant rise in equity inflows unlikely, Moody’s expects the external financing gap to be met by increased foreign currency borrowing, mainly by the government.

Pakistan’s external vulnerability indicator, the ratio of external debt payments due over the next year plus total nonresident deposits over one year to foreign exchange reserves, will rise to over 120% in FY2019 and further in FY2020, from around 80-85% at the start of FY2018.

Policy tool to have negative economic impact

The agency states that while policymakers have started to respond to the external pressures, the policy tools available are politically challenging and would likely have a negative economic impact.

It stated that the government has so far allowed the rupee to depreciate by a total of 15% against the US dollar since December 2017, raised policy rates by a total of 75 basis points, and imposed regulatory duties on imports of nonessential goods.

Moody’s expects these measures to contribute to somewhat lower growth, at 5.2% on average over the next two fiscal years, from an expected 5.8% in FY2018, and higher inflation at 7.0% in FY2019, from around 4% in FY2018.

Further currency depreciation, higher policy rates, fiscal tightening, and/or higher regulatory duties would likely weigh further on growth and raise inflation above Moody’s current projections.