Moody’s Investors Service has changed the outlook for Pakistan from negative to stable after improvements because of the IMF program and has affirmed the Government of Pakistan’s local and foreign currency long-term issuer and senior unsecured debt ratings at B3.
The credit rating agency stated that the change in outlook to stable is driven by Moody’s expectations that the balance of payments dynamics will continue to improve, supported by policy adjustments and currency flexibility.
Such developments reduce external vulnerability risks, although foreign exchange reserve buffers remain low and will take time to rebuild. Moreover, while fiscal strength has weakened with higher debt levels largely as a result of currency depreciation, ongoing fiscal reforms, including the country’s International Monetary Fund (IMF) program, will mitigate risks related to debt sustainability and government liquidity, said the rating agency.
The rating affirmation reflects Pakistan’s relatively large economy and robust long-term growth potential, coupled with ongoing institutional enhancements that raise policy credibility and effectiveness, albeit from a low starting point, added Moody’s.
These credit strengths are balanced against structural constraints to economic and export competitiveness: the government’s low revenue generation capacity that weakens debt affordability, fiscal strength that will remain weak over the foreseeable future as well as political and still-material external vulnerability risks.
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. The associated payment obligations are, in Moody’s view, direct obligations of the Government of Pakistan.
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 domiciled in the country.
Improving Balance of Payments Dynamics Reduces External Vulnerability Risks
Moody’s said that narrowing current account deficits, in combination with enhancements to the policy framework including currency flexibility, lower external vulnerability risks in Pakistan. However, foreign exchange reserve adequacy will take time to rebuild.
Moody’s expects Pakistan’s current account deficit to continue narrowing in the current and next fiscal year (ending June of each year), averaging around 2.2% of GDP, from more than 6% in fiscal 2018 (the year ending June 2018) and around 5% in fiscal 2019.
Under Moody’s baseline assumptions, subdued import growth will likely remain the main driver of narrowing current account deficits. In particular, the ongoing completion of power projects will reduce capital goods imports, while oil imports will remain structurally lower given the gradual transition in power generation away from diesel to coal, natural gas and hydropower.
It further said that currently tight monetary conditions and import tariffs on nonessential goods will also weigh on broader import demand for some time, although Moody’s sees the possibility of monetary conditions easing when inflation gradually declines towards the end of the current fiscal year.
Exports to Pick Up
Moody’s expects exports to gradually pick up on the back of the real exchange rate depreciation over the past 18 months, also contributing to narrower current account deficits. The government is focusing on raising the country’s trade competitiveness and has recently rolled out a National Tariff Policy aimed at incentivizing production for exports or import substitution.
Moody’s expects policy enhancements, including strengthened central bank independence and the commitment to currency flexibility, to support the reduction in external vulnerability risks. In particular, the government is planning to introduce a new State Bank of Pakistan (SBP) Act to forbid central bank financing of government debt and clarify SBP’s primary objective of price stability. The central bank has already stopped purchases of government debt in practice since the start of fiscal 2020.
Improved Balance of Payments Dynamics
Notwithstanding the improved balance of payments dynamics, Moody’s stated that Pakistan’s foreign exchange reserve adequacy remains low. Foreign exchange reserves have fluctuated around $7-8 billion over the past few months, sufficient to cover just 2-2.5 months of goods imports. Coverage of external debt due also remains low, with the country’s External Vulnerability Indicator — which measures the ratio of external debt due over the next fiscal year to foreign exchange reserves — remaining around 160-180%.
The IMF program, which commenced in July 2019, targets higher foreign exchange reserve levels and has unlocked significant external funding from multilateral partners including the Asian Development Bank and the World Bank. Nevertheless, unless the government can effectively mobilise private sector resources, foreign exchange reserves are unlikely to increase substantially from current levels.
Ongoing Fiscal Reforms Will Strengthen Very Weak Government Finances
Moody’s, on the fiscal side, said that Pakistan’s metrics have weakened recently, with wider fiscal deficits and an increase in government debt burden largely as a result of currency depreciation over the course of fiscal 2019. However, Moody’s expects ongoing fiscal reforms, anchored by the IMF program and technical assistance from other development partners, will contribute to a gradual narrowing of fiscal deficits. The reforms will also mitigate debt sustainability and government liquidity risks.
Moody’s expects the government’s fiscal deficit to remain relatively wide at around 8.6% of GDP in fiscal 2020, compared to 8.9% in fiscal 2019, before narrowing to an average of around 7% over fiscal 2021-23. High-interest payments owing to policy rate hikes will continue to weigh on government finances and significantly constrain fiscal flexibility. Meanwhile, government revenue as a share of GDP, while likely to increase, is growing from a lower base, having declined significantly in fiscal 2019.
To widen the tax net, the fiscal authorities have eliminated a number of tax exemptions and concessions and lowered the minimum threshold for personal income taxes. The authorities are also introducing automatic income tax filing to reduce tax evasion and applying the sales tax to a wider group of businesses. Support from the IMF and the World Bank will raise the effectiveness of the revenue measures.
However, Moody’s estimates that the revenue growth targets set by the IMF program are challenging to achieve in full in a subdued economic growth environment. In particular, Moody’s expects Pakistan’s GDP growth to slow to 2.9% in fiscal 2020 from 3.3% last fiscal year, given tight financial conditions that continue to weigh on domestic demand, before rising to 3.5% in fiscal 2021.
On the expenditure side, the government has introduced a new Public Financial Management (PFM) Act, which was approved in June 2019, to instil budget discipline.
Given baseline assumptions of gradually narrowing fiscal deficits, Moody’s expects the government’s general government debt to slowly decline over the next few years to around 75-76% of GDP by 2023, still a high debt burden, from a peak of around 82-83% of GDP currently.
In addition to the gradual decline in the debt burden, the debt structure will also continue to become more favourable. The government has already reprofiled a substantial portion of domestic debt from short-term Treasury bills into longer-term floating rate bonds.
This will reduce gross borrowing requirements to around 25% of GDP in fiscal 2020, from nearly 40% in the last fiscal year.