SINGAPORE: Moody's Investors Service has changed the outlook on Pakistan's rating to negative from stable and affirmed the B3 local and foreign currency long-term issuer and senior unsecured debt ratings.
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, 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 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 Pakistan's fragile external payments position and very weak government debt affordability owing to low revenue generation capacity.
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 our 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.
Rationale for the negative outlook
Moody's expects Pakistan's external account to remain under significant pressure.
The coverage by foreign exchange reserves of imports will likely fall further from already low levels, while coverage of 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 Pakistan's 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 2018 (FY2018, fiscal year ending June 2018) and compared to an average deficit of around 1.5% between FY2014 and FY2016.
Further, 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% year-on-year in US dollar terms, they only amount to half the level of goods imports.
While Moody's assumes continued strong growth in exports, this 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, in particular, 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.
Under Moody's baseline projection, 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.
Moody's 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 Pakistan's 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.
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.
The authorities have so far allowed the Pakistani 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.
Rationale for the rating affirmation
Pakistan's relatively strong growth potential, enhanced by investment that strengthens and stabilizes power supply, provides the economy with some capacity to absorb external or domestic shocks.
Notwithstanding a moderate slowdown in near-term economic activity induced by policy tightening, Moody's expects GDP growth in Pakistan to remain robust, above 5%.
Pakistan's growth potential has risen in part with the gradual elimination of the country's chronic energy shortage, which encourage investment in other sectors.
Moody's expects the ongoing implementation of CPEC-related infrastructure projects to raise the country's growth potential further, by improving road and rail connectivity within Pakistan, and allowing it to function as a transport and logistics hub under China's Belt and Road Initiative.
CPEC-related investments over FY2019 and FY2020 include the ongoing implementation of further energy projects, infrastructure projects such as the Karachi Circular Railway, the Karachi-Lahore-Peshawar Railway, and a highway connecting Gwadar and Quetta, which will shorten travel times in the western route of CPEC, and the establishment of special economic zones aimed at boosting Pakistan's export sector.
That said, Pakistan's very low economic competitiveness remains a significant credit constraint.
The country's global competitiveness ranking is low compared to peers, at 115th out of 138 countries according to the World Economic Forum's 2017-2018 Global Competitiveness Report, due mainly to poor infrastructure (including the chronic power supply shortage that is gradually being addressed), weak institutions, and deficiencies in health and primary education.
Like many of its South Asian neighbors, Pakistan is also vulnerable to climate change risk.
The magnitude and dispersion of seasonal monsoon rainfall continues to influence agricultural sector growth and rural household consumption.
As a result, both droughts and floods can create economic and social costs for the sovereign.
Low revenue generation capacity, high gross borrowing weigh on debt affordability
In addition to the fragile external payments position, Pakistan's weak revenue generation capacity is a main credit constraint for the sovereign.
Moody's expects government revenue to remain around 16% of GDP over the next two fiscal years -- one of the lowest globally -- albeit gradually increasing given the authorities' focus on expanding the tax base and raising tax compliance.
As a result, debt affordability will remain among the weakest across Moody's rated sovereigns and constrain the government's fiscal space, particularly in light of ongoing infrastructure and social spending needs.
Moody's expects the government's fiscal deficit to remain around 5% of GDP in FY2019 and FY2020, after a projected deficit of 5.8% in FY2018.
Unless nominal GDP growth deteriorates substantially, Moody's does not anticipate that the government's debt burden will rise significantly. However, the debt burden will not fall from the current, relatively high levels, hovering around 70-73% of GDP.
As a result of persistent deficits and a significant share of overall debt being financed through short-term securities, the government's gross borrowing requirement is one of the highest across Moody's rated sovereigns, and expected to remain around 27-30% of GDP over the next two fiscal years.
With Treasury bills estimated at around 12% of FY2018 GDP, and an average maturity of government debt of less than four years, a sudden rise in the cost of debt beyond Moody's assumptions would have a rapid and significant negative effect on debt affordability.
What could change the rating up
The negative outlook signals that a rating upgrade is unlikely. The outlook would likely be changed to stable if external vulnerability risks decreased materially and durably, including through policy adjustments that strengthen the external payments position.
A resumption of fiscal consolidation pointing to a meaningful reduction in the debt burden would also be credit positive.
What could change the rating down
A further deterioration in Pakistan's external position, including a more pronounced erosion of foreign reserve buffers, which would threaten the government's external repayment capacity and heighten liquidity risks further, would likely result in a downgrade of the rating.
Expectations that government debt would continue to rise markedly, with a related deterioration in debt affordability from already weak levels, would also put downward pressure on the rating.
GDP per capita (PPP basis, US$): 5,095 (2017 Actual) (also known as Per Capita Income)
Real GDP growth (% change): 5.4% (2017 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 3.9% (2017 Actual)
Gen. Gov. Financial Balance/GDP: -5.6% (2017 Actual) (also known as Fiscal Balance)
Current Account Balance/GDP: -4.1% (2017 Actual) (also known as External Balance)
External debt/GDP: 27.3% (2017 Actual)
Level of economic development: Very Low level of economic resilience
Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.
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