Fitch Ratings-Hong Kong-14 December 2018: Fitch Ratings has downgraded Pakistan's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'B-' from 'B'. The Outlook is Stable.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
The downgrade reflects heightened external financing risk from low reserves and elevated external debt repayments, as well as a continued deterioration in the fiscal position, with a rising debt/GDP ratio. A successful conclusion of ongoing negotiations on IMF support could help stabilise external finances, but the programme would then face significant implementation risk.
Liquid reserves have continued to fall, reaching USD7.3 billion as of 6 December 2018 - equivalent to 1.5 months of imports - despite significant stabilisation efforts by the State Bank of Pakistan (SBP) and the new Pakistan Tehreek-e-Insaf-led coalition government. We also project high gross financing needs, with an expected narrowing of the current account deficit offset by higher external debt service payments relative to last year. Sovereign debt-service obligations over the next three years amount to USD7 billion-9 billion per year, including a USD1 billion Eurobond repayment due in April 2019. External debt servicing will stay high throughout the next decade, with China Pakistan Economic Corridor (CPEC)-related outflows set to begin in the early 2020s.
The SBP has raised interest rates by a cumulative 425bp during 2018 and has allowed the rupee to fall by 24% against the US dollar since December 2017. Fitch forecasts the current-account deficit to narrow to 5.1% of GDP in the fiscal year ending June 2019 (FY19) and to 4.0% in FY20, from a revised 6.1% in FY18. Rupee depreciation, lower oil prices and newly imposed import duties will drive a deceleration in imports, while exports are likely to strengthen gradually. However, this may not be sufficient to re-build reserve buffers sustainably.
Bilateral financial assistance, including USD3 billion in short-term financing from Saudi Arabia (in addition to USD3 billion in deferred oil payments) along with undisclosed commitments from China and the UAE, has helped plug the near-term financing gap. The government also requested an IMF programme in mid-October 2018, with progress already made in related discussions. Successful negotiations could attract more stable and sustained financing by opening up budget support from the World Bank and the Asian Development Bank, and by improving access to bilateral lending and global capital markets. Implementation risks would be high in light of uneven adherence to previous programmes. Fitch estimates that in the absence of an IMF programme, liquid foreign-exchange reserves would continue falling to USD7 billion by FYE19.
Pakistan's debt/GDP ratio rose to 72.5% in FY18, from about 67% in FY17, due to rupee depreciation and a widening fiscal deficit. Fitch forecasts that the debt ratio will rise further, to 75.6% of GDP in FY19 on additional rupee depreciation. Debt is mainly denominated in local currency, but the pace of external borrowing has increased in the past two years. The government remains highly reliant on borrowing from the SBP and short-term treasury bill issuances as domestic banks lack appetite for longer maturity issues due to rising policy rates.
Fitch expects the fiscal deficit to narrow to 5.6% of GDP in FY19, from 6.6% in FY18, above the 5.1% target in the new government's FY19 mini-budget, which rolled back the previous government's tax relief plans, implemented new revenue measures and cut development expenditure. Revenue growth remained subdued in 1QFY19, but should pick up modestly as the government's policies come into place. Better fiscal coordination between the federal and provincial governments is also planned through the Fiscal Coordination Committee.
Pakistan's 'B-' IDR also reflects the following key rating drivers:
The accumulation of losses in public-sector enterprises poses a contingent liability for the government. So-called 'circular debt' (inter-company arrears) in the energy sector has continued to rise in the past few years and stands at about 3% of GDP due to inefficiencies, low tariffs and inadequate tariff collection. The new government is planning to reduce the accumulation and stock of circular debt.
Fitch forecasts GDP growth to fall to 4.2% in FY19, from a 13-year high of 5.8% in FY18, as monetary and fiscal tightening measures begin to weigh on activity. However, this remains above the current 'B' category median GDP growth of 3.5%. Reduced infrastructure capacity constraints, particularly in the energy sector, following CPEC investments, along with improved national security, could support growth in the medium term.
Inflation has risen due to significant rupee depreciation and higher energy prices. Fitch expects inflation to increase to an average of 7.0% in FY19, from 3.9% in FY18. Credit growth in the banking system remains robust. The system poses limited risk to the sovereign, as capital adequacy is well above regulatory minimums and represents a small share of GDP. Non-performing loans continued to decline, reaching 7.9% of total loans in FYE18, from a peak of 14.8% at FYE13.
The new government has an ambitious structural-reform agenda aimed at improving institutional governance and the business environment. This agenda could enhance medium-term policymaking and boost growth, but there are significant implementation challenges. Entrenched vested interests, internal coalition dynamics and a strong opposition could prevent the enactment of broad-reaching reforms.
Domestic security has improved, with a decline in terrorist incidents and casualties. Nevertheless, ongoing domestic threats continue to weigh on investor sentiment. Geopolitical tensions with neighbouring countries and issues around compliance with the intergovernmental Financial Action Task Force standards also pose risks.
Pakistan's rating is constrained by structural weaknesses in its development and governance indicators. Per capita GDP stands at USD1,519, well below the USD3,422 median of 'B' rated peers. Governance quality is also low, with a World Bank governance indicator score in the 22nd percentile, against a 'B' median in the 38th percentile.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Pakistan a score equivalent to a rating of 'B+' on the Long-Term Foreign-Currency IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term Foreign-Currency IDR by applying its QO, relative to rated peers, as follows:
- Structural: -1 notch to reflect domestic security issues and geopolitical risk arising from tension with neighbouring countries.
- External: -1 notch to reflect external financing pressure from the low level of liquid foreign-exchange reserves and rising external-debt repayments.
Fitch's SRM is the agency's proprietary multiple regression rating model, which employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign-Currency IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The main factors that could, individually or collectively, lead to a positive rating action are:
- Implementation of an effective policy stance to address external imbalances and facilitate a rebuilding of foreign-exchange reserves.
- Sustained fiscal consolidation sufficient to put debt on a downward trajectory.
- Improved export and growth prospects resulting, for example, from improvements in the business environment and the security situation as well as lower political risk.
The main factors that could, individually or collectively, lead to a negative rating action are:
- Inability to mobilise sufficient external funding to reduce financing strains, for example, through an IMF programme or other forms of bilateral assistance.