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December 3, 2019

Negative to stable: Moody’s upgrades Pakistan’s economic outlook

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December 3, 2019

KARACHI: Ratings agency Moody’s on Monday upgraded Pakistan’s credit outlook to stable from negative after more than one year as the IMF-backed reforms helped it improve its balance of payments position and stabilise currency.

Moody’s Investors Service affirmed the country’s local and foreign currency long-term issuer and senior unsecured debt ratings at B3 and changed the outlook to stable from negative.

“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,” Moody’s said in a statement.

“Such developments reduce external vulnerability risks, although foreign exchange reserve buffers remain low and will take time to rebuild.”

In June last year, the New York-based credit ratings agency downgraded the country to negative outlook due to external account’s vulnerability with foreign exchange reserves having plunged to the level not enough to pay 2 to 3 months of import bills.

The government ascribed the latest feat of improvement in credit outlook to its stability measures taken to heal the sagging economy.

“The upgradation of outlook to stable is affirmation of government’s success in stabilising the country’s economy and laying a firm foundation for robust long-term growth,” Adviser to Prime Minister on Finance Hafeez Shaikh said in a statement.

Moody’s sees a positive impact of IMF-backed reforms on the country’s external account sector. In July this year, the IMF approved a $6 billion loanprogramme for Pakistan against a score of conditions considered tough because of its implications for further slowing down growth.

The IMF program 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,” Moody’s said.

It said while fiscal strength has weakened with higher debt levels largely as a result of currency depreciation, ongoing fiscal reforms, including through the country’s IMF program, will mitigate risks related to debt sustainability and government liquidity.

It said the rating affirmation reflects the country’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.

“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.

Moody’s said narrowing current account deficits, in combination with enhancements to the policy framework including currency flexibility, lower external vulnerability risks in the country. “However, foreign exchange reserve adequacy will take time to rebuild.”

The ratings agency expects the country’s current account deficit to continue narrowing in the current and next fiscal years, averaging around 2.2 percent of GDP, from more than 6 percent in fiscal 2018 and around 5 percent in fiscal 2019.

“Under Moody’s baseline assumptions, subdued import growth will likely remain the main driver of narrowing current account deficits,” it said.

“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.”

Moody’s said tight monetary conditions and import tariffs on nonessential goods would weigh on broader import demand for some time, although it sees the possibility of monetary conditions easing when inflation gradually declines towards the end of the current fiscal year.

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 incentivising production for exports or import substitution.

“If effective, the policy, coupled with improvements in the terms of trade, will allow exports to grow more robustly,” it said.

“The substantial increase in power generation capacity over the past few years and improvements in domestic security have largely addressed two significant supply-side constraints and further support export-related investment and production.”

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 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. At the same time, it has strongly adhered to its commitment to a floating exchange rate regime since May 2019.

“These enhancements to the policy framework will foster confidence in the Pakistani rupee, while the use of the exchange rate as a shock absorber increases policy buffers,” it said. “Notwithstanding improved balance of payments dynamics, 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 percent.

On the fiscal side, 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 programme and technical assistance from other development partners, to contribute to a gradual narrowing of fiscal deficits. The reforms would also mitigate debt sustainability and government liquidity risks.

Moody’s expects the government's fiscal deficit to remain relatively wide at around 8.6 percent of GDP in fiscal 2020, compared to 8.9 percent in fiscal 2019, before narrowing to an average of around 7 percent 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,” Moody’s said. “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 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.

Moody’s expects Pakistan’s GDP growth to slow to 2.9 percent in fiscal 2020 from 3.3 percent last fiscal year, given tight financial conditions that continue to weigh on domestic demand, before rising to 3.5 percent in fiscal 2021.

Moody's expects the government's general government debt to slowly decline over the next few years to around 75-76 percent of GDP by 2023, still a high debt burden, from a peak of around 82-83 percent of GDP currently.

“In addition to the gradual decline in the debt burden, the debt structure will also continue to become more favourable,” Moody’s said.

“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 percent of GDP in fiscal 2020, from nearly 40 percent in the last fiscal year. The government is aiming to lengthen domestic maturities further and reduce its reliance on treasury bills and floating rate debt.

Moody’s expects that banks and other domestic institutional investors will retain strong appetite for government securities. Lower gross borrowing requirements and exposure to floating rate liabilities sustained over time will reduce the government’s exposure to liquidity and interest rate risks that is currently very high.

The affirmation of Pakistan's B3 rating is underpinned by the country's relatively large economy and robust growth potential, coupled with ongoing enhancements to the institutional and policy framework that raise policy credibility and effectiveness, albeit from a low starting point.

Economic and export competitiveness has been hampered by supply-side challenges, although power sector projects, including through the China-Pakistan Economic Corridor, have largely addressed chronic power shortages, domestic security has improved significantly in recent years, and ongoing investments in transport infrastructure will improve its quality and connectivity.

“Meanwhile, political risks remain material, despite a gradual normalisation of the working relationship between the federal government and the military and judiciary, as the institutional structure involves provincial level implementation of some fiscal and development policies, including services and property tax administration and the management of special economic zones.”

Meanwhile, Planning Minister Asad Umar Monday said Moody’s had downgraded Pakistan’s outlook from stable to negative after five years of the previous PML-N government on June 20, 2018.

“This was 2 months BEFORE PTI formed govt. After 15 months of PTI govt Moody’s upgrades Pak from negative to stable. Now you decide who destroyed Pak economy & who is rebuilding it,” he said.