‘Economic slowdown to adversely affect loan quality, profitability’

KARACHI: Banking profitability and loan quality will adversely be hurt by the slowdown in Pakistan’s economy that is expected to modestly grow 1.5 percent this fiscal year compared to 0.4 percent contraction a year earlier, ratings agency Moody’s said on Wednesday.

Moody’s Investors Service said stable outlook for the country’s banking system reflects banks’ solid funding and liquidity “although a challenging – but improving – operating environment will weigh on asset quality and profitability.”

“Despite a difficult environment, the government’s credit profile is stable due to ongoing reforms and increasing policy effectiveness. This is positive for the banks since their outsized holdings of Pakistani government debt links their credit profiles to that of the government,” Constantinos Kypreos, a Moody’s senior vice president said in the banking system’s outlook report.

The report covers projections for the economic indicators and their impact on the banking system as banks’ heavy exposure to government bonds continues to link banks’ credit profiles with the fiscal strength of the government.

Moody’s projects the growth to accelerate at 4.4 percent in 2022.

“However, economic activity will remain below pre-COVID levels for some time and vulnerable to successive waves of coronavirus infection, even as confidence has gradually rebounded from low levels,” it said. “The slow economic recovery will hurt government finances, while successive waves of coronavirus infection weigh on consumer spending and business confidence, all of which will affect the banking sector.”

Moody’s expects government deficit of 8 percent for 2021, with rising arrears and circular debt in the energy sector also affecting corporates’ repayment capabilities. Wide fiscal deficits, which will – to a large extent – be financed by local banks, may also take precedence over the private sector’s lending that is to grow by between 5 and 7 percent in 2021, below inflation expectations of 8 percent. Interest rates remain at the low end of historical rates, but muted confidence levels will prevent more robust growth.

Pakistani banks are heavily exposed to the B3-rated Pakistan sovereign through large holdings of government securities and lending. This links their creditworthiness with that of the government. Pakistani banks hold government securities worth Rs10.3 trillion, a sum equivalent to 7.2x their Tier 1 capital at the end of September 2020. Including lending to the government and to public-sector entities, the exposure rises to around 9.0x of Tier 1 capital.

“We expect government exposure to remain high over our outlook horizon because Pakistani banks will remain the main source of financing for the government. The government’s commitment to stop borrowing from the central bank will also lead to increased government reliance on banks to meet its financing needs,” Moody’s said.

Moody’s said nonperforming loans (NPLs) in the banking sector rose to 9.9 percent of total loans as of September 2020 (8 percent as of December 2018), and NPLs are expected to increase further as the economic slowdown takes its toll on borrowers’ repayment capabilities.

Moody’s said deposits will remain the primary source of funding for Pakistani banks over the outlook period, supported by initiatives to deepen financial inclusion and banking penetration, as well as a high level of remittances from Pakistani emigrant workers. Customer deposits accounted for 74 percent of total assets as of September 2020, of which around half are stable household deposits. Moody’s said Pakistan remains in the Financial Action Task Force’s (FATF) grey list as a result of deficiencies in its anti-money laundering and combatting terrorism financing capabilities. Authorities have, however, agreed an action plan with FATF to negotiate an exit from the grey list, and have now largely addressed 21 of the 27 actionable items. Partly as a result of AML issues, Habib Bank and United Bank have surrendered their US banking licenses and closed their US branches.

“Failure to meet AML requirements could push international banks to cut correspondent bank relationships, affecting banks’ foreign currency liquidity, business generation capabilities and leading to higher refinancing and compliance costs.”