Fitch revises outlook to negative

Fitch Ratings has revised the Outlooks on Pakistan's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to Negative from Stable and affirmed both IDRs at 'B'. A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
Pakistan's 'B' rating reflects a high public debt/GDP ratio, weak governance standards as measured by World Bank indicators, domestic political and security risks and a fragile external position, which are balanced by relatively strong growth. The revision of the Outlook on the Long-Term IDRs to Negative reflects the following key rating drivers:
Since the successful completion of Pakistan's three-year IMF Extended Fund Facility in September 2016, there has been a partial reversal of gains made under the programme. In particular, reserves have declined and the fiscal deficit has widened. Measures have recently been taken to address these trends, including some currency depreciation, tax rebates on exports, and import duties on non-essential items. However, these have proved insufficient thus far to arrest an ongoing decline in reserves. Moreover, political uncertainty and upcoming elections due by July 2018 are, in Fitch's view, likely to constrain the government's ability to address them convincingly in the near term.
Fitch forecasts that reserves (including gold) will fall to USD16.8 billion at end-FY18 (2.9 months of external current account payments), after having peaked at USD22.6 billion at the end of the IMF-programme in October 2016. This forecast incorporates proceeds from the USD2.5 billion in sukuk and Eurobond issuances at end-November 2017. The deterioration could be sharper in the absence of further currency flexibility and tightening of macro policies sufficient to restrain domestic demand.
The decline in reserves is driven by a rise in Pakistan's current account deficit, which widened to 4.1% of GDP in the fiscal year ending June 2017 (FY17) from 1.7% in FY16. The deficit reflects rising capital imports for China-Pakistan Economic Corridor (CPEC) projects, higher energy prices, sluggish exports and loose macroeconomic policies. Fitch assumes a further modest widening of the current account deficit to 4.7% of GDP in FY18 on the basis of a pickup in exports and levelling off of imports following recent currency depreciation as explained below.
The decision by the State Bank of Pakistan (SBP) in early December to allow market forces to play a greater role in determining the exchange rate would, if implemented, relieve some of the pressure on Pakistan's reserves and current account. Immediately after the announcement, the SBP allowed the rupee to depreciate by nearly 5% against the US dollar, but the currency has been held stable since then, and reserves have continued to slide in recent weeks. It remains to be seen how much flexibility the authorities will tolerate should there be sustained downward pressure on the currency, especially given political resistance in the past.
Fiscal consolidation efforts in Pakistan suffered a setback last year, limiting progress in reducing the elevated public debt/GDP ratio. The fiscal deficit surged to 5.8% of GDP in FY17 compared with 4.6% in FY16 and a revised target of 4.2%, driven by higher provincial government expenditures and an underperformance in revenues. The government views last year's breach of the target as temporary and aims to return to a path of fiscal consolidation. Fitch projects the FY18 deficit to decline to 5.0% of GDP based on rising revenues and expenditure constraint, which would lead to a decline in the public debt ratio from 67.2% of GDP in FY17 to 66.8% in FY18. Recent revenue performance has improved, but risks remain as the upcoming elections could limit near-term improvements to both revenue and expenditure.
Pakistan's 'B' IDRs also reflect the following key rating drivers:
Despite the rising external and fiscal pressures, Pakistan's growth performance has continued to improve, with annual GDP growth accelerating to 5.3% in FY17. This compares favourably with the 'B' country median of 3.5%. Fitch forecasts that growth momentum will be sustained, at 5.5% in FY18 and FY19, bolstered by recent investments under the CPEC initiative and reduced capacity constraints. There have been improvements in electricity generation and distribution networks, which should help to alleviate capacity constraints in the manufacturing and export sectors. A nascent export recovery may provide additional support.
Inflation in FY17 was low relative to Pakistan's historical average at 4.1%, but Fitch expects inflation to pick-up to around 5.5% over the next year due to pass-through from rupee depreciation and higher energy prices. Credit growth in the banking sector is robust. The system poses only limited risks to the sovereign as it is well capitalised and small relative to GDP. Non-performing loans have continued to decline from a peak of 14.8% of total loans in end-June 2013, but remain elevated at 9.4%.
Domestic security has improved in recent years, as evidenced by a decline in terrorist incidents and casualties. Nevertheless, ongoing domestic threats and attacks near the Afghan border, along with political uncertainty could weigh on investor sentiment and the economic outlook. Elections in mid-2018 heighten uncertainty in the coming year, particularly given the disqualification from office of Prime Minister Nawaz Sharif in July 2017 and ongoing corruption investigations.
The accumulation of losses in public sector enterprises (PSE), particularly electricity distribution companies, previously led to fund injections from the federal government to clear debt. Efficiency improvements, higher tariffs and relatively low global energy prices have helped cut PSE losses from previous highs, but losses have begun to trend upward again. The lack of faster progress towards privatisation impedes further progress in this area. PSE losses could rise considerably if Pakistan suffers an economic shock or there is a sharp rise in energy prices, ultimately feeding through to the government balance sheet.
Pakistan's rating is constrained by structural weaknesses relating to the level of development and governance indicators. Per capita GDP stands at USD1,541, well below the USD3,376 median of its 'B' rated peers. Governance quality is low in Pakistan with a World Bank governance indicator score in the 21st percentile ('B' median 30th 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 Factors: -1 notch, to reflect domestic security concerns, political uncertainty, and geopolitical risks arising from tensions with neighbouring countries. Pakistan also has a low rank on the World Bank's Ease of Doing Business index relative to 'B' rated peers.
Fitch's SRM is the agency's proprietary multiple regression rating model that 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.
RATING SENSITIVITIES
The main factors that could, individually or collectively, lead to negative rating action are:
-Failure to implement and sustain an effective macroeconomic policy mix to address external imbalances leading to a heightened risk of economic and financial instability.
-A further rapid loss of reserves or shift in investor confidence sufficient to undermine access to external funding, generating heightened external financing risks.
-Deterioration in the fiscal position that leads to a rise in government debt ratios or increase in exposure to contingent liabilities from state-owned enterprises.
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 halt the decline in reserves
-Sustained fiscal consolidation and containment of contingent liabilities, for example, through a strengthening of the revenue base.
-Sustained strong economic growth, for example resulting from improvements in the business environment, an improved security situation or decreased political risk.
KEY ASSUMPTIONS
-The global economy is assumed to perform broadly in line with Fitch's latest Global Economic Outlook.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR affirmed at 'B'; Outlook revised to Negative from Stable
Long-Term Local-Currency IDR affirmed at 'B'; Outlook revised to Negative from Stable
Short-Term Foreign-Currency IDR affirmed at 'B'
Short-Term Local-Currency IDR affirmed at 'B'
Country Ceiling affirmed at 'B'
Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at 'B'
Issue ratings on long-term senior unsecured local-currency bonds affirmed at 'B'
Issue ratings on The Third Pakistan International Sukuk Company Limited's foreign-currency global certificates affirmed at 'B'