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ISLAMABAD: Economic activity in Pakistan will remain below pre-outbreak levels, although the economy should return to modest 1.5 percent growth in fiscal 2021, says Moody’s Investors Services (Moody’s).

Moody’s in its latest report, “Pakistan banks face slow economic recovery, but solid funding and liquidity underpin stable outlook”, stated that the coronavirus pandemic is weighing on economic activity in Pakistan and real GDP contracted by 0.4 percent in fiscal 2020.

“We expect the economy to return to growth in fiscal 2021, reaching a modest 1.5 percent. Although high frequency indicators suggest that economic activity has started to rebound, restrictions on movements to prevent the spread of the coronavirus will keep economic output below pre-outbreak levels for some time. Growth will, however, accelerate to 4.4 percent in 2022,” it added.

“We expect the Pakistani economy to return to modest growth of 1.5 percent in fiscal 2021 after activity picked up at the start of the fiscal year in July,” Moody’s added.

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.

We project a government deficit of eight percent for 2021, with rising arrears and circular debt in the energy sector also affecting corporates’ repayment capabilities, Moody’s added.

“We perceive risks to the Pakistani economy to be lower than for similar-rated peers. Pakistan’s relatively closed economy has low reliance on exports and private capital inflows and limited trade and supply chain linkages. This reduces its exposure to weak global demand, including international tourism,” it added.

The report further stated that wide fiscal deficits, which will – to a large extent – be financed by local banks, may also take precedence over lending to the private sector. Lower consumer spending and business confidence will suppress lending growth and business opportunities.

In this environment, Moody’s expects private-sector lending to grow by between five percent and seven percent in 2021, below inflation expectations of eight percent.

Interest rates remain at the low end of historical rates, but muted confidence levels will prevent more robust growth.

Moody’s further stated Pakistan remains in the Financial Action Task Force (FATF)’s grey list, as a result of deficiencies in its anti-money laundering (AML) and combating terrorism financing (CTF) capabilities.

Failure to meet the 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.

Authorities have, however, agreed an action plan with the 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 the AML issues, Habib Bank and United Bank have surrendered their US banking licenses and closed their US branches.

The State Bank of Pakistan (SBP) has targeted 65 million active bank accounts, with total deposits accounting for 55 percent of GDP, through increased use of mobile bank accounts, biometric verification systems, and QR codes. A targeted 25 percent market share for Islamic banking by 2023, with an enhanced Shariah governance framework and initiatives to facilitate liquidity management.

Islamic banking assets accounted for 16 percent of banking assets as of September 2020. Increasing SME lending to around 17 percent of private-sector credit by 2023 by providing an enabling regulatory framework and improving the ease of doing business.

A new Pakistan Credit Guarantee Company and Secured Transactions Registry will support banks in achieving this target increasing housing finance to five percent of private-sector credit by December 2021, with a government mark-up subsidy facilitating banks to achieve this target, initiatives to increase agricultural finance, targeting disbursements of Rs1.8 trillion by 2023 and six million borrowers.

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,” it added.

Nonperforming loans (NPLs) in the Pakistan banking sector rose to 9.9 percent of total loans as of September 2020 (eight percent as of December 2018), and we expect a further increase as the economic slowdown takes its toll on borrowers’ repayment capabilities, Moody’s added.

Loan repayment holidays and other support measures will contain the deterioration but will not eliminate risks entirely.

A number of sectors will bear the brunt, including energy (affected by high circular debt), agri-business and sugar, exposures to the SME sector and export-oriented businesses, as well as banks’ foreign operations (particularly in the Gulf).

Loan quality risks will be mitigated by improvements in the legal and regulatory framework to support NPL recovery.

Pakistani banks reported a sector-wide Tier 1 ratio of 15.5 percent and an equity-to-assets ratio of 7.5 percent as of September 2020.

We typically adjust the risk weights on Pakistani government securities to 100 percent from zero in line with the risk associated with the government’s B3 credit rating.

Our preferred measure of capital, tangible common equity-to-adjusted risk weighted assets, is around 8.2 percent, which we consider modest.

We expect reported capital ratios to remain broadly stable over the next 12 to 18 months, even though SBP has eased capital requirements.

Reduced capital generation (due to lower profitability and potential implementation of IFRS 9 accounting standards in 2021) will be offset by lower dividend payments and muted growth in risk-weighted assets.

Where needed, we expect banks to issue Tier 1 or Tier 2 capital instruments or undertake other capital optimisation measures.

Existing risk-based minimum capital requirements are 11.5 percent of risk-weighted assets, which includes a Capital Conservation Buffer of 1.5 percent.

Systemically important banks are required to maintain even higher capital.

Three (unrated) small banks are under capitalised and are currently under capital enhancement/privatization programmes.

Potential one-off expenses by Pakistani banks (e.g. fines by US authorities, or the unfavourable resolution of NBP’s pension dispute) may hurt their capital adequacy position.

Under our base-case (or most likely) scenario, we expect the system-wide capital ratio to increase by around 18 basis points to 8.4 percent from 8.2 percent over a two-year horizon, ie, to end-2022.

Under our stress scenario, the impact would be extremely severe, leaving the system with a negative tangible common equity equivalent to 16.1 percent of risk-weighted assets at the end of two years, Moody’s added.

Under highly stressed conditions, capital would fall substantially by 24 percentage points over the two years, a more severe impact than for regional peers, as well as for the global median.

This is mainly due to the banks’ large exposure to government securities which under our stress scenario have a high expected loss rate.

Moody’s Scenario Analysis: Our baseline forecasts are based on econometric models and a set of assumptions.

Probabilities of default per asset class are derived from our forecasts for problem loans, and general assumptions on loan book growth and write-off rates that have been adapted to the particular circumstances of the system.

The model includes macroeconomic variables such as real GDP growth, unemployment, inflation and exchange rate.

Our rated Pakistani banks reported a return on assets of 1.2 percent for the nine months ended in September 2020.

For 2021, we project profitability to come under renewed pressure, primarily from: (1) Increased loan-loss provisions reflecting challenging operating environment, as well as weak loan performance in the Gulf region; (2) Pressure on net interest margins after a cumulative 625bps interest rate cut during 2020. Pressure on margins was not yet visible in 9M2020 results, as banks managed to lock-in higher yields on their investments via their holdings of Pakistani Investment Bonds (PIBs) but these are now gradually maturing; (3) subdued business generation, trading gains and dividend income; and (40 the extension of a four percent special tax imposed on banks, as well as high costs as a result of investments to strengthen compliance and security infrastructure, and potentially higher staff pension payment requirements.

Customer deposits accounted for 74 percent of total assets as of September 2020, of which around half are stable household deposits.

Deposits at Islamic financial institutions reached 17 percent of total deposits.

A significant share of deposits is, however, sourced from the government and related institutions.

The recent introduction of a Treasury Single Account (TSA), where federal government deposits will be required to be held at the SBP, will lead to some deposit outflows from banks.

Market funding remains high at 18 percent of assets as of September 2020.

This is mainly in the form of interbank and SBP repo facilities, used for “carry trades” (i.e. buying government bonds funded by short-term borrowing).

We expect Pakistani banks to maintain comfortable liquidity buffers, with core liquid assets (cash and bank placements) accounting for 13 percent of assets as of September 2020, complemented by the banks’ investments in government securities (43 percent of total assets), which are accepted by the State Bank of Pakistan as collateral for repo funding.

“We expect banks foreign-currency liquidity to remain adequate, partly supported by low levels of dollars in the system and SBP policies that allow for the exchange rate to act as shock absorber,” it added.

The government’s capacity to provide support is constrained by the fiscal challenges that drive its B3 rating.

As such, we incorporate one notch of government support uplift to the ratings of Habib Bank and National Bank of Pakistan, whose Baseline Credit Assessment is positioned at caa1.

This aligns their deposit ratings to the B3 government level.

The other rated banks are already level with the B3 government bond rating.

Government and central bank policy responses and structural reforms will soften the pandemic’s impact but not fully offset it.

In this environment, we expect private-sector lending to grow modestly, by five percent-seven percent, over the calendar year.

In another report, “Sovereigns–Asia Pacific 2021 outlook”, Moody’s stated that Pakistan’s cross-border repayments are also large relative to reserves, but the government has secured external financing from multilateral and bilateral partners, including rollover commitments, that contain liquidity risks.

“ Our assessment in August that Pakistan's (B3 stable) participation in the Group of 20 (G-20) Debt Service Suspension Initiative does not result in additional material risk to private sector creditors drove our confirmation of its B3 rating with a stable outlook, concluding an earlier review for downgrade,” it added.

Reserve adequacy remains weak for Laos, Mongolia, Pakistan, and Sri Lanka, whose cross-border debt repayments – including on non-concessional borrowings such as from Chinese policy banks – remain large relative to foreign reserves.

In these cases, sustaining access to cross-border funding markets or external liquidity assistance will depend highly on commitment to and demonstrated traction on reform, and greater macroeconomic and fiscal stability.

Further some emerging markets have progressed on reforms to strengthen social protection systems, for instance, China, Indonesia, Pakistan, and the Philippines, where welfare assistance has risen under conditional cash transfer programs.

Copyright Business Recorder, 2021