ISLAMABAD: Moody’s Investors Services (Moody’s) has changed its outlook on the banking sector of Pakistan (Caa3 stable) to “stable” from “negative”, while saying macro challenges and fiscal pressures ease.
The rating agency stated that the banks’ solid profitability and stable funding and liquidity provide an adequate buffer to withstand the country’s macroeconomic challenges and political turmoil. Economic and fiscal pressures are easing, and we forecast the Pakistani economy will return to modest growth of two per cent in 2024 after subdued activity in 2023, and inflation to fall to around 23 per cent from 29 per cent last year, Moody’s added.
Pakistani banks remain highly exposed to the government via large holdings of government securities that amount to around half of total banking assets, which links their credit strength to that of the sovereign.
Moody’s upgrades Pakistan’s banking sector outlook from negative to ‘stable’
Persistent external pressures against a challenging operating backdrop will weigh slightly on the performance of Pakistani banks’ loan portfolios. Profitability will remain strong because of wide net interest margins (NIMs) but decline from 2023 peaks because of subdued business growth, increased funding costs on the back of higher rates, and elevated taxes. We expect the banks’ modest capital ratios to remain stable, as strong earnings offset high dividend payouts. Banks’ stable deposit-based funding will continue to support financial stability.
The stable outlook reflects banks’ adequate performance despite macroeconomic and fiscal pressures macroeconomic conditions remain very weak, and government liquidity risk and external vulnerability very high. Recovery from the 2022 floods and low base effects will support a modest economic recovery in Pakistan, though challenging external conditions and tight monetary policy will keep growth below potential. We forecast real GDP growth of around 2 per cent in 2024, up from -0.3 per cent in 2023, and gradual easing of inflation to 23 per cent from 29 per cent in 2023. However, high-interest rates and inflation will continue to curb private-sector spending and investment. Furthermore, banks are financing the sovereign’s wide fiscal deficits, leaving little space to lend to the real economy. Initiatives to deepen financial inclusion and assistance for key sectors will only partly support credit demand.
Asset risk is mainly linked to high government securities exposure. Government securities account for 51 per cent of Pakistani banks’ total assets and around nine times their equity, among the highest levels for Moody’s-rated banks globally. This exposure links banks’ credit profiles to that of the Caa3 Pakistani sovereign, for which concerns around debt restructuring persist, and banks will remain the main source of government financing over our outlook period. The problem loans ratio of the Pakistani banks we rate rose to 8.5 per cent as of September 2023, up from 7.3 per cent in December 2022, following severe shocks that subdued economic growth and as historically high inflation and interest rates erode borrowers’ repayment capacity. We expect problem loans to stabilise at around nine per cent of gross loans, partly because of the banks’ reluctance to lend in this challenging environment (loan growth was flat in 2023). The expected introduction of IFRS 9 accounting standards in 2024 will likely increase provisioning needs.
Capital will remain broadly stable as banks’ subdued growth and solid earnings offset dividend payouts. The reported Tier 1 capital ratio for the rated Pakistani banks was 15.3 per cent of risk-weighted assets as of September 2023, up from 14.4 per cent in 2022 and well above the regulatory minimum. Moody’s capital metric, the tangible common equity to adjusted risk-weighted assets ratio, is a low 5.2 per cent, reflecting the 150 per cent risk weighting for government securities in line with the Caa3 sovereign rating. Our base case is for banks to maintain high dividend payout ratios in 2024, but with sufficient retained earnings and moderate balance sheet growth that keep reported capital ratios steady. However, our high-stress scenario projects a severe impact from material losses on government securities that would render the banking sector insolvent.
Moody’s stated that profitability will gradually decline to normalised but still strong levels. We expect Pakistani banks’ interest revenue – the largest contributor to operating income – to moderate in 2024, with monetary policy beginning to ease as inflation and interest rates gradually recede from 2023 peaks. However, NIMs (4.3 per cent as of September 2023) will remain generally strong in 2024, driven by high investment income from government securities holdings, while banks optimise their cost of funds. Subdued business and lending activity will keep interest on lending and non-interest income in check. Operating expenses will likely stabilise in line with easing inflation and banks’ cost-control efforts. Persistently elevated tax rates and potentially higher loan-loss provisions will weigh on banks’ bottom-line profitability, with the return on average assets hovering around 3 per cent.
Stable funding and liquidity are a strength. Deepening financial inclusion and remittances from non-resident Pakistanis are broadening domestic deposit inflows. Banks are mainly deposit-funded, with customer deposits accounting for 58 per cent of total assets as of September 2023, and have very low reliance on more volatile market funding (5.6 per cent of tangible assets as of December 2022) given limited access to international debt markets. However, the cost of funds is rising moderately as high-interest rates have driven a migration to interest-bearing deposits from non-interest bearing deposits, which were down to 74 per cent of total system deposits as at end-2023 from 75.2 per cent a year earlier. The introduction of a Treasury Single Account – which requires government deposits to be held at the State Bank of Pakistan – will have only a modest impact on deposit outflows. Banks have sufficient liquidity buffers, with around 12 per cent of assets held as cash and interbank placements and another 51 per cent invested in government securities. However, we estimate that around 40 per cent of banks’ government securities holdings are encumbered, placed as collateral with the central bank with the newly raised liquidity used to buy more government bonds. Pakistani banks have limited reliance on dollar funding and generally run matched currency positions.
The government has demonstrated willingness but limited capacity to support banks. Pakistani authorities have historically supported banks in difficulty, with no depositor losses recorded, and remain willing to do so given banks’ role as the main source of government financing. However, the government’s capacity to provide support is constrained by the fiscal challenges that drive its Caa3 rating, which also constrains Pakistani banks’ deposit ratings at this level. However, deposit insurance of Rs500,000 per depositor covers about 94 per cent of individual depositors and 15 per cent of banks’ total deposits.
Copyright Business Recorder, 2024
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