The Standard and Poor's (S&P) rating agency has affirmed 'B-' long-term and 'B' short-term sovereign credit ratings for Pakistan, as the ratings remain constrained by a narrow tax base and domestic and external security risks, which continue to be high. The rating agency stated that Pakistan faces a muted economic outlook, along with a highly stressed external position, as the government attempts to address its elevated fiscal deficit and debt stock. "We expect the sovereign's credit metrics to remain under pressure over the medium term as a result," maintained the agency.
The government's securing of an IMF reform and funding programme along with considerable additional bilateral and multilateral funding, will help address near-term funding risks. Nevertheless, continued reform progress will likely be necessary to address Pakistan's credit vulnerabilities. "We are affirming our 'B-' long-term and 'B' short-term sovereign credit ratings on Pakistan. The stable outlook reflects our expectations that funding from the IMF and other partners will be sufficient for Pakistan to meet its considerable external obligations over the next one to two years," maintained the agency.
On August 29, 2019, S&P Global Ratings affirmed its 'B-' long-term and 'B' short-term sovereign credit ratings on Pakistan. The outlook for the long-term rating is stable. "We also affirmed our 'B-' long-term issue rating on Pakistan's senior unsecured debt and sukuk trust certificates."
"The stable outlook reflects our expectations that donor and partner financing will ensure that Pakistan is able to meet its external obligations over the next 12 months, and that external, fiscal, and economic metrics will not deteriorate materially beyond our current projections.
"We may lower our ratings if Pakistan's fiscal, economic, or external indicators continue to deteriorate, such that the government's external debt repayments come under pressure. Indications of this would include GDP growth below our forecast, or external or fiscal imbalances higher than what we expect. Conversely, we may raise our ratings on Pakistan if the economy materially outperforms our expectations, strengthening the country's fiscal and external positions more quickly than forecast."
The ratings on Pakistan reflect subdued expectations for the country's economic growth, heightened external indebtedness and liquidity needs, and an elevated general government fiscal deficit and debt stock. While Pakistan has secured financial aid from the IMF and numerous other international partners to address its immediate external financing needs, fiscal and external imbalances will remain elevated over the near to medium term.
Institutional and economic profile: Economic outlook subdued amid financial, fiscal stress subdued domestic sentiment, a negative fiscal impulse, and difficult external conditions will weigh on economic growth over the medium term. Pakistan's very low income level remains a rating weakness. Inadequate infrastructure and security risks continue to be structural impediments to foreign direct investment and sustainable economic growth. The economic slowdown results from a paucity of growth drivers.
In particular, real investment contracted sharply by 8.9% in the fiscal year ended June 2019, the worst performance since fiscal 2011. Prospects for a rapid recovery in investment are limited owing to the fading impulse from China-Pakistan Economic Corridor (CPEC) related projects, along with cautious sentiment in the private sector.
Nevertheless, the government has begun to implement more powerful economic reform measures, in line with its agreement to a US$6 billion, 39-month extended funding facility with the IMF. Chiefly, these include fiscal reforms aimed at increasing the government's revenue mobilization, as well as the introduction of and commitment to a more flexible, market-determined exchange rate regime. The government's fiscal 2020 budget, announced in July, aims to boost revenue by 1.7% of GDP this fiscal year, primarily through improvements to the government's sales and income tax regimes.
The ratings on Pakistan remain constrained by a narrow tax base and domestic and external security risks, which continue to be high. Although the country's security situation has gradually improved over the recent years, ongoing vulnerabilities weaken the government's effectiveness and weigh on the business climate.
Pakistan's economy has begun a period of structural adjustment which entails slower real GDP growth as officials address significant external and fiscal imbalances. In view of the negative impulse stemming from the government's nascent fiscal reforms, as well as weak domestic and external demand conditions, we expect real GDP growth to fall to 2.4% this fiscal year-a 12-year low.
Taken together with Pakistan's relatively fast population growth of approximately 2.0% per year, real per capita economic growth will fall to an anemic 0.4%. That will contribute to a decline in Pakistan's 10-year weighted average per capita growth to 1.8%, below the global average of 2.3% for economies at a similar level of income.
The Pakistani rupee's approximately 25% depreciation against the US dollar in fiscal 2019 has also contributed to a decline in the economy's nominal GDP per capita. "We forecast GDP per capita to fall to just above US$1,200 by the end of this fiscal year, versus US$1,565 in fiscal 2017-2018."
"Although we believe that economic reforms, including the introduction of enhanced flexibility for the Pakistani rupee, will help to stabilize and eventually support a recovery in economic activity, this effect is unlikely to sufficiently offset the loss in momentum in the economy during this period of acute fiscal and external stress," maintained by the Agency.
Growth will also be constrained by domestic security challenges and extended hostility with neighboring India and Afghanistan. These conditions, along with inadequate infrastructure, mainly in transportation and energy, are additional bottlenecks to foreign direct investments.
The then Pakistan Muslim League government improved the security situation within the country, and we would expect the Pakistan Tehreek-e-Insaf (PTI) government to continue this positive momentum. However, tensions with neighboring India have flared on multiple occasions in 2019, and further incidents, especially in the vicinity of the Line of Control in Kashmir, cannot be ruled out.
Flexibility and performance profile: Reforms and partner funding to help stabilize acute fiscal and external stresses, structural imbalances have contributed to a significant weakening in external metrics.
Pressure on external and fiscal accounts should stabilize from 2020 onward, although it will remain elevated for some time.
"We forecast net general government debt to rise toward 75% of GDP by the end of fiscal 2022 before leveling off. Meanwhile, Pakistan's interest-servicing burden will average more than 40% of total revenue over the next three years."
Pakistan is facing considerable external and fiscal pressure following a significant rise in both general government and external indebtedness in the fiscal year ended June 2019. These metrics have deteriorated owing largely to aggressive external fund raising and the rupee's rapid depreciation, because the central bank allowed the currency to weaken in line with fundamentals following a period of overvaluation.
In order to meet the economy's elevated external funding needs, the government has secured substantial foreign exchange support from a large contingent of multilateral and bilateral creditors. Creditors including the IMF, Saudi Arabia, the UAE, Qatar, and China, among others, have committed to total support for Pakistan of approximately US$38 billion. These funds will help to alleviate acute external stresses and to supplement the central bank's limited foreign exchange reserves.
International support has coalesced around the IMF's Extended Fund Facility (EFF), which has helped to ensure sufficient funding for Pakistan's considerable external financing needs throughout the duration of the 39-month program, which began in July 2019.
"We believe the combined support from Pakistan's international partners will add to debt, but will also help to smooth pressing external financing needs. However, more will need to be done to stem Pakistan's vulnerability over the long term, especially on export promotion and energy security." The country's current account deficit decreased to 4.8% of GDP in the fiscal year ended June 2019, from 6.3% the year before. The narrowing of the deficit was due largely to import compression amid weakening demand, especially following official administrative measures, along with the decreased purchasing power of the Pakistani rupee. We expect the current account deficit to continue to decline gradually over the next few years as the economy rebalances.
"Although we expect the current account deficit to decline somewhat over the next three years, Pakistan's external financing and indebtedness metrics exhibit significant stress. Its high degree of external stress is marked by a continued rise in the economy's gross external financing needs relative to its current account receipts and usable reserves; we forecast this ratio will climb to approximately 161% at the end of fiscal 2020, versus approximately 133% at the end of fiscal 2018. We deduct approximately US $8 billion from gross reserves owing to the central bank's net short position with the domestic commercial banking sector, resulting in usable reserves of just US$1.9 billion as of the end of fiscal 2019.
"Although we believe the central bank will gradually pare down its net short position over the coming years, usable reserves will remain modest in terms of import cover. Meanwhile, we project the country's narrow net external debt will rise to approximately 188% of current account receipts this fiscal year, from just 140% two years prior. Although external aid will help to meet immediate payment needs, indebtedness will also rise
"Pakistan's fiscal profile has deteriorated, as evident from a surge in the general government's budget deficit to an estimated 8.9% of GDP in fiscal 2019. The government is in the process of implementing difficult reform measures, which will aim to rein in its deficit largely through revenue generation. Change in net general government debt rose to 13.3% in fiscal 2019 versus 9.3% in the previous year, largely owing to the government's higher fiscal deficit, the depreciation of the Pakistani rupee, and borrowing from bilateral and multilateral partners.
"Under the auspices of the IMF EFF programme, the government has elucidated its aim to consolidate its fiscal accounts, and we believe it can make material progress toward achieving lower annual fiscal deficits and a greater revenue share of GDP." Pakistan's ratio of tax revenue to GDP remains one of the lowest among sovereigns that we rate, and improvements in collection will be critical in determining the success of its fiscal reform program.
"Constructive measures including the withdrawal of exemptions and preferential rates under the government's sales tax regime, a rationalization of income tax thresholds and rates, and the augmentation of Federal Excise Duties, among others, should help to solidify the government's revenue base beginning this fiscal year. A proposed strengthening of the Fiscal Responsibility and Debt Limitation Act should contain fiscal risks over the long term.
"Reforms in the energy sector also constitute an important pillar of the government's agenda, especially given the recent rise in circular debt (arrears) stemming from imbalances in the power sector. The total stock of circular debt stood at more than 4% of GDP as of March 2019, according to IMF estimates. This poses a contingent liability to the sovereign. The authorities' implementation of an automatic quarterly tariff adjustment scheme, along with further structural changes to the sector under its comprehensive strategy planned for introduction in September, should help to alleviate this risk.
"However, we also note the difficulty in growing revenue as a share of GDP during a period of muted economic growth; we therefore expect the government's revenue-to-GDP ratio to rise only gradually over the next three years. We forecast the average annual change in net general government debt at 6.9% of GDP through 2022, which is higher than our previous expectations.
"Coupled with our lower expectations for real GDP growth, the forecast fiscal deficits will gradually raise net general government indebtedness close to 75% of GDP by the end of 2022."
"Pakistan's unusually high interest expense relative to fiscal revenue is an additional constraint on our assessment of the government's debt burden. Interest expense consumes more than a third of government revenue, partly a function of its narrow tax base.
"Pakistan's banking system is relatively small by international standards, with total bank assets comprising approximately 56% of GDP. We do not have a Banking Industry Country Risk Assessment on Pakistan. However, its banking system appears stable, reflecting its high profitability, adequate liquidity, and strong capitalization. Combining our view of Pakistan's government-related entities and its financial system, we assess the country's contingent fiscal risks as limited. That said, at more than 20% of total system assets, Pakistan's banking system bears an outsized exposure to the sovereign.
"We believe the State Bank of Pakistan's (SBP) autonomy and performance has strengthened since the setup of a monetary policy committee for rate-setting in January 2016. The SBP's interest rate corridor helps the monetary transmission mechanism by providing directions for short-term market interest rates. The central bank has also allowed the Pakistani rupee to float more freely and to find its level over recent quarters, which should mitigate the risk of further external imbalances in future
"However, inflationary pressure is likely to remain elevated in fiscal 2020 following the recent depreciation of the rupee. From 2020 onward, we expect inflation to gradually decline toward its long-term trend. The government's commitment to end budget financing by the SBP starting July 2019 should also assist in cutting inflationary pressure over the medium-term."
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