InternationalVOLUME 15 ISSUE # 09

Moody’s weighs pros and cons of Pakistan’s economy

It is good news for the economy. The well-known Moody’s Investors Service has affirmed Pakistan’s local and foreign currency long-term issuer and senior unsecured debt ratings at B3 and changed the outlook to stable from negative.

Moody’s expectations are based on the fact that the balance of payments dynamics will continue to improve, supported by policy adjustments and currency flexibility. It is relevant to mention here that in November, Moody’s changed the outlook on India’s ratings to negative from stable and affirmed the Baa2 foreign-currency and local-currency long-term issuer ratings. Moody’s also affirmed India’s Baa2 local-currency senior unsecured rating and its P-2 other short-term local-currency rating. Regarding Pakistan, Moody’s said that such developments reduce external vulnerability risks, although foreign exchange reserve buffers remain low and will take time to rebuild.

According to the rating agency, while fiscal strength has weakened with higher debt levels largely as a result of currency depreciation, ongoing fiscal reforms, including through the IMF programme, will mitigate risks related to debt sustainability and government liquidity. To quote it, “The rating affirmation reflects Pakistan’s relatively large economy and robust long-term growth potential, coupled with ongoing institutional enhancements that raise policy credibility and effectiveness, albeit from a low starting point. These credit strengths are balanced against structural constraints to economic and export competitiveness, the government’s low revenue generation capacity that weakens debt affordability, fiscal strength that will remain weak over the foreseeable future, as well as political and still-material external vulnerability risks.” Significantly, Moody’s has affirmed the B3 foreign currency senior unsecured ratings for the Second Pakistan Int’l Sukuk Co. Ltd. and the Third Pakistan International Sukuk Co Ltd. The associated payment obligations are, in Moody’s view, direct obligations of the government of Pakistan.

However, Pakistan’s Ba3 local currency bond and deposit ceilings remain unchanged. The B2 foreign currency bond ceiling and the Caa1 foreign currency deposit ceiling are also unchanged. The short-term foreign currency bond and deposit ceilings remain unchanged at Not Prime. These ceilings act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country. Among the positive factors, the narrowing current account deficits, in combination with enhancements to the policy framework including currency flexibility, have lowered external vulnerability risks for Pakistan.

Moody’s expects Pakistan’s current account deficit to continue narrowing in the current and next fiscal year, averaging around 2.2% of GDP, from more than 6% in fiscal 2018 (the year ending June 2018) and around 5% in fiscal 2019. The narrowing down of the current account deficit would be due to subdued import growth. Another positive development is that the ongoing completion of power projects will reduce capital goods imports, while oil imports would remain structurally lower given the gradual transition in power generation away from diesel to coal, natural gas and hydropower. At the same time, tight monetary conditions and import tariffs on nonessential goods will also weigh on broader import demand for some time, although Moody’s sees the possibility of monetary conditions easing when inflation gradually declines towards the end of the current fiscal year.

According to Moody’s, exports will gradually pick up on the back of the real exchange rate depreciation over the past 18 months, also contributing to narrower current account deficits. It is a good thing that the government is focusing on raising the country’s trade competitiveness. Recently, it framed a National Tariff Policy aimed at incentivising production for exports or import substitution. The policy, coupled with improvements in the terms of trade, will help exports to grow more rapidly in the coming days. The substantial increase in the power generation capacity over the past few years and improvements in domestic security have also removed two significant supply-side constraints, paving the way for export-related investment and production.

In its report, Moody’s foresees further policy reforms, including greater central bank independence and the commitment to currency flexibility, which will support the reduction in external vulnerability. In particular, the government is planning to introduce a new State Bank of Pakistan Act to forbid central bank financing of government debt and clarify SBP’s primary objective of price stability. At the same time, the government has strongly adhered to its commitment to a floating exchange rate regime since May 2019. These enhancements to the policy framework will foster confidence in the Pakistani rupee, while the use of the exchange rate as a shock absorber increases policy buffers.

However, despite an improved balance of payments position, Pakistan’s foreign exchange reserves adequacy remains low. Foreign exchange reserves have fluctuated around $7-8 billion over the past few months, sufficient only to cover just 2-2.5 months of goods imports. Coverage of external debt due also remains low, with the country’s External Vulnerability Indicator — which measures the ratio of external debt due over the next fiscal year to foreign exchange reserves — remaining around 160-180%.To take care of this problem, Moody’s has recommended that the government should take effective measures to mobilise private sector resources in order to raise foreign exchange reserves substantially from current levels.

In Moody’s view, downward pressure on the rating would stem from renewed deterioration in Pakistan’s external position, including through a significant widening of the current account deficit and erosion of foreign exchange reserve buffers, which would threaten the government’s external repayment capacity and heighten liquidity risks. A continued rise in the government’s debt burden, without prospects for stabilisation over the medium term, would also put downward pressure on the rating.