S&P affirms B- long-term, B short-term sovereign credit ratings on Pakistan

The outlook for the long-term rating is stable.

LAHORE (Web Desk) - The Standard & Poor’s (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 can meet its external obligations over the next 12 months, and that the country will continue to roll over its commercial credit lines.

We may lower our ratings if Pakistan’s fiscal, economic, or external indicators deteriorate further, such that the government’s external debt repayments come under pressure. Indications of this would include 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 the fallout of the COVID-19 pandemic on the country’s already weak economy, considerable external indebtedness and liquidity needs, and an elevated general government fiscal deficit and debt stock. While Pakistan had made progress toward consolidating its fiscal accounts during the first nine months of its Extended Funding Facility (EFF) program with the IMF, related imbalances have been worsened by much slower economic growth since March 2020. The pandemic has worsened Pakistan’s deep economic downturn. In particular, domestic demand in the economy remains very weak, as evident from contractions in both real consumption and imports in the fiscal year ended June 2020. Prospects for a near-term recovery have dimmed following strict domestic virus containment measures implemented between March and June, and in the face of a much weaker global economic outlook.

Prior to the onset of the pandemic, Pakistan was making important headway toward implementing economic and fiscal reforms under its EFF program with the IMF. As of end-December 2019, the government had met all performance criteria and completed all structural benchmarks of the IMF program. In particular, Pakistan had made strong progress toward containing its twin current account and primary fiscal deficits, and had begun to rebuild its foreign exchange reserves alongside a more flexible rupee exchange rate regime.

The pandemic will challenge further progress in some of these areas, especially fiscal consolidation and reserve accumulation. Despite having stabilized in the first three quarters of the fiscal year, a deep downturn in the April-June period led the Pakistani economy to a full-year contraction of nearly 0.4% in fiscal 2020. Renewed weakness in the economy will undermine revenue generation while complicating the government’s efforts to curtail expenditure. The government is likely to focus on implementing last year’s new revenue measures in the current fiscal period, rather than to introduce additional policies against a backdrop of poor business and consumer sentiment.

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 is likely to recover only gradually as the global pandemic is progressively better contained. Following Pakistan’s worst economic performance on record in fiscal 2020, we forecast a modest expansion of 1.3% in fiscal 2021. Taken together with its relatively fast population growth of approximately 2.0% per year, real per capita economic growth will likely remain negative for a third straight year, at -0.7%. That will contribute to a further decline in Pakistan’s 10-year weighted average per capita growth rate to just 0.6%, well below the global median of 1.5% for economies at a similar level of income.

The Pakistani rupee’s approximately 38% depreciation against the U.S. dollar between 2017 and 2020 has also contributed to a considerable decline in the economy’s nominal GDP per capita. We forecast GDP per capita to remain just above US$1,200 by the end of this fiscal year, versus closer to US$1,600 in fiscal 2018.

Although we believe the government’s adoption of reforms under the IMF program has been constructive in addressing accumulated economic and external balances, the economy is likely to face further stress until the pandemic is meaningfully contained and global conditions materially improved.

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 former 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 flared on multiple occasions in 2019, and further incidents, especially in the vicinity of the line of control in Kashmir, cannot be ruled out. The country’s fiscal and debt positions will deteriorate further owing to the pandemic-induced economic downturn.

Despite the ongoing implementation of reforms, the Pakistan government continues to face substantial pressure on its finances. After an estimated general government fiscal deficit of 8.1% of GDP in fiscal 2020, we forecast an elevated shortfall equivalent to 8.5% of GDP this year, largely owing to revenue constraints amid the weak economy.

Heading into 2020, the government had begun to implement difficult reform measures, with an emphasis on revenue generation. These measures appeared to be leading toward a more sustainable fiscal trajectory for the government, with the primary balance shifting into surplus prior to the onset of the pandemic. The economy’s weak performance in the April-June quarter undermined these improvements, and we estimate that the general government’s net indebtedness rose by 11.8% of GDP in fiscal 2020.

Under the auspices of the IMF EFF program, the government has shown a strong willingness to consolidate its fiscal position, and we believe it would have achieved lower annual fiscal deficits and a greater revenue share of GDP in the absence of the exogenous shock of the pandemic.

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 over the next three years. However, Pakistan’s ratio of tax revenue to GDP remains one of the lowest among sovereigns we rate, and we believe material improvements will be delayed by Pakistan’s weak economic outlook. In our view, it is difficult to increase revenue as a share of GDP during a period of muted economic growth; we therefore expect the government’s revenue-to-GDP ratio to retreat slightly to 12.5% this fiscal year, before recovering to more than 13% from fiscal 2022. We forecast the average annual change in net general government debt at 6.9% of GDP through 2023, reflecting our expectations for a high deficit this year, followed by gradually smaller shortfalls.

Coupled with the economy’s weak growth outlook, continued high fiscal deficits will push Pakistan’s net general government debt to a multi-decade high of 84.5% of GDP this fiscal year.

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 is set to rise to a record high of more than 57% of revenues this year, an extremely elevated level where more of the government’s income goes toward debt servicing than to the provision of public goods and services. The government’s ability to scale this ratio down over the coming years, mostly through increased revenue generation, will be critical in maintaining its debt sustainability.

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. Amid Pakistan’s 2018-2019 economic downturn, the country secured financing from the IMF, Saudi Arabia, United Arab Emirates, Qatar, and China, among others; they have committed total support for Pakistan of approximately US$38 billion. More recently, Pakistan has secured an additional commitment of US$1.4 billion from the IMF under its Rapid Financing Instrument, as well as US$1.8 billion from the World Bank, and US$1.7 billion from the Asian Development Bank. These funds have helped to stabilize Pakistan’s gross foreign exchange reserves.

The government has secured Pakistani rupees (PKR) 335 billion (approximately US$2 billion) in debt forgiveness on official obligations to G20 creditors, with an agreement set to be signed by the various parties before Dec. 31, 2020. The agreement will alleviate the government’s high external debt stock, although it represents only a small share of its total external public indebtedness, which we estimate at approximately US$89 billion. Critically, the Pakistan government has stated that it has no intention to seek debt relief or restructuring on its commercial debt.

Combined support from Pakistan’s international partners remains crucial in meeting its external financing needs over the coming years. That said, the country’s external position has stabilized and improved somewhat from one year ago. Its current account deficit fell to 1.1% of GDP in fiscal 2020, from 4.8% the year before and 6.1% in fiscal 2018. 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. Much lower energy prices have also played an important role. We expect the current account deficit to remain below 2% of GDP over the next few years as the economy continues to rebalance, although higher capital imports associated with the restart of China-Pakistan Economic Corridor projects could widen the deficit again.

Pakistan’s external financing and indebtedness metrics have moderated in line with its lower current account deficit. However, gross external financing needs remain elevated, at approximately 140% of current account receipts and usable foreign exchange reserves at the end of fiscal 2020. We expect this figure to gradually decline to nearly 119% by the end of fiscal 2023, but a rekindling of import demand or higher commodity prices would challenge that trend. We deduct approximately US$5 billion from gross reserves owing to the central bank’s borrowing position from the domestic commercial banking sector. Pakistan’s usable reserves have improved considerably over the past two years, rising from a nadir of just US$2.4 billion in fiscal 2019 to nearly US$10 billion as of June 2020.

We expect the central bank to continue to gradually pare down its short position over the coming years, which would enhance the quality of its gross reserves. Pakistan’s external indebtedness remains very high, with narrow net external debt forecast to rise to 171% of current account receipts this year. Although external aid is helping to meet immediate external financing requirements, it will also add to the debt stock.

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 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 have 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.

Inflation rates have improved, with price levels having largely adjusted to the much weaker rupee. We expect inflation to gradually decline from 2020 toward its long-term trend of about 6%. 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.