August 17, 2020: Fitch Ratings has affirmed Pakistan's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'B-' with a Stable Outlook.
Pakistan's 'B-' rating reflects weak public finances, including large scale deficits and a high government debt/GDP ratio, a challenging external position characterized by large external debt repayments against low foreign-exchange reserves and low governance indicator scores. The coronavirus pandemic has exacerbated these challenges by depressing economic growth and pressuring the public finances. The external finances appear resilient to the shock due to the authorities' policy actions and continuing multilateral and bilateral financial support.
Policy actions by the authorities over the past couple of years eased external vulnerabilities prior to the coronavirus shock. These included tighter monetary policy settings and the move to a more market-determined exchange rate regime, which contributed to a sharp narrowing of the current account deficit and a modest rebuilding of foreign-exchange reserves. Greater exchange rate flexibility has continued during the pandemic and has been an important shock absorber.
Liquid gross foreign-exchange reserves rose to about USD12.5 billion by end-July from USD7.7 billion a year prior. A sharp reversal in March of record non-resident inflows to local-currency government notes (reaching a stock of USD3.2 billion in February) generated exchange rate volatility and a modest decline in foreign exchange reserves. Foreign holdings have stabilised since then, and reserves have been restored through multilateral and bilateral disbursements. The central bank's net forward position has increased somewhat in the past months and net reserves remain negative, even though they have narrowed. Fitch forecasts a further rise in liquid gross reserves to about USD16 billion by end of scale year ending June 2021 (FY21).
Pakistan's current account deficit narrowed to 1.1% of GDP in FY20, from a peak of 6.1% in FY18, due mainly to import compression and lower oil prices. Fitch forecasts a slight widening of the current account deficit to 1.7% in FY21 due to a modest recovery in imports and declining remittances. Remittances rose unexpectedly by 7.3% in 4QFY20, but we view this as temporary and expect a decline of about 10% in FY21 due to the impact of the global economic shock on Pakistan's overseas workers
External financing requirements have declined, in line with the narrowing of the current account deficit. However, the government's external debt repayments remain high at about USD10.3 billion (about 80% of current gross liquid reserves) in FY21 and USD8.9 billion in FY22. The USD3 billion in deposits at the central bank from Saudi Arabia were slated to be rolled over through 2022, but the Saudi authorities requested repayment on USD1 billion of the deposits in July. In our baseline scenario, we assume the additional USD2 billion will be rolled over when the respective tranches mature in December and January, but this is subject to some risk.
Pakistan has received approval for its participation in the G-20's Debt Service Suspension Initiative (DSSI), which will lower FY21 debt repayments to bilateral creditors by roughly USD2 billion. The relief provided by bilateral creditors does not constitute a default under Fitch's definitions, and we understand that the authorities have ruled out any request for participation by private creditors
Access to external financing appears sufficient in the near-term to close any financing gap, underpinned by support from multilateral and bilateral creditors. In April, the IMF board approved USD1.4 billion in financing through its Rapid Financing Instrument. The 39-month, USD6 billion IMF programme, which began in July 2019, remains in place. We expect the second review to be completed in the coming months, although it has been delayed since March, due mainly to the IMF's willingness to facilitate the authorities' policy focus on the coronavirus response. We understand that both the IMF and government of Pakistan remain committed to the programme, which has facilitated significant financing from a range of multilateral institutions. Official bilateral and commercial bank borrowing from China has also been a key source of financing. The authorities have also indicated they plan to return to the international bond market later this calendar year
Public finances are a rating weakness. Fiscal consolidation efforts were affected by the coronavirus shock, but the general government scale deficit still declined to 8.1% of GDP in FY20 from 9.1% in FY19. The shock weighed on revenue in 4QFY20, but it still increased 28% for the full year due in large part to base effects from low revenue collection during FY19 and the authorities' earlier efforts to improve revenue collection. The government passed a PKR1.2 trillion (2.9% of GDP) coronavirus support package in March to lift health spending and provide assistance to low-income households, although delayed disbursements limited the impact on the FY20 deficit. Limited headroom due to a large scale deficit, low revenue and high debt is likely to constrain further scale stimulus beyond the March package.
Fitch forecasts the scale deficit to remain roughly stable at 8.2% in FY21, due to the lingering impacts of the coronavirus shock. Under the recently passed FY21 budget, the government targets a deficit of 7.0%, but, in Fitch's view, this target relies on optimistic revenue growth assumptions from ongoing administrative initiatives, as the budget does not contain new revenue raising measures.
It also forecasts that Pakistan's debt/GDP ratio will rise to about 90% at FYE21, from 87.2% at FYE20, well above the 'B' median of 50.8%, increasing debt sustainability concerns. The deterioration in the debt/GDP ratio is much more significant than our expectation of an 80% level by FYE20 at our last review in January, due to the coronavirus shock, as well as further currency depreciation. Under Fitch's baseline the debt ratio will begin a gradual decline in FY22, to about 85% of GDP by FYE25, as the scale deficit narrows and GDP growth picks up. Mitigating the risk around a high debt ratio is that roughly two-thirds of the debt stock is in local currency, compared with a 'B' median of about a third. The government is also seeking to extend maturities to limit rollover risks by taking advantage of the apparent appetite from the domestic banking sector for longer-dated issues.
Moreover, Fitch forecasts GDP growth to rebound to 1.2% in FY21, following a contraction of 0.4% in FY20 resulting from the pandemic and the authorities' macro adjustment policies. Risks to the forecasts are skewed to the downside given uncertainty around the coronavirus. Recent data show the spread of the virus to be declining, and the government appears keen to avoid re-imposition of widespread lockdown measures, opting instead for a “smart lockdown” strategy of targeting coronavirus hotspots. Recent locust infestations pose another downside risk to agriculture, and to the broader growth and the inflation outlook.
The monetary policy stance has been loosened to support the economy during the coronavirus shock. The central bank cut the policy rate by a cumulative 625bp to 7% between March and June. As a result, the real interest rate has turned negative, although Fitch forecasts that inflation will remain on a downward trajectory, averaging 7.8% during FY21 from 10.7% in FY20, supported by diminishing pass through from last year's substantial rupee depreciation.
The coronavirus poses a potential setback to the government's reform agenda, with policy focused on the pandemic response, and possibly affects the ability to advance politically challenging reforms. Nevertheless, the government has undertaken some reforms in the past months, although further steps to address circular debt in the power sector – a key element of the IMF programme – have been delayed.
Pakistan's rating is constrained by structural weaknesses, reflected in weak development and governance indicators. Per capita GDP of USD1,264 is below the USD2,867 median of its 'B' rated peers. Governance quality is also low in Pakistan with a World Bank Governance Indicator (WBGI) score in the 22nd percentile compared with a 'B' median in the 38th percentile.
ESG – Governance: Pakistan has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. These scores reflect the high weight that the WBGIs have in our proprietary Sovereign Rating Model. Pakistan has a low WBGI ranking at 22.5, reflecting the absence of a recent record of peaceful political transitions, relatively weak rights for participation in the political process, weak institutional capacity, uneven application of the rule of law and a high level of corruption.
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