July 19, 2022 (MLN): Fitch Ratings on Tuesday revised Pakistan's Outlook to Negative from Stable while affirming its Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at 'B-'.

The revision of the outlook to Negative reflects a significant deterioration in Pakistan's external liquidity position and financing conditions since early 2022.

Fitch assumes IMF board approval of Pakistan's new staff-level agreement with the IMF but sees considerable risks to its implementation and to continued access to financing after the program's expiry in June 2023 in a tough economic and political climate.

With regards to political risks, the rating agency is of the view that renewed political volatility cannot be excluded and could undermine the authorities' fiscal and external adjustment, as happened in early 2022 and 2018, particularly in the current environment of slowing growth and high inflation.

Former Prime Minister Imran Khan, who was ousted in a no-confidence vote on 10 April, has called on the government to hold early elections and has been organizing large-scale protests in cities around the country. The new government is supported by a disparate coalition of parties with only a slim majority in parliament.

Regular elections are due in October 2023, creating the risk of policy slippage after the conclusion of the IMF program, the agency noted. 

In addition, limited external funding and large current account deficits (CADs) have drained foreign exchange (FX) reserves, as the State Bank of Pakistan (SBP) has used reserves to slow currency depreciation. Liquid net FX reserves at the SBP declined to about $10 billion or just over one month of current external payments by June 2022, down from about $16bn a year earlier.

According to the estimations put forth by Fitch, the CAD reached $17bn (4.6% of GDP) in FY22, driven by soaring global oil prices and a rise in non-oil imports boosted by strong private consumption. Fiscal tightening, higher interest rates, and measures to limit energy consumption, and imports underpin our forecast of a narrowing CAD to $10bn (2.6% of GDP) in FY23.

Public debt maturities in FY23 are about $21bn. Maturities of about $9bn are to bilateral creditors (chiefly Saudi Arabia and China), which should be fairly easy to roll over with an IMF program in place. Much of the USD5 billion in debt to commercial banks are also to China.

The staff-level agreement will potentially unlock USD4 billion in IMF disbursements to Pakistan in FY23, assuming board approval of a USD1 billion augmentation and extension to June 2023, the report added.

It further noted that Pakistan's 'B-' rating reflects recurring external vulnerability, a narrow fiscal revenue base, and low governance indicator scores compared with the 'B' median. External funding conditions and liquidity will likely improve with the new staff-level agreement.

Nevertheless, slippage against program conditions is a risk and could quickly lead to renewed strains, while diminished FX reserves and high funding needs now leave less room for error. Pakistan's access to market finance could remain constrained.

Fitch further estimated that the fiscal deficit widened to 7.5% of GDP (nearly PKR5 trillion) in FY22, from 6.1% in FY21. Tax reductions and subsidies on fuel and electricity account for most of the fiscal deterioration; these were introduced by the previous government in February and lasted until June.

A narrowing of the deficit to 5.6% of GDP (about PKR4.6 trillion or USD22 billion) in FY23 is anticipated by the agency, driven by spending restraint as well as by expanded taxation, including higher corporate and personal income taxes and increases in the petroleum levy. “Our forecast of the fiscal deficit is about 1% of GDP wider than the authorities' target,” it said.

Debt Expected to Decline: We estimate Pakistan's debt/GDP at 73% as of FYE22, broadly in line with the current 'B' median, following an earlier GDP rebasing in FY21, which lowered the debt ratio by 12pp.

“We expect debt/GDP to decline to 66% in FY23 and remain on a downward trend, helped by high inflation and a modest primary deficit, which we forecast at 0.9% of GDP in FY23, down from 2.8% of GDP in FY22,” it said. 

Furthermore, a low FX exposure at just over 30% of total debt has limited the negative impact of currency depreciation on debt dynamics. Nevertheless, debt/revenue (at over 600% in FY22) and interest/revenue (at about 40%) are significantly worse than the 'B' median. This largely reflects low general government revenue of 12% of GDP in FY22.

The report also highlighted that consumer price inflation averaged 12.2% in FY22 but accelerated to 21.3% YoY (6.3% mom) in June on hikes to petrol and electricity prices. The SBP forecast inflation of 18%-20% in FY23, as it raised its policy rate by 125bp to 15% at its most recent action on 7 July. SBP's latest action took cumulative rate hikes to 800bp in this latest tightening cycle.

“Our forecast of average inflation of 19% in FY23 and 8% in FY24 largely reflects base effects, but recent and planned future energy price hikes will all fuel broad-based inflation, and mean inflation is skewed to the upside,” Fitch noted. 

Preliminary estimates show real GDP growth of 6% for FY22, up from 5.7% in FY21, mostly driven by private consumption, as in FY21, while net exports continued to weigh on growth. In our view, this largely reflected a loosening of fiscal policy in FY22, as well as a fairly loose monetary policy despite significant tightening throughout the year (ex-post real policy rates on average negative in FY22).

The SBP estimates that the economy was operating above potential in FY22, and we forecast slower growth of 3.5% in FY23 amid fiscal and monetary tightening, high imported inflation, and a weaker external demand outlook, all of which will also hit household and business confidence.

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. These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model (SRM). Pakistan has a low WBGI ranking at the lower 22nd percentile.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

External Finances: Lack of improvement in external liquidity and funding conditions

Public Finances: A fiscal policy reversal undermining IMF program performance and disbursements, for example as a result of socio-political pressures

Factors that could, individually or collectively, lead to positive rating action/upgrade:

External Finances: Rebuilding of Pakistan's foreign-currency reserves and easing of external financing risks

Public Finances: Sustained reduction in debt/GDP and debt/revenue ratios, for instance through revenue-driven fiscal consolidation and strong economic growth.

Macro: Improved medium-term growth and export prospects, for example as a result of improvements to the regulatory and business environments

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Pakistan a score equivalent to a rating of 'CCC+' on the LTFC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM score to arrive at the LTFC IDR by applying its QO, relative to SRM data and output, as follows:

Structural: +1 notch to adjust for the negative effect on the SRM of Pakistan's take-up of the Debt Service Suspension Initiative, which prompted a reset of the 'years since default or restructuring event' variable, which can pertain both to official and commercial debt. In this case, we judged that the deterioration in the model as a result of the reset does not signal a weakening of the sovereign's capacity or willingness to meet its obligations to private-sector creditors.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centered averages, including one year of forecasts, to produce a score equivalent to an LTFC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the IDR, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

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