Strong growth momentum, supported by domestic demand and CPEC investments
After growing 5.3% in the fiscal year ending June 2017 (FY2017), Pakistan's economy has maintained its solid momentum through the first half of FY2018. Economic growth has been supported in particular by the ongoing recovery in the agricultural sector, aided by an increase in credit disbursements and more favorable weather conditions, as well as robust activity in large-scale manufacturing owing to improved energy availability and capacity expansions. Higher remittance inflows, which rose 3.4% year-on-year in the first eight months of FY2018 after having contracted for most of FY2017, would likely have provided a further fillip to growth.
Moody’s GDP growth forecast of 5.5% for FY2018 takes into account these domestic factors, as well as ongoing investments related to CPEC. The strong domestic economy has been acknowledged by the State Bank of Pakistan (SBP), which raised its policy rate in January this year for the first time since June 2016 – by 25 basis points to 6%. That said, analysts at Moodys’ do not anticipate the SBP to aggressively raise rates ahead of the July 2018 general election. Inflationary pressures remain modest; in fact, inflation in February was 3.8%, down from the recent peak of 4.6% in December 2017 and lower than the SBP's inflation target of 6% for FY2018.
External pressures remain, currency adjustments unlikely to provide substantial relief
The strong domestic demand has also increased pressure on Pakistan's external account. In particular, the current account deficit widened to $7.5 billion in the first half of FY2018 (compared to $4.7 billion in the first half of FY2017), driven by a large increase in the goods deficit. This was due primarily to higher CPEC-related capital goods imports, even though exports and secondary income also rose. Despite the larger first half deficit, Moodys’ expect the FY2018 current account deficit to remain around similar levels at 3.5% of GDP, with downside risks to our forecast. We think the brighter prospects for exports and remittances – the latter will be supported by higher inflows from Gulf Cooperation Council (GCC) economies if oil prices remain at current levels – as well as the completion of most energy-related projects under CPEC, which are more import-intensive than infrastructure projects, will prevent a sharp deterioration in the current account.
By contrast, we do not expect the exchange rate of the Pakistani rupee (PKR) to provide meaningful relief to the external pressures, at least not until after the general election. The SBP had announced in a press release last December that it would allow the PKR to reflect supply and demand conditions in the foreign exchange market in the face of rising external pressures and declining foreign exchange reserves. However, the 5% depreciation of the PKR against the US dollar (USD) over three trading days has not been followed by further depreciation, despite a decline in Pakistan's foreign reserves. Foreign reserves reached a thirty-four month low of $12.1 billion on 9 March 2018, representing 2.5 months of import cover on a three-month rolling basis and below the IMF's three-month minimum adequacy guideline.
US military aid has resumed after initially announcing in January 2018 that all security assistance aid to Pakistan would be suspended, the Trump administration subsequently submitted a proposal to the US Congress to approve civil and military aid that is roughly in line with prior year funding levels. While Moodys’ continue to think that a reduction in US military aid in itself would not have a material effect on Pakistan's public finances, the resumption of military aid flows would on margin ease the pressure on the government deficit, which it expect will amount to 5.5% of GDP in FY2018.
Meanwhile, the media has speculated that Pakistan will be added to the Financial Action Task Force's (FATF) grey list in June 2018, joining countries such as Serbia (Ba3 stable), Ethiopia (B1 stable), Sri Lanka (B1 negative), and Tunisia (B2 stable) as monitored jurisdictions. However, Moodys’ does not expect Pakistan's addition to the grey list to have a material impact on its external financing. Pakistan was previously on this list between 2012 and 2015 but managed to negotiate and enter into an IMF program during that time. As such, we do not anticipate any disruptions to borrowing from multilateral sources, which account for a significant portion of Pakistan's external borrowing. Any adverse effects are more likely to materialize in the form of higher risk premia and borrowing costs, as well as more onerous compliance requirements.