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SINGAPORE: Moody’s on Wednesday changed the outlook on Pakistan’s rating to negative from stable driven by heightened external vulnerability risk as ongoing balance of payment pressures erode foreign exchange buffers.
Nonetheless, he affirmed the B3 debt ratings, considered as being speculative and a high credit risk.
The decision to change the outlook to negative is driven by heightened external vulnerability risk. Foreign exchange reserves have fallen to low levels and, absent significant capital inflows, and will not be replenished over the next 12-18 months. Low reserve adequacy threatens continued access to external financing at moderate costs, in turn potentially raising government liquidity risks.
The rating agency expects the government’s tax amnesty scheme — due to expire on June 30 — to have a modest impact of around $2-3 billion in foreign exchange inflows.
Moody’s said that the foreign exchange reserves have fallen to low levels and in the absence of significant capital inflows ‘would will not be replenished over the next 12-18 months’.
These credit strengths balance the fragile external payments position and very weak government debt affordability owing to low revenue generation capacity.
“Low reserves adequacy threatens continued access to external financing at moderate costs, in turn potentially raising government liquidity risks”.
Concurrently, Moody’s also affirmed the B3 foreign currency senior unsecured ratings for the second and third Pakistan International Sukuk, considered direct obligations of the government of Pakistan.
“These credit strengths balance Pakistan’s fragile external payment position and very weak government debt affordability owing to low revenue generation capacity”, Moody claimed.
Furthermore, 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 in the country.
Pakistan’s Ba3 local currency bond and deposit ceilings remain unchanged. There was no change in the B2 foreign currency bond ceiling and the Caa1 foreign currency deposit ceiling.
The short-term foreign currency bond and deposit ceilings also 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,” Moody’s concluded.
The ratings agency expects Pakistan’s external account to remain under significant pressure. Foreign exchange reserves will likely fall further from already low levels due to imports, while external debt payments due will weaken from currently adequate levels.
In turn, higher foreign currency borrowing needs, in combination with the low levels of foreign exchange buffers, risks weighing on the ability of the government to access external financing at moderate costs.
First, external vulnerability risks are related to sizeable current account deficit, which Moody’s expect will only narrow slightly to around 4-4.3% of GDP over the next few years, after an expected 4.6% in fiscal year 2018 compared to an average deficit of around 1.5% between FY2014 and FY2016.
Furthermore, continued growth in imports of goods, driven by demand for capital goods under the China-Pakistan Economic Corridor (CPEC) project, higher fuel prices and robust household consumption, will prevent a significant narrowing of the current account deficit.
Although goods exports have picked up since the start of 2018, growing around 10-15% per year, they will not be enough to narrow the trade gap. As a result, unless capital inflows increase significantly, Moody’s does not expect official foreign exchange reserves to replenish from their current low levels.
Stable foreign direct investment (FDI) inflows have not kept pace with the increased outflows driven by trade. As of end-May 2018, official foreign exchange reserves were around $10 billion, down more than 40% from their October 2016 peak and sufficient to cover just two months of imports.
Moody’s projects that the import cover of reserves will likely fall to around 1.7-1.8 months over the next fiscal year, below the adequacy level of three months generally recommended by the International Monetary Fund.
Second, the coverage by foreign exchange reserves of external debt payments due is weakening, pointing to further external vulnerability risks.
Pakistan’s external vulnerability indicator, the ratio of external debt payments due over the next year plus total nonresident deposits over one year to foreign exchange reserves, will rise to over 120% in FY2019 and further in FY2020, from around 80-85% at the start of FY2018.
It is stated that the government has so far allowed the rupee to depreciate by a total of 15% against the US dollar since December 2017, raised policy rates by a total of 75 basis points, and imposed regulatory duties on imports of nonessential goods.
Moody’s expects these measures to contribute to somewhat lower growth, at 5.2% on average over the next two fiscal years, from an expected 5.8% in FY2018, and higher inflation at 7.0% in FY2019, from around 4% in FY2018.
Further currency depreciation, higher policy rates, fiscal tightening, and/or higher regulatory duties would likely weigh further on growth and raise inflation above Moody’s current projections.