Fitch Revises Pakistan’s Outlook to Negative; Affirms at ‘B-‘

HONG KONG:

FitchRatings has revised Pakistan’s Outlook to Negative from Stable, while affirming its Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at ‘B-‘.

The agency has issued a detailed statement listing rating actions as listed below:

KEY RATING DRIVERS

Risks to Adjustment, Financing: The Revision of the Outlook to Negative reflects significant deterioration in Pakistan’s external liquidity position and financing conditions since early 2022. We assume IMF board approval of Pakistan’s new staff-level agreement with the IMF, but see considerable risks to its implementation and to continued access to financing after the programme’s expiry in June 2023 in a tough economic and political climate.

Political Risks: 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 organising 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 programme.

Reserves under Pressure: 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 USD10 billion or just over one month of current external payments by June 2022, down from about USD16 billion a year earlier.

External Deficits:We estimate the CAD reached USD17 billion (4.6% of GDP) in fiscal year ended June 2022 (FY22), driven by soaring global oil prices and a rise in non-oil imports boosted by strong private consumption. Fiscal tightening, higher interest rates, measures to limit energy consumption and imports underpin our forecast of a narrowing CAD to USD10 billion (2.6% of GDP) in FY23.

Large Funding Needs: Public debt maturities in FY23 are about USD21 billion. Maturities of about USD9 billion are to bilateral creditors (chiefly Saudi Arabia and China), which should be fairly easy to roll over with an IMF programme in place. Much of the USD5 billion in debt to commercial banks is also to China. 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.

Policy Getting Back on Track: 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 programme 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.

Fiscal Worsening then Consolidation: We estimate 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.

We expect a narrowing of the deficit to 5.6% of GDP (about PKR4.6 trillion or USD22 billion) in FY23, 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.

Debt Expected to Decline: We estimate Pakistan’s debt/GDP at 73% as at 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.

Other Debt Metrics Mixed: 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.

High Inflation, Monetary Tightening: 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.

Overheated Economy; Falling Growth: 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.

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. 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 programme 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 centred averages, including one year of forecasts, to produce a score equivalent to a 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.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Pakistan has an ESG Relevance Score of ‘5’ for political stability and rights, as WBGIs have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As Pakistan has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.

Pakistan has an ESG Relevance Score of ‘5’ for rule of law, institutional & regulatory quality and control of corruption, as WBGIs have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As Pakistan has a percentile rank below 50 for the respective governance indicators, this has a negative impact on the credit profile.

Pakistan has an ESG Relevance Score of ‘4’for human rights and political freedoms, as the voice and accountability pillar of the WBGIs is relevant to the rating and a rating driver. As Pakistan has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.

Pakistan has an ESG Relevance Score of ‘4’ for creditor rights, as willingness to service and repay debt is relevant to the rating and is a rating driver for Pakistan, as for all sovereigns. As Pakistan has had restructuring of public debt in 1998 and 2001, this has a negative impact on the credit profile.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity. For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.