Spearhead Analysis – 21.06.2018
By Farrukh Karamat
Senior Research Coordinator, Spearhead Research
After the recent Rupee devaluation and the potential looming payment obligations on account of cases in international arbitration, on June 18, 2018, Moody’s Investors Service (Moody’s) rating committee reviewed the rating of Pakistan. After a thorough economic and financial review of key fundamentals the outlook on Pakistan’s rating was changed to negative from stable, while the B3 country rating was maintained along with B3 for local and foreign currency long-term issuer and senior unsecured debt. The negative outlook is a direct result of increased “external vulnerability risk”. A main reason is the continued decline in the Central Bank held Foreign Exchange reserves that currently stand at US$10.04 Billion (May 2017: US$16.4 Billion), and limited prospects of increased inflows over the next year and a half, with rising outflows. As per Moody’s: “Low reserve adequacy threatens continued access to external financing at moderate costs, in turn potentially raising government liquidity risks”.
At the same time the B3 rating is based on potential for growth, with improved energy supply and physical infrastructure, which has the potential to raise economic competitiveness. However, the external payments position has been termed “fragile” and the government debt affordability “very weak” with low levels of government revenue generation capacity. This reflects the misaligned developmental work undertaken by the government and the huge reliance on debt for funding projects and fiscal gaps as opposed to genuine revenue enhancement over the past five years.
Based on the fact that the debt payment obligations for Sukuk offerings are a direct obligation of the Government of Pakistan, the B3 foreign currency senior unsecured ratings have been maintained for The Second Pakistan Int’l Sukuk Co. Ltd. and The Third Pakistan International Sukuk Co Ltd. The Pakistan’s Ba3 local currency bond and deposit ceilings; the B2 foreign currency bond ceiling; and the Caa1 foreign currency deposit ceiling have been maintained. It is relevant to note that the short-term foreign currency bond and deposit ceilings remain unchanged at Not-Prime.
Moody’s has stated that there is an expectation that Pakistan’s external account is likely to remain strained, as the import coverage by foreign exchange reserves is likely to continue to decline in the coming months, and external debt payment coverage will “weaken” further. As a result, the continued higher foreign currency borrowing needs to meet the external account deficits in the face of declining forex reserves will curtail the ability of the government to access external funding at competitive rates. Moody’s prediction is coming true, as the government scrambles to raise financing from Chinese Banks at commercial rates, even with the sovereign guarantees.
The current account deficit shot up by 43 per cent to US$15.96 Billion in the first 11 months of the outgoing fiscal year with higher imports, sluggish exports and lower workers’ remittances. The July-May deficit is close to the full-year’s estimate of US$16 Billion, and the FY2017-18 deficit could potentially rise to US$17.5 Billion by end of June 2018. As a result, the external vulnerability risks have increased with expected deficit at 4.6 per cent of GDP. Moody’s expects the current account deficit level to remain within 4.0-4.3 per cent of GDP over the next few years. It is relevant to note that the current account deficit averaged around 1.5 per cent between FY2014 and FY2016.
The current account deficit is unlikely to go down with a significant increase in imports fueled by the China-Pakistan Economic Corridor (CPEC) projects, rising fuel prices and the strong household consumption from a growing middle class. Pakistan’s oil import bill rose nearly 30.43 per cent year-on-year (YoY) to US$12.928 Billion in the July-May period of the current fiscal year, and is likely to rise further with higher oil prices in international markets. While Pakistan has improved its exports in the current fiscal year as a result of subsidies and devaluation, the exports remains much below the imports and the trade gap is unlikely to be reduced in the near future.
As a result, there is limited scope for upside in capital inflows and an increase in foreign exchange reserves. It is a fact that foreign direct investment (FDI) inflows have not kept pace with the increased outflows. “Under Moody’s baseline projection, the import cover of reserves will likely fall to around 1.7-1.8 months (from the current 2 months) over the next fiscal year, below the adequacy level of three months …. recommended by the International Monetary Fund (IMF)”. The much advertised Tax Amnesty Scheme is likely to have a US$2-3 Billion impact on forex inflows, as per Moody’s.
With the rising debt levels and limited inflows the external debt payments coverage is also weakening. A limited possibility of increase in equity inflows is cited and the external financing gap will have to be met by increased foreign currency borrowing. As per Moody’s “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 per cent in FY2019 and further in FY2020, from around 80-85 per cent at the start of FY2018.”
It is relevant to note that Moody’s has asserted that, ‘while the Pakistani rupee has depreciated by around 15 per cent against the US dollar since December 2017, the policy rates has risen by 75 basis points, and regulatory duties have been imposed on imports of nonessential goods…. these measures would contribute to ….. lower growth, at 5.2 per cent on average over the next two fiscal years, from an expected 5.8% in FY2018, and higher inflation at 7.0 per cent in FY2019, from around 4 per cent 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’.
The growth potential of Pakistan has been maintained at above 5.0 per cent partly as a result of the management of the energy shortage, which has the potential for spurring investment in the different sectors. In addition, the CPEC-related infrastructure projects are likely to enhance the growth potential, through improved transport connectivity allowing Pakistan to become a regional trade hub.
Despite the positives Pakistan’s ranks very low on economic competitiveness at 115th out of 138 countries according to the World Economic Forum’s 2017-2018 Global Competitiveness Report. This is a direct manifestation of poor infrastructure, weak institutions, and deficiencies in health and primary education. Unfortunately, successive governments have failed to address the issues of institution building and strengthening, and robust social sector reforms in the health and education sectors. In addition, with a rapidly rising population and a looming water crisis, Pakistan faces a significant internal threat in terms of unrest within large segments of marginalized population.
With a focus on expanding the tax base and instituting reforms to increase tax compliance there is an expectation that there would be a gradual increase in the revenue generating capacity from the current low levels of 16 per cent of GDP — one of the lowest globally. For now, debt affordability remains weak, severely ‘constraining the government’s fiscal space, particularly in light of ongoing infrastructure and social spending needs’. The lackluster response to the recent Amnesty Scheme is a proof of a trust deficit, where the people are unwilling to come forward even with assurance by the government. This combined with the endemic corruption within the government departments poses a significant threat to any efforts for enhancing revenue generating capacity.
It is relevant to note the salient features of Moody’s expectations from the rating review were:
- Fiscal deficit to remain around 5 per cent of GDP in FY2019 and FY2020, after a projected deficit of 5.8 per cent in FY2018.
- The debt burden will not fall from the current, relatively high levels, of around 70-73 per cent of GDP.
- The government’s gross borrowing requirement remains one of the highest across Moody’s rated sovereigns, and is expected to remain around 27-30 per cent of GDP over the next two fiscal years.
- A sudden rise in the cost of debt beyond Moody’s assumptions would have a rapid and significant negative effect on debt affordability.
The assigned negative outlook is significant as it clearly signals that a rating upgrade in unlikely in the near future, given the high external macroeconomic vulnerability risks and the considerable rise in debt. Any further decline in the external position, including erosion of foreign exchange reserves could threaten the external repayment capacity and significantly heighten liquidity risks. Shocks such as a continued rise in oil prices, further devaluation of the Rupee, and the possibility of having to make heavy payments on account of arbitration cases could pose significant threats for an already fragile economy. Just as there is euphoria over a rating upgrade it is now time to ponder the Moody’s outlook downgrade. It should act an eye-opener for the current interim government and the incoming incumbents to get their act together and devise policies to address the macroeconomic vulnerabilities that could potentially threaten Pakistan.