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S&P Downgrades Pakistan To 'CCC+/C' On Enduring External, Economic, Fiscal Risks

Dec 23, 2022, 12:20 pm

As per a report by S&P Pakistan's economy faces a weaker outlook in fiscal 2023 following the floods. Simultaneously, domestic demand is grappling with rising prices, particularly for staple goods. Consumer price index (CPI) inflation has surged to more than 20% year on year at the national level, and will remain elevated for the rest of this fiscal year.

After successfully completing the seventh and eighth reviews under the IMF's Extended Funding Facility (EFF) program, the Pakistan government is facing fresh challenges in meeting the performance requirements for subsequent reviews. Disbursements under the EFF, which began in July 2019, amount to approximately US$4.0 billion so far, including a US$1.2 billion allocation in August 2022.

The current inflationary environment, coupled with a material slowdown in economic activity and, in some cases, severe humanitarian needs related to the floods, complicates the implementation of measures to consolidate the government's wide fiscal deficit. It will be more difficult for the government to achieve a primary fiscal balance surplus, and boost its stock of foreign exchange reserves, than it was in earlier in 2022.

With its tenure set to end by August 2023 or earlier, the government has limited time to implement meaningful economic reforms, especially those that may imperil electoral support for coalition members. S&P expects political uncertainty to remain elevated over the coming quarters, with continued pressure from the opposition to hold early elections.

The ratings on Pakistan remain constrained by a narrow tax base and elevated domestic and external security risks. The country's security situation has gradually improved over recent years, but ongoing vulnerabilities weaken the government's effectiveness and weigh on the business climate. Occasional tensions with India, and Pakistan's extended land border with Afghanistan, pose challenges to Pakistan's long-term economic outlook.

The Pakistani rupee's recent depreciation against the U.S. dollar has also contributed to a continued stagnation in the country's nominal GDP per capita. Coupled with lower real GDP growth expectations, we forecast GDP per capita will stabilize just above US$1,500 by fiscal 2025.

Flexibility and performance profile: Fiscal and external accounts face mounting pressure from steep inflation and rising interest rates

  • S&P projects Pakistan's current account deficit will narrow to 3.3% of GDP in 2023 versus 4.7% of GDP this year, but improvement is highly contingent on energy and food prices, as well as the continued imposition of administrative measures on imports.

  • S&P estimates that Pakistan's usable foreign exchange reserves will remain low, at around one month of current account payments.

  • Higher debt-servicing costs are exerting pressure on the government's fiscal position. With revenues of just over 12% of GDP, the government's capacity to raise taxes is among the weakest of all rated sovereigns.

Pakistan's fiscal and external positions will face continued pressure from high inflation and interest rates, as well as difficult market conditions, which are set to continue over the next 12 months. S&P forecast sthe general government's fiscal deficit will remain elevated at 6.5% of GDP in the current fiscal year, versus 7.9% of GDP in fiscal 2022. Weaker economic growth conditions this year will constrain revenue growth, even as the government maintains efforts to rein in its expenditure bill. The willingness and ability of of policymakers to stay the course on tight expenditure settings while making continued enhancements to the country's revenue program will be critical to meeting ambitious targets in the IMF's EFF agreement.

S&P forecasts Pakistan's average annual change in net general government debt will be 7.8% of GDP from fiscal 2023 through to fiscal 2025. This reflects our expectations of gradually smaller shortfalls, in combination with a continued depreciation of the Pakistani rupee.

These trends will keep Pakistan's net debt stock high at about 71% of GDP. Of the government's gross debt stock, approximately 27% of GDP is external debt, and we estimate that slightly less than 40% of the total debt stock is denominated in foreign currency.

Pakistan's elevated interest expense relative to fiscal revenue is an additional constraint on our assessment of the government's debt burden. S&P anticipates rising interest rates and a weaker rupee will keep this ratio highly elevated, at more than 45% of revenues, over the next few years. This interest burden level poses risks to the sustainability of the government's debt stock.

Financial support from bilateral creditors, including the United Arab Emirates, the People's Bank of China (PBoC), and Saudi Arabia, remains critical to Pakistan's ability to meet high external financing needs. We estimate total support from these three partners at US$13.6 billion, and add this sum to the government's total stock of debt. Additional support from bilateral partners could increasingly depend on Pakistan's ability to maintain its EFF program with the IMF.

Combined support from Pakistan's international partners, including multilateral institutions, remains crucial in the country meeting its external financing needs over the coming years.

Pakistan's external data provision is timely and generally of good quality. The current account deficit has declined over recent months following a shortfall of 4.7% of GDP in fiscal 2022. However, this narrowing is partially the product of import compression, related to a much weaker economy and administrative measures to tighten the generation of credit facilities for imports.

Despite S&P's expectation for a moderation of the full-year deficit to about 3.3% of GDP, Pakistan's overall balance of payments deficit and continued debt maturities will place sustained downward pressure on its foreign exchange reserves, absent considerable new funding.

Gross external financing needs, as well as net external indebtedness, will remain at critical levels over the next one to two years, reflecting Pakistan's weak external balance sheet and enduring liquidity stress.

Pakistan's foreign exchange reserves depend heavily on the renewal of existing bilateral credit and commercial loan facilities, as well as on the potential extension of new ones. Despite sizable disbursements from the Asian Development Bank, the Asian Infrastructure Investment Bank, and the IMF over recent months, liquid foreign exchange reserves held by the State Bank of Pakistan (SBP) continue to decline, and stood at a multi-year low of about US$6.7 billion as of Dec. 9, 2022.

Additional aid from either multilateral institutions or bilateral partners would further add to Pakistan's substantial net external debt position.

S&P forecasts this net external debt position will reach 175% of current account receipts by the end of this fiscal year.

Pakistan is experiencing rapid inflation, with the national CPI rising by 26.6% year on year in October. The central bank has responded by aggressively tightening monetary policy, including a cumulative 625 basis points (bps) hike to its policy rate since December 2021, in order to tamp down inflationary pressure and lean against continued depreciation of the rupee.

S&P expects inflation to remain elevated into 2023, before beginning to moderate in the second half of that calendar year. Nevertheless, Pakistan's higher interest rates will continue to squeeze the government's debt-servicing costs over the next two to three years, given its large stock of local currency-denominated debt.

Pakistan's banking system is modest by international standards (though larger than that of other sovereigns in the 'CCC' category). Total bank assets comprise about 52% of GDP. S&P Global Ratings does not publish a Banking Industry Country Risk Assessment on Pakistan. However, despite the banking system's large exposure to the sovereign, it is, in our opinion, stable, liquid, and adequately capitalized. Combining our view of Pakistan's government-related entities and its financial system, we assess the country's contingent fiscal risks as limited. That said, at more than 20% of total system assets, Pakistan's banking system bears an outsized exposure to the sovereign.

Earlier this year, Pakistan amended the SBP Act, which affords additional independence to the central bank, in line with IMF program objectives. S&P believes that the SBP's autonomy and performance have strengthened since the establishment of a monetary policy committee for rate-setting in January 2016.

S&P understands that under the IMF's EFF program for Pakistan, the SBP will no longer provide net financing to the central government. This has strengthened the SBP's capacity to focus on fighting inflation. In keeping with this objective, the SBP's interest rate corridor strengthens the monetary transmission mechanism by better targeting of short-term market interest rates, in our view.

The central bank has allowed the rupee to float more freely with market forces over the past two years. While recent currency depreciation against the U.S. dollar will push up external debt-servicing costs, a more flexible exchange rate will also mitigate the risk of currency-driven structural imbalances accumulating over the long term.

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