Fitch Ratings downgrades Pakistan to 'CCC+'
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Fitch Ratings Friday downgraded Pakistan's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'CCC+' from 'B-'. Fitch typically does not assign Outlooks to sovereigns with a rating of 'CCC+' or below.
KEY RATING DRIVERS
Worsening Liquidity, Policy Risks: The downgrade reflects further deterioration in Pakistan's external liquidity and funding conditions, and the decline of foreign-exchange (FX) reserves. This is partly a result of widespread floods, which will undermine Pakistan's efforts to rein in twin fiscal and current account deficits. The downgrade also reflects our view of increased risks of policies potentially undermining Pakistan's IMF programme and official financial support.
Reserves Under Pressure: Liquid net FX reserves of the State Bank of Pakistan (SBP) were about USD7.6 billion by 14 October 2022, or about a month of current external payments, down from more than USD20 billion at end-August 2021. Falling reserves reflect large, albeit, declining current account deficits (CADs), external debt servicing and earlier FX interventions by the SBP.
Before stabilising in the week to 14 October, reserves had been falling every week since the disbursement of USD1.2 billion from the IMF in the week to 2 September, upon the completion of the 7th and 8th reviews of Pakistan's Extended Fund Facility (EFF).
External Deficits: The CAD reached USD17 billion (4.6% of GDP) in the fiscal year to June 2022 (FY22), driven by soaring oil prices and higher non-oil imports on strong private consumption. Fiscal tightening, higher interest rates and measures to limit energy consumption and imports underpin our forecast for the CAD to narrow to USD10 billion (2.7% of GDP) in FY23, despite the hit to export revenue and import needs after the recent floods. Lower imports and commodity prices helped to narrow the CAD in recent months, to about USD300 million in September.
Large Funding Needs: Pakistan's external public debt maturities in FY23 are over USD21 billion, mostly to bilateral and multilateral creditors, which mitigates rollover risks, and there are already agreements to roll over some of these. The authorities estimate the flood damage at USD10 billion-30 billion, but reconstruction costs are likely to be lower, as is the impact on Pakistan's twin deficits.
Some New Funding: Pakistan recently received funding commitments of USD2.5 billion from the World Bank and Asian Development Bank, according to the authorities, although we understand that much of this is repurposed from ongoing programmes. It remains unclear to what degree the IMF will be able to relax Pakistan's programme targets, or augment Pakistan's access under the EFF.
Policy, IMF Programme Risks: We assume Pakistan will continue to receive disbursements under its IMF programme, but risks to this have risen. Fuel-price cuts from 1 October may not be compatible with commitments to the IMF. A quarterly electricity tariff adjustment due in October has yet to happen. The new finance minister has re-affirmed commitment to the programme, but prefers a strong exchange rate, and may revisit the SBP law that was amended in early 2022 to grant the SBP greater autonomy, as previously agreed with the IMF.
The 'CCC+' Long-Term Foreign-Currency IDR also reflects the following factors:
Debt Relief Raised, Rejected: The previous finance minister said before resigning that Pakistan would seek debt relief from non-commercial creditors, although he reiterated the intention to repay the USD1 billion bond due in December 2022. Prime Minister Shehbaz Sharif also appealed for debt relief within the Paris Club framework. More recently, however, the Minister of Finance publicly ruled this out.
Pakistan's debt to private creditors (or official Paris Club creditors) is only a small fraction of the total and the authorities maintain that they have no intention to restructure debt to private creditors.
Political Volatility: Former Prime Minister Imran Khan, who was ousted in a no-confidence vote on 10 April, continues to put political pressure on the government, organising protests across the country calling for early elections. Mr Khan's PTI party won by-elections in the key Punjab province in July, defeating the incumbent PML-N, and PTI won more national and provincial seats in by-elections on 17 October. Regular elections are due in October 2023, creating the risk of policy slippage after the conclusion of the IMF programme due in June.
Fiscal Worsening, Consolidation: The fiscal deficit widened to 7.9% of GDP (over 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 6.2% of GDP (about PKR5 trillion or USD23 billion) in FY23, driven by some spending restraint and higher taxes.
Debt to Decline: Pakistan's debt/GDP ratio was 73% at FYE22, broadly in line with the current 'B' median. We expect debt/GDP to fall to 70% in FY23 and continue decreasing, helped by high inflation and a modest primary deficit. A low FX exposure at just over 30% of total debt limits 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 and averaged 25% yoy (1.8% mom) in July-September, driven by hikes to petrol and electricity prices. The SBP maintained its policy rate at 15% at its last meeting on 10 October, after cumulative rate hikes of 800bp in the latest tightening cycle.
Slowing Growth: We forecast GDP growth to decelerate to about 2% in FY23, from 6% in FY22, amid fiscal and monetary tightening, high imported inflation, a weak external demand outlook, and flood-related disruptions. This is broadly in line with the government's forecast, down from its initial target of 5% and a 3.5% forecast in the IMF programme. The 2010-2011 floods contributed to Pakistan's weak recovery after the global financial crisis.
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.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
- External Finances: Further deterioration in external liquidity and funding conditions, for example reflected in renewed widening of current account deficits and further decline in international reserves.
- Public Finances: Increased possibility of default, for example due to policies undermining availability of IMF and other funding, or moves by the authorities to formally seek debt restructuring.
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: Strong performance against IMF programme conditions ensuring continued availability of funding.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Pakistan a score equivalent to a rating of 'CCC+' on the Long-Term Foreign-Currency (LT FC) IDR scale.
However, in accordance with its rating criteria, Fitch's sovereign rating committee has not utilized the SRM and QO to explain the ratings in this instance. Ratings of 'CCC+' and below are instead guided by the rating definitions.
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 LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, 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.
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. Pakistan participated in the Debt Service Suspension Initiative in 2020, and had earlier restructurings of public debt in 2001 and 1998.