Hong Kong February 14 2023: FitchRatings has downgraded Pakistan’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘CCC-‘, from ‘CCC+’. There is no Outlook assigned, as Fitch typically does not assign Outlooks to ratings of ‘CCC+’ or below.
KEY RATING DRIVERS
Further Worseningin Liquidity, Policy Risks: The downgrade reflects further sharp deterioration in external liquidity and funding conditions, and the decline of foreign-exchange (FX) reserves to critically low levels. While we assume a successful conclusion of the 9th review of Pakistan’s IMF programme, the downgrade also reflects large risks to continued programme performance and funding, including in the run-up to this year’s elections. Default or debt restructuring is an increasingly real possibility, in our view.
Reserves Under Pressure: Liquid net FX reserves of the State Bank of Pakistan were about USD2.9 billion on 3 February 2023, or less than three weeks of imports, down from a peak of more than USD20 billion at end-August 2021. Falling reserves reflect large, albeit declining, current account deficits (CADs), external debt servicing and earlier FX intervention by the central bank, particularly in 4Q22, when an informal exchange-rate cap appears to have been in place. We expect reserves to remain at low levels, though we do forecast a modest recovery during the remainder of FY23, due to anticipated inflows and the recent removal of the exchange rate cap.
Large Refinancing Risks: External public-debt maturities in the remainder of the fiscal year ending June 2023 (FY23) amount to over USD7 billion and will remain high in FY24. Of the USD7 billion remaining for FY23, USD3 billion represent deposits from China (SAFE) that are likely to be rolled over, and USD1.7 billion are loans from Chinese commercial banks which we also assume will be refinanced in the near future. The SAFE deposits are scheduled to mature in two instalments: USD2 billion in March and USD1 billion in June.
CAD Declining, but May Widen Again: Pakistan’s CAD was USD3.7 billion in 2H22, down from USD9 billion in 2H21. As such, we forecast a full-year deficit of USD4.7 billion (1.5% of GDP) in FY23 after USD17 billion (4.6% of GDP) in FY22. The narrowing of the CAD has been driven by restrictions on imports and FX availability, as well as by fiscal tightening, higher interest rates and measures to limit energy consumption.
Reported backlogs of unpaid imports in Pakistan’s ports indicate that the CAD could increase once more funding becomes available. Nevertheless, exchange-rate depreciation could limit the rise, as the authorities intend for imports to be financed through banks, without recourse to official reserves. Remittance inflows could also recover after they were partly switched to unofficial channels in 4Q22 to benefit from more favourable exchange rates in the parallel market.
Difficult IMF Conditions: Shortfalls in revenue collection, energy subsidies and policies inconsistent with a market-determined exchange rate have held up the 9th review of Pakistan’s IMF programme, which was originally due in November 2022. We understand that completion of the review hinges on additional front-loaded revenue measures and increases to regulated electricity and fuel prices.
Challenging Political Context: The IMF’s conditions are likely to prove socially and politically difficult amid a sharp economic slowdown, high inflation, and the devastation wrought by widespread floods last year. Elections are due by October 2023, and former prime minister Imran Khan, whose party will challenge the incumbent government in the elections, earlier rejected an invitation by Prime Minister Shehbhaz Sharif to hold talks on national issues, including IMF negotiations.
Funding Contingent on IMF Programme: Recent funding stress has been marked by the apparent reluctance of traditional allies – China, Saudi Arabia and the United Arab Emirates – to provide fresh assistance in the absence of an IMF programme, which is also critical for other multilateral and bilateral funding.
The Long-Term Foreign-Currency IDR also reflects the following factors:
Renewed Commitment by Authorities: The authorities appear close to agreement on the 9th programme review after the conclusion of the IMF’s staff visit to Pakistan on 9 February, and have already taken action that should facilitate agreement. This includes an apparent removal of a cap on the rupee exchange rate in January. The prime minister has repeatedly expressed the intention to remain in the programme.
Funding in the Pipeline: In addition to remaining IMF disbursements of USD2.5 billion, Pakistan stands to receive USD3.5 billion from other multilaterals in FY23 after agreement with the IMF is reached. There have been reports of over USD5 billion in additional commitments being considered by allies, on top of rollovers of existing funding, although details on the size and conditions are still pending. Pakistan received USD10 billion in pledges at a flood-relief conference in January 2023, mostly in the form of loans.
Government Committed to Debt Service: The prime minister has also expressed the intention to remain current on all debt obligations. Pakistan repaid a sukuk due in December 2022, and the next scheduled bond maturity is not until April 2024.
Restructuring Cannot be Fully Excluded: The previous finance minister said before resigning that Pakistan would seek debt relief from non-commercial creditors.
In addition, the prime minister had appealed for bilateral debt relief within the Paris Club framework, although no official request has been sent and this is no longer under consideration according to the authorities. Should Paris Club debt treatment be sought, Paris Club creditors would be likely to require comparable treatment for private external creditors in any restructuring. We believe local debt might be included in any restructuring, despite macro-financial stability considerations, as it accounts for 90% of the government’s interest burden.
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 WBGI ranking at the lower 22nd percentile.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to negative rating action/downgrade:
– Public Finances: Signs that a default of some sort appears probable; for example, indications that the authorities are considering debt restructuring, or further deterioration in external liquidity and funding conditions making traditional payment default more likely.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
– Public Finances: Strong performance against IMF programme conditions, ensuring continued availability of funding.
– External Finances: Rebuilding of foreign-currency reserves and easing of external financing risks.
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 IDR scale. However, in accordance with its rating criteria, Fitch’s sovereign rating committee has not utilised 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 Long-Term Foreign-Currency 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.
