The new low

The Moody’s Investors Service on Tuesday downgraded PakistanR17;s local and foreign currency issuer and senior unsecured debt ratings to Caa3 from Caa1. It also downgraded the rating for the senior unsecured MTN programme to (P)Caa3 from (P)Caa1. However, it changed the outlook to stable from negative. The decision to downgrade the ratings is driven by Moody’s assessment that PakistanR17;s increasingly fragile liquidity and external position significantly raises default risks to a level consistent with a Caa3 rating, the global rating agency said in a statement. In particular, the country’s foreign exchange reserves have fallen to extremely low levels, far lower than necessary to cover its imports needs and external debt obligations over the immediate and medium term. Although the government is implementing some tax measures to meet the conditions of the IMF programme and a disbursement by the IMF may help to cover the country’s immediate needs, weak governance and heightened social risks impede PakistanR17;s ability to continually implement the range of policies that would secure large amounts of financing and decisively mitigate risks to the balance of payments, it added. The stable outlook reflects Moody’s assessment that the pressures that Pakistan faces are consistent with a Caa3 rating level, with broadly balanced risks. Significant external financing becoming available in the very near term, such as through the disbursement of the next tranches under the current IMF programme and related financing, would reduce default risk potentially to a level consistent with a higher rating. However, in the current extremely fragile balance of payments situation, disbursements may not be secured in time to avoid a default. Moreover, beyond the life of the current IMF programme that ends in June 2023, there is very limited visibility on PakistanR17;s sources of financing for its sizeable external payments needs. The downgrade to Caa3 from Caa1 rating also applies to the backed foreign currency senior unsecured ratings for The Pakistan Global Sukuk Programme Co Ltd. The associated payment obligations are, in Moody’s view, direct obligations of the Government of Pakistan. Concurrent to the action, Moody’s has lowered PakistanR17;s local and foreign currency country ceilings to Caa1 and Caa3 from B2 and Caa1, respectively. The two-notch gap between the local currency ceiling and sovereign rating is driven by the government’s relatively large footprint in the economy, weak institutions, and relatively high political and external vulnerability risk. The two-notch gap between the foreign currency ceiling and the local currency ceiling reflects incomplete capital account convertibility and relatively weak policy effectiveness. It also takes into account material risks of transfer and convertibility restrictions being imposed. Government liquidity and external vulnerability risks have risen further since Moody’s last review in October 2022. PakistanR17;s foreign exchange reserves have declined to a critically low level, sufficient to cover less than one month of imports. Amid delays in securing official sector funding, risks that Pakistan may not be able to source enough financing to meet its needs for the rest of fiscal 2023 (ending June 2023) have increased. Beyond this fiscal year, liquidity and external vulnerability risks will continue to be elevated, as PakistanR17;s financing needs will remain significant and financing sources are far from secure. At the same time, prospects of the country materially increasing its foreign exchange reserves are low. Overall, Moody’s estimates that PakistanR17;s external financing needs for the rest of the fiscal year ending June 2023 to be around $11 billion, including the outstanding $7 billion external debt payments due. The remainder includes the current account deficit, taking into account a sharp narrowing as imports have contracted markedly. To meet these financing needs, Pakistan will need to secure financing from the IMF and other multilateral and bilateral partners. Despite recent delays, Moody’s assumes successful completion of the ninth review of the existing IMF programme, although this is not secured yet. This would in turn catalyse financing from other multilateral and bilateral partners. At the same time, the government will also need to obtain the roll-over of the $3 billion China SAFE deposits and secure $3.3 billion worth of refinancing from Chinese commercial banks for the rest of this fiscal year. Of this $3.3 billion, Pakistan has already received a deposit of $700 million from the China Development Bank on 24 February 2023.While this year’s external payments needs may be met, the liquidity and external position next year will remain extremely fragile. PakistanR17;s external debt repayments will remain high for the next few years. Moody’s estimates PakistanR17;s external financing needs for fiscal 2024 are around $35-36 billion. Pakistan has about $25-26 billion worth of external debt repayments (including interest payments) to make in fiscal 2024, including a $1 billion Eurobond due in April 2024. In addition, Moody’s estimates PakistanR17;s current account deficit at around $10 billion.PakistanR17;s financing options beyond June 2023 are highly uncertain. It is not clear that another IMF programme is under discussion and if it does happen, how long the negotiations would take and what conditions would be attached to it. However, in the absence of an IMF programme, Pakistan is unlikely to unlock sufficient financing from multilateral and bilateral partners. Elevated social risks and weak governance compound the government’s difficulty in advancing further reforms. Households are already facing high and increasing costs of living. Inflation in Pakistan is very high, with food inflation at 42.9% and transport inflation at 39.1% year-on-year in January 2023. Headline inflation is likely to rise further as energy prices increase in tandem with the removal of energy subsidies. Implementing further measures to raise revenue or cut spending in this environment is extremely socially and politically challenging. At the same time, reform measures to raise fiscal revenue are likely to remain key to unlocking further financing from the IMF, as they will help to alleviate debt sustainability risks. In particular, Pakistan has very weak debt affordability. Moody’s estimates that interest payments will increase to around 50% of government revenue in fiscal 2023 and stabilise at this level for the next few years. A significant share of revenue going towards interest payments will increasingly constrain the government’s capacity to service its debt while also meeting the population’s essential social spending needs.The stable outlook reflects Moody’s assessment that the credit pressures that Pakistan faces are broadly balanced at a Caa3 rating level.Continued IMF engagement, including beyond the current programme, would likely help to support additional financing from other multilateral and bilateral partners, which could reduce default risk, if this is achieved urgently and without further raising social pressures. Conversely, this fiscal year or beyond, financing from the IMF and other partners may not be disbursed in time, which, given the extremely low reserves position, could lead to default. PakistanR17;s ESG credit impact score is highly negative (CIS-4), reflecting its very high exposure to social risks and weak governance profile, as well as its high exposure to environmental risks. PakistanR17;s weak governance and institutions and its very weak fiscal strength constrain the government’s capacity to address ESG risks.Exposure to environmental risk is highly negative (E-4 issuer profile score) because of PakistanR17;s vulnerability to climate change and the limited supply of clean, fresh and safe water. Pakistan drains a significant proportion of its scarce fresh water resources every year, and a large share of its population is exposed to unsafe drinking water. Water utility services tend to be intermittent, because of high leakage levels, limited supply and insufficient access to power. The inadequate quality of drinking water has health and economic consequences for Pakistan, such as contributing to stunting which undermines human capital. With varied climates across the nation, Pakistan is significantly exposed to extreme weather events, including tropical cyclones, drought, floods and extreme temperatures. In particular, the magnitude and dispersion of seasonal monsoon rainfall influence agricultural sector growth and rural household consumption. Agriculture accounts for around 20% of GDP and exports, and nearly 40% of total employment. Overall, around 70% of the entire population live in rural areas. As a result, both droughts and floods can create economic, fiscal and social costs for the sovereign. Exposure to social risk is very highly negative (S-5 issuer profile score). Very low incomes as well as limited access to quality healthcare, basic services, housing and education, especially in rural areas, together with safety concerns, are important social issues. Social risks have increased alongside persistent upward pressures on inflation. Households are likely to continue facing difficult conditions in the foreseeable future. As a significant share of revenue goes towards interest payments, it will increasingly constrain the government’s capacity to service its debt while also meeting the population’s essential social spending needs.PakistanR17;s governance risk exposure is highly negative (G-4 issuer profile score). International surveys of various indicators of governance, while showing some early signs of improvement, continue to point to weak rule of law and control of corruption, as well as limited government effectiveness. Fiscal policy effectiveness is particularly low, resulting in a persistently narrow revenue base that constrains the government’s capacity to address the country’s needs.