Moody’s Investors Service on Thursday downgraded Pakistan’s credit rating from B3 to Caa1, while maintaining its negative outlook, saying it was driven by increased government liquidity, external vulnerability risks, and higher debt sustainability risks following this year’s devastating floods.
According to Moody’s, the floods have worsened Pakistan’s liquidity and external credit weaknesses and vastly increased social spending needs against a reduction in revenue. “Debt affordability, a long-standing credit weakness for Pakistan, will remain extremely weak for the foreseeable future,” it said, adding that the Caa1 rating reflected the view that Pakistan would remain “highly reliant” on financing from multilateral partners and other creditors to meet its debt payments. “In particular, Moody’s expects that Pakistan’s IMF Extended Fund Facility (EFF) program will remain in place and provide an avenue for financing from the IMF and other multilateral and bilateral partners in the near term,” it added.
On the negative outlook, it said this was based on risks to Pakistan’s ability to secure required financing to fully meet its needs in the next few years. “Elevated social and political risks compound the government’s difficulty in implementing reforms, including revenue-raising measures, that would improve the country’s fiscal position and alleviate liquidity stresses,” it said, warning the floods had also raised the risks of a balance of payments crisis. “Pakistan’s weak institutions and governance strength adds uncertainty around whether the country will maintain a credible policy path that supports further financing,” it said, adding there was also risk that should a debt restructuring be needed, it might extend to private sector creditors.
“Moody’s has lowered Pakistan’s local and foreign currency country ceilings to B2 and Caa1 from B1 and B3, respectively,” it said, adding that the gap between the local currency ceiling and sovereign rating was driven by the government’s relatively large footprint in the economy, weak institutions, and relatively high political and external vulnerability risk.
Explaining its reasoning, Moody’s said Pakistan’s economic outlook in the near- and medium-term has deteriorated sharply as a result of the floods. “The government’s preliminary estimates put the economic cost of the floods at about $30 billion, far above the estimated $10 billion economic cost of the 2010 floods, which was until now the country’s worst flooding episode,” it said, adding it had also lowered Pakistan’s real GDP growth to 0-1% from a pre-flood estimate of 3-4%. “The floods will affect all sectors, with the impact likely more acute in the agriculture sector, which makes up about one-quarter of the economy,” it warned, adding that it expected growth to pick up next year but still stay below trend.
The “supply shock” caused by the floods would lead to higher inflation, warned Moody’s, noting it expected it to rise to 25-30% for the ongoing fiscal against a pre-flood estimate of 20-25%. This, it warned, could also lead to more social risks.
Debt sustainability
The growth shock would lower government revenues, while government expenditures would be raised by the costs of rescue and relief operations, said Moody’s, adding it expects the fiscal deficit to widen to 7-8% of GDP for fiscal 2023, from a pre-flood estimate of 5-6% of GDP. “Pressures on public finances are likely to persist in the next few years, as expenditures remain high because of reconstruction and social needs,” it said, adding this would lead to Pakistan’s debt affordability worsening.
“Against a backdrop of increasing interest rates and weaker revenue collection, Moody’s estimates that interest payments will increase to around 50% in fiscal 2023, from 40% of government revenue in fiscal 2022, and stabilize 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,” it said.
External vulnerability risks
Moody’s expects the current account deficit to widen to 3.5-4.5% of GDP for fiscal 2023, compared to a pre-flood estimate of 3-3.5%. This, it said, was a result of the country needing to import essential items and an expected hit to its export capacity. “That said, Moody’s expects the larger trade deficit to be partially offset by an increase in remittances which tend to increase at times of crises,” it said.
“External liquidity conditions have also tightened significantly for Pakistan. Its access to market financing at affordable cost is extremely constrained, and will likely remain so for some time,” it warned, stressing this meant Pakistan would remain highly reliant on financing from multilateral and bilateral partners.
Negative outlook
“The negative outlook captures the downside risks beyond what would be consistent with a Caa1 rating,” said Moody’s, adding elevated social and political risks compound the government’s difficulty in implementing reforms, including revenue-raising measures, that could improve the country’s fiscal position and alleviate liquidity stresses. It said the negative outlook also captured risks that, should a debt restructuring be sought, it might extend to private sector creditors, despite assurances by the government that it is not seeking debt relief from commercial banks or Eurobond holders.
Moody’s said the negative outlook could be upgraded—even though it is unlikely in the near term—if Pakistan’s liquidity and external vulnerability risks decreased materially and durably. “This could come from access to material external financing that significantly raised foreign exchange reserves,” it said, adding a resumption of fiscal consolidation that led to a meaningful improvement in debt affordability would also be credit positive.
However, it said, the outlook could be downgraded further if it became increasingly likely that Pakistan was not able to meet its debt obligations. “In particular, a rising probability that a debt restructuring involved private sector creditors would point to a higher risk of default than consistent with a Caa1 rating,” it said, reiterating risks of a balance of payments crisis. “An increase in social and political risks that disrupted policymaking and undermined Pakistan’s ability to secure financing would put further downward pressure on the rating,” it added.
Not cause for concern
Reacting to the downgrade, Finance Minister Ishaq Dar claimed it was not a cause for concern, as it was more relevant for the issuance of Sukuk Bonds, which the government was not planning on doing. Stressing he would respond to Moody’s reasoning “properly,” he said of three major credit rating agencies in the world, one had even downgraded the U.K.’s credit rating.
“We now have to improve our economic indicators,” he said, adding he would seek answers on their decision when he met representatives of the agency during a visit to the U.S. next week.