S&P Global Maintains CCC+ Rating for Pakistan Amid Political Risks

The Standard and Poor (S&P Global Ratings) affirmed its ‘CCC+’ long-term sovereign credit rating and ‘C’ short-term rating for Pakistan. The outlook on the long-term rating is stable. “Our transfer & convertibility assessment remains at ‘CCC+’, said the rating agency. It further stated that the stable outlook balances the risks to Pakistan’s external liquidity position and fiscal performance over the next 12 months against the prospect of continued support from multilateral and bilateral partners. “We could lower our ratings if Pakistan’s external indicators deteriorate rapidly or fiscal deficits widen to exceed the domestic banking system’s financing capacity, to the extent that the government’s willingness or ability to service its commercial debt is diminished. One potential indication of domestic financing stress would be further increases in the government’s interest burden, which we estimate will exceed 45% of government revenues over the next few years”, it added. Conversely, S&P said it would raise its ratings if Pakistan’s external and fiscal positions improve materially from current levels. Signs of improvement could include a sustained rise in foreign exchange reserves, a reduction of Pakistan’s debt-service costs relative to revenues, and a lengthening of debt maturities, S&P Global added. Pakistan has shored up its foreign reserves over the last 12 months and near-term default risks have lessened. However the country remains reliant upon favorable macroeconomic and financial developments to meet its obligations over the long term. Sustained external concessional help will be key to rebuilding buffers. Strong foreign fund inflows and moderate current account deficits would likely be required for Pakistan to restore its external buffers. Pakistan continues to face high gross external financing needs, vulnerabilities to energy price developments, and the availability and timing of foreign support. A notable inflow of funds from the International Monetary Fund (IMF) and prospective rollovers with Saudi Arabia, United Arab Emirates (UAE), and China, will support Pakistan in managing its external financial requirements over the next six to 12 months. The agency expects the ratio of government debt to GDP and budgetary deficits to remain elevated. In combination with continued high domestic interest rates, this means that over 50% of government receipts will likely be used to service debt in fiscal 2025 (July 1, 2024-June 30, 2025), with a gradual reduction in the government’s cost of borrowing in subsequent years. Pakistan’s interest servicing-to-revenue ratio remains one of the highest globally among rated sovereigns. According to recent media reports, the government is in the early stages of renegotiating the terms of certain external loans to its power sector. “We do not consider the restructuring of official (non-commercial) debt as a default event. Should these power sector loans be restructured and we view them as official debt, this will not constitute a sovereign default and may support the reduction of Pakistan’s debt servicing burden,” the agency said. Institutional and economic profile: Economic growth to remain moderate against a challenging backdrop of fractious politics. Pakistan’s economic growth in fiscal 2024 modestly rebounded, following a contraction in fiscal 2023. Tight domestic monetary conditions and persisting inflationary pressures will continue to weigh on growth, which will be about 3.5% in fiscal year 2025. The government’s reform efforts will face volatile social and political resistance toward austerity and tax-enhancing measures. Pakistan’s economy grew 2.4% in fiscal 2024, having recovered from the impact of severe floods. Agriculture–a critical sector accounting for 25% of economic output–recovered due to improved crop yields. This was counterbalanced by underwhelming industry and services growth. GDP growth will remain modest in the current fiscal year at 3.5%, as elevated prices and daunting reform measures will weigh on economic activities; however, prices are gradually declining. The Pakistani rupee’s depreciation against the U.S. dollar in recent years has also contributed to a sustained stagnation in the country’s nominal GDP per capita. Coupled with lower real GDP growth expectations, S&P forecasts GDP per capita will stabilize just below US$1,700 in fiscal 2026. The government successfully completed the Stand-By-Arrangement (SBA) with the IMF in April 2024. Disbursements under the SBA, which began in July 2023, totaled approximately US$3.0 billion. The IMF disbursement, in addition to new deposits from bilateral partners, has helped to rebuild Pakistan’s liquid foreign exchange reserves from critical lows early last year. Pakistan and the IMF have since reached a new Staff Level Agreement (SLA) on a 37-month Extended Fund Facility (EFF) announced on July 12, 2024. The financial support under the EFF will be US$7 billion, which is currently subject to approval of the IMF board. The performance requirements of this program are a continuation and extension of those set in the SBA. Meeting the EFF conditions will be critical for Pakistan to receive the disbursements in the coming quarters. Persisting inflationary pressures, coupled with modest economic activity, continue to complicate the implementation of measures to consolidate the government’s wide fiscal deficit. Inflation averaged 23.4% for fiscal year 2024, albeit lower than 29.2% in the previous fiscal year. The fiscal consolidation efforts of the government will be eclipsed by sustained high inflation till it recedes substantially. The newly formed coalition government, in the aftermath of the February 2024 general elections, appointed Shehbaz Sharif from the Pakistan Muslim League-Nawaz (PML-N) party as the prime minister, for the second time since 2022. “We expect political uncertainty to remain high owing to a fractious political environment. The government’s ability to navigate the necessary reform implementation under the IMF program without significant social unrest, will have a significant bearing on policy efficacy over the coming quarters,” it said. Pakistani politics has been in a state of flux since the ouster of former Prime Minister Imran Khan of the Pakistan Tehreek-e-Insaf (PTI) party in a parliamentary no-confidence motion in April 2022. The political turmoil has hampered the government’s reform efforts to deal with economic challenges in the last two years and has damaged sovereign credit metrics. The agency said a more stable political environment in Pakistan is likely an important precondition to repairing the government’s creditworthiness. The ratings on Pakistan remain constrained by elevated domestic and external security risks. The country’s security situation has improved since the early 2010s, but the potential to deteriorate in the future remains. Possible border tensions with India and Afghanistan could also have a short-term impact on economic sentiments. Flexibility and performance profile: Foreign inflows have helped to stabilize the critically low external buffers, but there’s sustained pressure on the fiscal and external accounts. Bilateral and multilateral aid has shored up usable foreign exchange reserves, following a steep decline in fiscal year 2023. Continued support and rollovers of existing credit facilities will be important to maintaining external buffers. Interest costs consume an enormous proportion of government receipts. Pakistan’s fiscal and external positions will face continued pressure from the still-elevated inflation level and interest rates, although conditions have improved compared with the last fiscal year. The willingness and ability of policymakers to stay the course on tight expenditure settings while making continued enhancements to the revenue base will be critical to meeting targets set out in the IMF’s EFF. In the recently passed fiscal 2025 budget, the government has set an ambitious target to cut the budget deficit to 5.9% of GDP from an estimated 7.4% the year before. It is aiming for an increase in revenue to Pakistani rupee (PKR) 13 trillion, about 40% higher than the prior year. Under the new IMF program, Pakistan is mulling over raising the agricultural income tax rate, which is currently much lower than other sectors, to be at par with corporate tax rates. The highest effective tax rate for agriculture income can rise to as much as 45% from the current 15%. The government expects tax revenue measures to increase tax revenues by 1.5% of GDP in the current fiscal year and about 3% of GDP over the IMF program. “We believe Pakistan will face significant political and social pushbacks in trimming its fiscal deficit so quickly. For fiscal 2025, we forecast the general government’s fiscal deficit to decline less steeply to 6.9% of GDP. As a result, Pakistan’s average annual change in net general government debt will average 6.7% of GDP from fiscal 2025 through to fiscal 2027,” it added. Pakistan’s net debt stock is likely to remain high at 71% of GDP. But the main pressure on debt sustainability is the high interest expense relative to fiscal revenue. This is a major constraint on assessment of the government’s debt burden. The agency anticipates the protracted high interest rates and depreciated rupee will keep this ratio very elevated, at more than 45% of revenues, over the next few years. The government’s interest burden is exacerbated by high domestic interest rates. The State Bank of Pakistan (SBP) undertook aggressive monetary policy to tame surging inflation in the last two years. In June 2024, the SBP reduced the policy rate by 150 basis points (bps) to 20.5%; it cut the rate by another 100 bps on July 29, to 19.5%. These were the first cuts in four years. For the rest of the fiscal year, S&P envisages a gradual easing of the policy rate due to needs to anchor inflationary forward expectations. As of mid-July 2024, the government’s short-term debt auctions are yielding between 18% and 21%, down from the 22%-25% a year ago. The high cost of capital for the government will continue to weigh on its interest bill. As a result, the government will likely eschew significant long-term debt issuance during this period of high rates, so that it can more quickly reprofile its debt stock if rates fall materially in future. New financial aid inflows helped stabilize the external position during fiscal year 2024. Financial support from bilateral creditors, including the UAE, Kuwait, Saudi Arabia, and China, remains critical to Pakistan’s ability to meet high external financing needs. The company estimates total support from these four partners at US$16.9 billion as of end-fiscal 2024 and add this sum to the government’s total stock of debt. Additional support from concessional lenders will depend on Pakistan’s ability to maintain its IMF program. 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. Sizable disbursements and deposits from Saudi Arabia (US$2 billion), the UAE (US$1 billion), and the IMF (US$3 billion) over the last fiscal year boosted liquid foreign exchange reserves held by the SBP to about US$9.1 billion at end-May 2024, or less than two months of projected goods import cover. Additional deposits or loans from multilateral institutions or bilateral partners would further add to Pakistan’s substantial narrow net external debt position. S&P forecasts the net external debt position will reach 135% of current account receipts by the end of this fiscal year. Pakistan’s external data provision is timely and generally of good quality. The current account deficit declined to about 1% of GDP in fiscal 2023, following a shortfall of 4.7% of GDP in fiscal 2022. However, this has narrowed substantially in fiscal 2024 to a deficit of 0.2% of GDP, driven by growth in remittances and exports. Despite the agency’s expectation of current account deficits remaining modest at an average 1.1% of GDP from fiscal 2025 through fiscal 2027, Pakistan’s continued debt maturities will place sustained downward pressure on its foreign exchange reserves, absent considerable net new funding. Consequently, gross external financing needs, as well as net external indebtedness, will remain at critical levels over the next one to two years. “We expect inflation to remain elevated during the first half of fiscal 2025, before moderating more meaningfully toward the second half to average 12.7%, on continued high interest rates and fading currency effects. Pakistan experienced rapid inflation averaging over 20% in the last two fiscal years, driven in large part by the depreciation of the rupee,” it added. The central bank executed aggressive tightening monetary policy, culminating in a 1,500 bp hike to its policy rate from September 2021 to tame inflationary pressure and stop the further depreciation of the rupee. “We expect the policy rate to remain high over the next 12 months to guide inflation to the medium-term target range of 5%-7%,” the agency further added.