Moody's Investors Service ("Moody's") has on Monday affirmed the Government of Pakistan's local and foreign currency long-term issuer and senior unsecured debt ratings at B3 and changed the outlook to stable from negative. The change in outlook to stable is driven by Moody's expectations that the balance of payments dynamics will continue to improve, supported by policy adjustments and currency flexibility. Such developments reduce external vulnerability risks, although foreign exchange reserve buffers remain low and will take time to rebuild. Moreover, while fiscal strength has weakened with higher debt levels largely as a result of currency depreciation, ongoing fiscal reforms, including through the country's International Monetary Fund (IMF) program, will mitigate risks related to debt sustainability and government liquidity. The rating affirmation reflects Pakistan's relatively large economy and robust long-term growth potential, coupled with ongoing institutional enhancements that raise policy credibility and effectiveness, albeit from a low starting point. These credit strengths are balanced against structural constraints to economic and export competitiveness, the government's low revenue generation capacity that weakens debt affordability, fiscal strength that will remain weak over the foreseeable future, as well as political and still-material external vulnerability risks. Concurrently, Moody's has affirmed the B3 foreign currency senior unsecured ratings for The Second Pakistan Int'l Sukuk Co. Ltd. and The Third Pakistan International Sukuk Co Ltd. The associated payment obligations are, in Moody's view, direct obligations of the Government of Pakistan. Moreover, the B2 foreign currency bond ceiling and the Caa1 foreign currency deposit ceiling are also unchanged. The short-term foreign currency bond and deposit ceilings remain unchanged at Not Prime. These ceilings act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country. Moody's expects Pakistan's current account deficit to continue narrowing in the current and next fiscal year (ending June of each year), averaging around 2.2% of GDP, from more than 6% in fiscal 2018 (the year ending June 2018) and around 5% in fiscal 2019. Under Moody's baseline assumptions, subdued import growth will likely remain the main driver of narrowing current account deficits. In particular, the ongoing completion of power projects will reduce capital goods imports, while oil imports will remain structurally lower given the gradual transition in power generation away from diesel to coal, natural gas and hydropower. Currently, tight monetary conditions and import tariffs on nonessential goods will also weigh on broader import demand for some time, although Moody's sees the possibility of monetary conditions easing when inflation gradually declines towards the end of the current fiscal year. Moody's expects exports to gradually pick up on the back of the real exchange rate depreciation over the past 18 months, also contributing to narrower current account deficits. The government is focusing on raising the country's trade competitiveness and has recently rolled out a National Tariff Policy aimed at incentivizing production for exports or import substitution. If effective, the policy, coupled with improvements in the terms of trade, will allow exports to grow more robustly. The substantial increase in power generation capacity over the past few years and improvements in domestic security have largely addressed two significant supply-side constraints and further support export-related investment and production. Moody's expects policy enhancements, including strengthened central bank independence and the commitment to currency flexibility, to support the reduction in external vulnerability risks. In particular, the government is planning to introduce a new State Bank of Pakistan (SBP) Act to forbid central bank financing of government debt and clarify SBP's primary objective of price stability. The central bank has already stopped purchases of government debt in practice since the start of fiscal 2020. At the same time, it has strongly adhered to its commitment to a floating exchange rate regime since May 2019. These enhancements to the policy framework will foster confidence in the Pakistani rupee, while the use of the exchange rate as a shock absorber increases policy buffers. Notwithstanding improved balance of payments dynamics, Pakistan's foreign exchange reserve adequacy remains low. Foreign exchange reserves have fluctuated around $7-8 billion over the past few months, sufficient to cover just 2-2.5 months of goods imports. Coverage of external debt due also remains low, with the country's External Vulnerability Indicator – which measures the ratio of external debt due over the next fiscal year to foreign exchange reserves ¬– remaining around 160-180%. The IMF program, which commenced in July 2019, targets higher foreign exchange reserve levels and has unlocked significant external funding from multilateral partners including the Asian Development Bank and the World Bank. Nevertheless, unless the government can effectively mobilize private sector resources, foreign exchange reserves are unlikely to increase substantially from current levels. — SG
