Did someone say “default” again?
Two of the three major US credit rating agencies — Moody’s and Fitch Ratings — recently downgraded Pakistan’s bonds deeper into junk, stoking concerns over the government’s ability to repay and service its debt. The question is how worried should we be?
Earlier in the month, Fitch cut Pakistan’s long-term issuer default rating to CCC+ from B- while Moody’s lowered its issuer and senior unsecured debt ratings to Caa1 from B3. Both cited liquidity risks in the aftermath of devastating floods as a key factor behind their downgrades, while flagging depleting reserves.
A downgrade “has a negative spillover effect on local/foreign currency bond yields” as “it influences country’s degree risks, hence causing impediments for much-needed foreign capital inflows,” Sana Tawfik, senior analyst at Arif Habib, said in an Oct. 21, 2022, report after the Fitch rating action.
Pakistan’s international bond yields — which are inversely related to bond prices — have soared 22 to 96 basis points since July 2022, when Fitch downgraded Pakistan’s rating outlook, according to the report. But with the International Monetary Fund (IMF) on board, markets are feeling confident. Tawfik told ProPakistani on Oct. 24, 2022:
“We did see initial reaction to the downgrading across financial markets. However, with (the) IMF (program) on track, markets do feel that Pakistan will be able to meet its financing requirements.”
Taking a Step Back and Understanding Ratings
Moody’s Caa-rated obligations “are judged to be speculative of poor standing and are subject to very high credit risk,” the agency’s reference guide published Oct. 3, 2022, showed.
“The floods have exacerbated Pakistan’s liquidity and external credit weaknesses and vastly increase social spending needs, while government revenue is severely hit,” Moody’s said Oct. 6, 2022. “Debt affordability, a long-standing credit weakness for Pakistan, will remain extremely weak for the foreseeable future.”
However, Moody’s mentioned in its report that Pakistan’s access to official sector financing will be maintained, which should be “enough to meet” the country’s needs.
Fitch’s CCC category, which is four scales above the lowest possible rating, carries “substantial credit risk,” with a “very low margin for safety,” according to rating definitions published by Fitch. “Default is a real possibility” for issuers in the CCC category, according to the document, but Pakistan is at CCC+, which is the highest rank within that grouping.
“The downgrade reflects further deterioration in Pakistan’s external liquidity and funding conditions, and the decline of foreign-exchange reserves,” Fitch said late last week. “This is partly a result of widespread floods, which will undermine Pakistan’s efforts to rein in twin fiscal and current account deficits.”
Pakistan’s foreign exchange reserves plunged to $7.6 billion by Oct. 14, 2022, from more than $20 billion in August 2021, State Bank of Pakistan (SBP) data shows.
Dar Eyes Debt Reschedule, But Rules Out Default
The IMF forecasts a total of $35.12 billion in debt service payments in FY23, including $15.58 billion payable to external creditors. About $1 billion is payable on bonds maturing in December.
Finance Minister Ishaq Dar recently told Reuters that Pakistan will seek to reschedule non-Paris Club debt, but he ruled out a default scenario or a renegotiation of IMF terms. China represents about $23 billion of the $26.93 billion non-Paris Club debt stock, IMF data shows.
Tawfik said in a statement made to ProPakistani:
“Given the current economic situation post flood crisis, we anticipate support from international creditors as the destruction caused by these floods is unprecedented and calls for support from all corners.”
The IMF’s ninth review is due on Nov. 3, 2022. Pakistan would be eyeing another tranche from the IMF, funding from bilateral creditors and materialization of inflows from the Asian Development Bank and World Bank. Pakistan could also seek rollovers and deferments, Tawfik said.
“If we are able to receive all these flows, we’ll be able to honour our short-term obligations comfortably,” Tawfik said.
Back to Ratings
Moody’s said access to external financing would ease of liquidity and external vulnerability risks and likely warrant an outlook upgrade. In addition, a meaningful improvement in debt affordability via fiscal consolidation, including revenue-raising measures, would also be credit positive.
Fitch said higher foreign reserves and lower external financing risks, along with compliance with IMF conditions, could justify a positive rating action.
However, a deterioration in current conditions that point to an increased risk of default is expected to result in a negative rating action, the credit rating agencies said.
Conclusion
SBP in July 2022 said Pakistan will be able to meet its external financing requirements for FY23, and the IMF’s predictions from Sept. 1, 2022, concur with that. Pakistan’s total external financing requirement is expected to be slightly above $31 billion for FY23 versus estimated available financing, including IMF funds, of around $37 billion, according to an Arif Habib report from last week.
Pakistan’s exit from the Financial Action Task Force’s so-called grey list should also help lift investor confidence and potentially improve foreign direct investment prospects. Recall that exiting the FATF’s list of jurisdictions with serious deficiencies was one of the structural benchmarks laid down by the IMF, meaning Pakistan complies with an additional IMF demand ahead of next month’s review.
Costs associated with floods reflect a major economic headwind but assuming inflows from the international community materialize, hopefully we’ll be able to navigate these uncertain times.
