Pakistan banking system outlook changed from stable to negative. Moody’s Investors Service released the statement on Monday. “Over the next 12-18 months, banks in Pakistan will see their credit profiles challenged by their high exposure to the country’s low-rated sovereign debt and a slowing economy,” says Constantinos Kypreos, a Moody’s senior vice president
The banks’ operating conditions will be difficult, with Pakistan’s GDP growth slowing to 4.3% in fiscal year ending June 2019 from 5.8% in 2018
A slowing economy and high exposure to sovereign debt drive our negative outlook
Our outlook for Pakistan’s banking system is negative. The outlook expresses our expectation of how bank creditworthiness will evolve in this system over the next 12 to 18 months.
Pakistan’s (B3 negative) “Very Weak +” macro profile reflects high external vulnerability, driven by wider current account deficits and reduced foreign exchange reserves, a weak institutional framework, and weaknesses in bank credit and funding conditions.
The macro profile also incorporates Pakistan’s strong growth potential, though near-term economic activity has slowed as a result of policy tightening, and its relatively large but low income including through projects under the China-Pakistan Economic Corridor (CPEC) initiative, will address some long-term economic constraints and strengthen the country’s growth potential. Further planned institutional reforms will bolster institutional strength if effectively implemented.
In terms of the banking sector, our assessment reflects: (1) significant weaknesses in credit conditions relating to gaps in the legal framework for secured lending, limited financial transparency and very high credit concentrations, including to the government; and (2) higher vulnerabilities in funding conditions, reflecting banks’ increased reliance on short-term market funding.
Real GDP growth will slow to 4.3% in the fiscal year ending June 2019, down from 5.8% in 2018. Tighter domestic monetary conditions –driven by a wide current account deficit and low foreign exchange reserves –will weigh on economic activity.
The Pakistani rupee depreciated 30% versus the US dollar, interest rates rose by 450bps between December 2017 and February 2019 and inflation is rising (2019F: 7%), all of which affect business and consumer confidence and the private sector’s debt repayment capacities.
High exposure to government securities (34% of assets) links banks’ credit profile to that of the sovereign, whose credit profile is increasingly challenged as also evident by the negative outlook on its B3 rating. The declining trend in problem loans (8% of gross loans as of Sept 2018) will stall, as challenging operating conditions and structural impediments hamper banks’ ability to resolve legacy NPLs.
Regulatory capital (Tier 1 at 13.2% as of September 2018) will remain broadly stable, but our calculations point to only modest capital buffers. Higher profit retention, hybrid Tier 1 capital issuances and other capital optimization measures will offset credit growth and so support reported Tier 1 ratios.
Profits will increase slightly but remain below historical levels. Profitability will be driven by higher net interest margins (on the back of higher interest rates and rising government bond yields), 10%-12% credit growth and lower one-off costs, which will compensate for rising provisioning needs and ongoing pressures at banks’ overseas operations.
Stable customer deposits and high liquidity will remain key strengths. Customer deposits make up around 71% of total assets, and we expect these to grow 10% this year, providing banks with ample low-cost funding. Cash and bank placements account for around 15% of total assets, while another 34% is invested in government securities (which are reproable with the central bank) offering sound liquidity.
The government’s capacity to support banks has deteriorated given its high debt levels, but its commitment to supporting the banks remains strong.
Key drivers for negative outlook
Moody’s project a slowdown in economic activity on the back of tightening domestic monetary conditions.
Longer-term, Pakistan’s growth potential remains strong, supported by infrastructure investments that address economic constraints.
Private-sector credit growth will be sustained on the back of efforts to increase financial inclusion, and facilitate growth in the small business and mortgage sectors, and in Islamic finance.
High exposure to government bonds links banks’ creditworthiness with that of the sovereign.
Deteriorating economic conditions will increase the risk of NPL formation. Efforts to address structural/legal obstacles and improve risk management will only partly mitigate this negative impact.
Regulatory capital will remain broadly stable, but Moody’s adjusted ratios and stress tests point to vulnerabilities.
Improving margins, healthy credit growth and a drop in one-off costs will support profitability; but gains will be partly offset by rising provisions and challenges at foreign operations.
Good access to cheap funding is an strength, underpinned by strong inflows of stable, low-cost customer deposits.
Banks’ liquidity buffers will remain solid.
The Pakistan government remains committed to supporting systemically important banks, but its capacity to do so has weakened.
Moddy’s adjust Pakistan’s Macro Profile downwards by two notches for credit conditions to reflect high credit risk and the following three factors. First, gaps in the legal framework for secured lending. Specifically, there are impediments to enforcing contracts – according to the World Bank’s Doing Business 2019 report, more than 1,000 days are required to enforce contracts – and weaknesses in collateral based lending, which create an inefficient recovery environment for banks and hinder their ability to reduce their high stocks of nonperforming loans (NPLs). Second, the limited amount of financial information available, particularly for small and medium sized enterprises and retail customers, compromising banks’ ability to accurately assess credit risk. Third, high borrower and sector concentrations on banks’ loan books, including to the government.
Moody’s expect regulatory initiatives to remove some of these impediments in the medium term. The government has enacted legislation governing the establishment of private credit bureaus as part of its National Financial Inclusion Strategy, which is likely to improve banks’ access to information. It has also approved legislation allowing the creation of corporate restructuring companies that acquire NPLs from banks; amended foreclosure clauses to provide a comprehensive legal framework on foreclosure; and passed legislation that will strengthen the bankruptcy framework and facilitate the resolution of NPLs in the banking system. Finally, State Bank of Pakistan (SBP, the central bank) has stepped up its macro-level monitoring of large borrowers to proactively address systemic risks that may arise as a result of defaults by large borrowers.