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Continued cautious optimism – Pakistan’s banking sector

Recent ratings reports by Moody’s and Fitch Ratings on Pakistan’s banking sector and economy respectively show a stable outlook with GDP continued to grow between 4.9% (Moody’s) and 5.3% (Fitch) for the 2017 fiscal or financial year. The main potential impediments to continued growth are viewed to be political and regional instability, policy slippage that would create unexpected inflationary pressures and drastic drops in reserves as well as potentially erode current debt ratios.

Fitch’s rating of ‘B’ with a stable outlook is also based on an “economic base case (that) assumes Pakistan’s economic policy framework remains broadly unchanged over the political cycle.” Their view also takes into account that current relationships with the country’s neighbors will not deteriorate into an armed conflict.

Moody’s have given Pakistan’s banking sector a ‘stable’ outlook within an overall macro profile as ‘Very Weak+’ – while acknowledging the improvements and progress with the country’s structural programs with the IMF and the accretion to the economy once CPEC projects further develop, their assessment takes into account a low income per-capital and chronic factors (such as electricity shortfalls) that have stunted growth. These factors coupled with high levels of government borrowing and still needed reforms in legal and financial transparency.

The growth in the banking sector has occurred within a positive economic climate. In September 2016, Pakistan closed out its first ever IMF program during which reserves were strengthened, fiscal deficits reduced and progress registered in structural reforms. Over the last 7 years, there has been almost a year on year real GDP growth coupled with a fall in inflation, measured by the Consumer Price Index, falling from over 13% in 2010 to an expected level of close to 5%  this year. A large portion of this is attributable to lower energy and commodity prices, which is quote astonishing in view of a depreciating currency.

The economic growth of the last few years has enabled rising overall economic confidence, in spite of the usual political dramatics, and with it a healthy growth in credit to the private sector even taking into account a certain amount of crowding out due to increasing government borrowing. Other areas of growth will originate from the initiatives in financial inclusivity, continued SME lending and a standardized mortgage lending policy begging to be initiated in an era of historically low domestic and international interest rates.

The main current risk to banking assets is the exposure to government borrowing(approximately 23% in sector wise lending) which is treated as zero risk domestically but of fairly low quality when measure by international ratings. This classification of risk is paramount for capital reserve purposes for which applied at international levels reduces the ‘comfort’ levels of the banking systems safeguards. Non-Performing Loans which currently stand at about 11.1% of total loans (the worst levels in its peer group) but this has shown signs of improvements especially in light of continued economic health and growth.

Falling net interest margins, (approximately 4% at present but still very healthy in comparison to their peer group) have been affected by falling interest rates and reduction in yields from government securities and banks will look to counter balance this by increasing their low cost deposit base and target increased credit exposure to the private sector as well as increase the lucrative auto and personal loan segments.

Things are looking extremely healthy from within Pakistan and all the pointers direct to continued healthy growth. From outside Pakistan, where investors and financial institutions are forced to take a broader and more balanced perspective in order to weigh up investment opportunities, things are looking relatively promising provided geo-political matters stay only at the oratory and rhetoric levels.

Operating EnvironmentStable+ Large-scale infrastructure projects related to the US$45 billion China-Pakistan Economic Corridor will boost the economy.+ Business-friendly government policies and infrastructure investment will support foreign investment and increase demand for credit.

– High government debt and a long-standing budget deficit will remain a burden; chronic energy shortages will continue to hinder economic output.

– Steady progress on economic reforms may be derailed as the country moves towards elections in 2018, following completion of its IMF program

Asset Risk and CapitalStable= Loan performance will improve slightly, supported by Pakistan’s improving economy, amendments to the legislation to regulate credit bureaus, and proposed changes in bankruptcy law.= High exposure to sovereign bonds links banks’ creditworthiness to that of the low-rated government.

– Capital levels are modest in the context of the banks’ significant exposure to the sovereign, while our stress test also points to the system’s vulnerability

Profitability and EfficiencyStable= Profitability is strong and will stabilize at current levels as the impact of lower yields on government securities is absorbed by higher lending growth and low provisioning expenses.
Funding and LiquidityStable+ Remittances from workers overseas and deepening banking penetration will continue to provide banks with ready access to inexpensive and stable deposit funding.= Core liquidity buffers will remain strong
GovernmentSupportStable= Government remains committed to supporting systemically important banks (but its capacity is constrained by the B3 government rating).

Source: Moody’s Investor Services

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