KARACHI: International Financial rating agency Moody’s has declared Pakistan’s banking system as stable, stating that Pakistan’s economic expansion will benefit the country’s banks over the next 12 to 18 months, and drives Moody’s stable outlook.
The accelerating economy, boosted by progress in structural reforms and China-funded infrastructure projects, will stimulate lending growth at the country’s banks and support loan performance. The biggest challenge facing the banking system will be its concentrated exposure to the low-rated Pakistan government (B3 stable) and its agencies, as well as the banks’ modest capital levels.
Real GDP is expected to expand by 4.9 per cent and five per cent in the fiscal years ending June 2017 and 2018. The China-Pakistan Economic Corridor (CPEC) project, a $45 billion programme of Chinese-funded infrastructure upgrades, will continue to support manufacturing and construction activities, and will be a key driver of growth. Accordingly, bank lending is likely to expand by between 12 per cent and 14 per cent during 2017-18.
Downside risks to the economic recovery remain, however, owing to the threat of political instability, deterioration in domestic security, or disruption of the government’s reform agenda ahead of elections in 2018. Deeply entrenched weaknesses in the power sector also act as an economic bottleneck.
Heavy exposure to Pakistan government securities–estimated at 7.2x of the system’s Tier One capital–ties the banks’ creditworthiness to that of the sovereign (B3 stable).
Asset risks will remain high in light of prevailing fragile operating conditions, but problem loans are expected to decline overall as economic conditions improve, easing to around 10 per cent of total loans over our outlook horizon from 11.3 per cent at the end of September 2016.
Capital buffers will remain modest. The system’s reported Tier One ratio is likely to remain broadly stable at around 13.6 per cent. However, when applying a 100 per cent risk weight to sovereign securities, in line with our global standards, the system’s Tier One ratio declines to 6.9 per cent, pointing to the vulnerability of the banks’ capital buffers, which is also illustrated by Moody’s forward-looking solvency analysis.
Profitability is strong–with an aggregate return on average assets of 1.3 per cent–and compares well against emerging market peers. Faster lending growth and low provisioning requirements will support the banks’ profitability over the outlook horizon, mitigating pressures stemming from lower yields on government securities and thinning margins.
Large volumes of low-cost customer deposits are credit strengths. Customer deposits make up over 70 per cent of total assets, these are expected to grow by 12 per cent-15 per cent during 2017. Remittances from workers overseas and increased banking penetration will drive deposit growth, while reliance on costly and confidence-sensitive market funding will remain low. Banks will continue to maintain good liquidity buffers, with cash and bank placements accounting for around 11 per cent of total assets and government securities for an additional 46 per cent.
The authorities are expected to support the largest banks, if needed, and the Pakistani government remains committed to supporting the country’s largest banks, given their role as the main source of financing for the government. Moody’s stable outlook for the Pakistani banking system is in line with our stable outlooks on the deposit ratings of our rated banks and on Pakistan’s government B3 bond rating.
Moody’s rated the five largest banks in Pakistan, which together account for around 50 per cent of total banking system deposits. The average asset-weighted Baseline Credit Assessment (BCA), or standalone credit strength, for these banks is b3. The rated banks’ average asset-weighted local currency deposit rating is B3 and does not benefit from government support uplift, given that–in most cases–their standalone BCAs are already on a par with the government’s B3 rating.
Economic reforms and substantial infrastructure investment will strengthen the economy and increase business opportunities for the banking sector. Economic growth will accelerate on the back of improved macroeconomic stability and reduced vulnerabilities. Pakistan has made steady policy progress under its $6.15 billion, three-year, economic reform programme with the International Monetary Fund (IMF), bringing the programme to a successful close in September 2016.
The government has bolstered its foreign currency reserves, which rose to $14.4 billion as of December 2016 (2013: $3.1 billion). Furthermore, it has made significant progress in fiscal consolidation, with the fiscal deficit narrowing to an estimated 4.3 per cent of GDP (2013: 8.1 per cent), and has also been successful in containing inflation. This has allowed the State Bank of Pakistan (SBP) to cut benchmark interest rates to 5.75 per cent in May 2016, a 40-year low, from 10 per cent in November 2014.
Real GDP is expected to grow by 4.9 per cent and five per cent in the fiscal years ending June 2017 (FY2017) and June 2018 (FY2018) respectively, the fastest pace since 2008. A major impetus to growth will come from the China Pakistan Economic Corridor (CPEC) and related investment projects in transportation and power generation infrastructure totalling $45 billion (16 per cent of FY2016 GDP), which will support manufacturing and construction activities.
CPEC-related projects will connect China and Pakistan via rail and road, as well as through oil and gas pipelines. Although investments under CPEC are long-term and will continue until 2030, a large number of projects in the energy and transportation sectors are already underway.
These projects are expected to boost investment and strengthen trade flows between Pakistan and China. In the long term, if the CPEC materialises as planned, it can bolster Pakistan’s growth potential by removing supply-side bottlenecks and infrastructure constraints, particularly the chronic energy shortages which have been weighing on economic activity in recent years.
While CPEC projects will be financed predominantly outside Pakistan, their indirect impact, through a pick-up in construction, trading, industrial and business activity in general, will create lending opportunities for the banks. Improved macroeconomic fundamentals and the government’s commitment to fiscal and economic reforms have also improved investor sentiment towards Pakistan. This is demonstrated by the successful issuances of bonds in the international market, with the government raising $1 billion in an oversubscribed Sukuk issuance in October 2016 at a rate of 5.5 per cent.
International corporations have also expressed interest in investing in Pakistan, as shown by a stream of purchases of significant stakes in various firms (utilities, dairy, and home appliances) by Chinese, Turkish and Dutch firms, as well as in the Pakistan Stock Exchange by a Chinese consortium.
At the same time, interest rates at multi-year lows and lower oil prices have been accompanied by rising domestic demand and strengthening business confidence–all factors that will support loan demand. Likewise, the government’s pro-business policies, a reflection of its commitment to improving the business climate, will also help lift credit growth.
These policies include:
(1) reducing corporate tax by one percentage point annually to 30 per cent by 2018,
(2) introducing Alternative Dispute Resolution mechanisms to facilitate the resolution of commercial disputes, and
(3) facilitating new company registrations by creating a ‘one-stop shop’ for business start-ups and rationalising the fee structure for opening new businesses.
Accelerating economic growth hinges on the successful implementation of CPEC and the timely execution of projects. Risks related to the implementation of the CPEC stem from:
(1) threats of terrorism in areas where infrastructure projects are planned, or where there is hostility to those projects, and
(2) the risk of a more severe slowdown in China than expected that could derail associated investment plans.
Moody’s noted, however, that the Chinese government is committed to CPEC as a way of countering slowing domestic growth by drastically reducing shipping times and establishing linkages to markets that will consume Chinese exports. In addition, the pledged investments represent less than one per cent of China’s GDP.
Despite an improving macroeconomic environment, Pakistan remains vulnerable to deterioration in domestic security or any source of political instability. The country has made progress in its fight against terrorism, which has strengthened confidence, but any renewed unrest could threaten the planned upgrades in infrastructure and could undermine confidence and economic growth.
The recent escalation of violence in the disputed territory of Kashmir continues to strain relations with India and presents geopolitical risk. Similarly, any shift towards more populist policies ahead of parliamentary elections in 2018 could compromise the county’s fiscal consolidation efforts and impede its progress in resolving long-standing structural weaknesses and improving the business environment.
Economic growth will support credit growth for banks
The accelerating economy will support bank lending. High government borrowing requirements to fill the fiscal budget gap have consumed the lion’s share of bank credit in recent years. We expect credit to the private sector to pick up and overall lending to grow between 12 per cent and 14 per cent over the next 12 to 18 months.
Moody’s expects stronger loan growth to be sustained over the medium term by central bank initiatives to increase banking penetration. Pakistan remains one of the world’s most under-banked countries, with private-sector credit equal to just 15 per cent of GDP in 2015. Only nine per cent of adults over 15 years have an account at a formal financial institution, according to the World Bank.
Such initiatives include:
- A National Financial Inclusion Strategy targeting bank account ownership for 50 per cent of the adult population. It encourages banks and other players to deploy branchless banking strategies in financially under-served and hard-to-reach areas to enhance outreach of financial services, including fund transfers, utility bill payments, remittances from overseas, government and salary payments, cash deposit and withdrawal, and loans.
- Targeting a 15 per cent market share for Islamic banking by 2018. This approach includes a comprehensive legal framework for Shari’ah-compliant banking and the exemption of Islamic banks from a minimum rate on savings deposits. In order to address a shortage of Shari’ah-compliant instruments for liquidity management purposes, the authorities have increased Sukuk issuances, initiated Shari’ah-compliant open market operations, and lowered the statutory liquidity ratio for Islamic banks. As a result, the average growth for Islamic banking has outpaced that for the wider banking industry, and the sector had a 12 per cent share of total banking system assets as of September 2016.
- Boosting lending to small businesses. Lending to small and medium-sized enterprises (SMEs) represented only seven per cent of private sector lending as of June 2016, and only one per cent of GDP. The central bank is targeting a 15 per cent share of lending by 2020 and has assigned individual SME targets for banks, introduced credit guarantee schemes, and established various refinance facilities through which the banks can borrow from the central bank and lend at pre-defined spreads. Specific prudential regulations for SMEs have been revised, including increasing the maximum exposure the banks can have to an SME. The authorities have also enacted the Secured Transactions Act, which enables the treatment of movable assets as collateral, and which would also encourage lending to SMEs, particularly the agricultural sector. SME financing is gradually gathering pace, although from a low base. It grew by 14 per cent year-on-year in June 2016.
- Developing housing finance. With a mortgage-to-GDP ratio of 0.5 per cent as of September 2016, housing finance in Pakistan remains underdeveloped. The central bank has established a mortgage refinance company which will provide long-term funding at attractive rates for the banks. It has also amended foreclosure laws that facilitate foreclosure and will, over the longer term, also expand housing credit. Housing loans grew by 13.5 per cent year-on-year as of September 2016.
Asset Risk and Capital
Problem loans will gradually decline as the economy strengthens, but asset risks remain high. Capital buffers will remain modest, considering the banks’ high, concentrated exposure to the Government of Pakistan.
The balance sheets of Pakistani banks are heavily skewed towards government exposures. Their holdings of government securities stood at an estimated $66 billion at the end of September 2016, up 14 per cent year-on-year. The amount is equivalent to around 46 per cent of total assets, or 7.2 times the system’s Tier One capital as of September 2016.
The banks are further exposed to the government through loans to government agencies and state-owned companies, which we estimate at an additional 8.4 per cent of their assets, or 1.3x of their Tier One capital. That brings total government related exposure to 8.5x the system’s Tier One capital. This heavy level of exposure links the banking system’s credit profile to that of the Pakistani sovereign (B3 with a stable outlook), and leaves the banks’ credit profiles intertwined with that of the government.
Moody’s expects the banks’ exposure to the government to remain high over our outlook horizon, as banks will remain a major source of local currency financing for the government.
NPL levels will decline as economic conditions strengthen …
Problem loans will gradually improve as the domestic economy recovers and private-sector lending accelerates. Non-performing loans (NPLs), which stood at a high 11.3 per cent of gross loans as of the end of September 2016, are likely to decline slightly to around 10 per cent by the end of our outlook horizon, the lowest level observed since 2008.
The formation of new NPLs is decelerating and lending growth will start to outpace NPL formation over the coming quarters, aided by the improvements in the economy and good loan diversity. The diverse business sectors represented in banks’ loan books are a credit strength that reflects the broad-based nature of the domestic economy.
The largest loan exposures are to government and public-sector entities, which accounted for 23 per cent of loans as of December 2016. These entities are typically guaranteed by the government. Within the private sector, the banks are mainly exposed to the manufacturing sector, which includes food and textiles and accounts for 38 per cent of their loan portfolio.
Persistent energy shortages have hampered manufacturing output in the recent past. However, gradual increases in energy supply as projects under CPEC come on line and this development should raise capacity and aid recovery. Recent improvements in the manufacturing sector are captured in the acceleration of the Large-Scale Manufacturing Index, which shows improved output.
Infrastructure projects planned under CPEC are expected to support manufacturing and construction industries over the coming quarters. Local sales of cement and imports of related products–metal products, auto parts and machinery–are rising, indicating a strengthening in domestic demand. The construction sector remains a smaller contributor to loan portfolios, but it’s likely that its contribution will rise as higher government spending and projects relating to CPEC increase construction and infrastructure activity in the country.
… but asset risks remain high
Heavy exposures to a few very large borrowers create significant concentration risks. Indicatively, more than 65 per cent of total loans are large loans greater than PKR100 million and these are extended to less than one per cent of total borrowers. This situation reflects the concentrated nature of wealth in Pakistan. The corporate sector accounted for 66 per cent of loans as of September 2016, leaving the banks vulnerable to a single default in this group. Similarly, weaknesses in the legal framework and a time-consuming and inefficient foreclosure process hinders banks’ ability to resolve the high level of legacy NPLs. Looking ahead, however, we anticipate that recent legislative changes and regulatory initiatives will remove some of these impediments and gradually improve the banks’ recovery of problem loans, as well as strengthen their underwriting and risk management efforts.
Legislative developments include:
- Legislation governing the incorporation, functioning and supervision of private credit bureaus, and establishing the central bank as their regulator. This regulatory change will probably provide the banks with more comprehensive information on the financial obligations and credit histories of potential borrowers, enabling them to make more informed credit decisions.
- Enactment of the Corporate Restructurings Companies Bill will allow the creation of private corporate restructuring companies, regulated by the Securities and Exchange Commission of Pakistan, that will acquire NPLs from banks, as well as restructure and liquidate distressed companies.
- Amendments to foreclosure rules (Financial Institutions Recovery of Finances Ordinance) provide a comprehensive legal framework on foreclosure and facilitate recovery of problem loans by enabling the banks to repossess and sell mortgaged properties through public auction. The amendments contain provisions that strengthen the capacity of the Banking Courts to resolve these cases more efficiently, by increasing the statutory limit of the cases with which they deal and allowing district judges to be appointed as judges of the Banking Court. At the same time, the amendments penalise wilful defaults, thus promoting a healthier credit culture. Enactment of the Corporate Rehabilitation Act, which is still in process, will amend bankruptcy rules to support the rehabilitation of weak, but viable, companies.
- Issuance of Debt Property Swap regulations, in order to minimise risks in the settlement of fully provided NPLs with real estate as collateral. Capital levels are modest, considering the banks’ significant sovereign exposure. The banking sector reported an average Tier One capital ratio of 13.6 per cent as of September 2016. When the risk-weighted assets of Pakistan’s banks were adjusted to capture the credit risk of the B3-rated local-currency government securities which are zero risk-weighted by these banks (a standard Moody’s adjustment to ensure global comparability), the adjusted Tier One for the system declines to an estimated 6.9 per cent of risk-weighted assets as of September 2016, pointing to the system’s capital vulnerability. Enactment of the Corporate Rehabilitation Act, which is still in process, will amend bankruptcy rules to support the rehabilitation of weak, but viable, companies.
Stress scenario: extremely severe impact under stressed conditions
Moody’s also considered an alternative stress scenario. This is not the agency’s base-case expectation, but a measure of the capacity of banks to withstand highly stressed conditions based on a one-in-25-year event. Thus, they inform Moody’s opinion on the creditworthiness of the system as a whole. The results of our stress scenario on the Pakistani financial system show that the impact would be extremely severe, leaving the banks with a negative Tangible Common Equity (Moody’s-adjusted for global comparability) equivalent to -11.3 per cent of risk weighted assets at the end of the two-year horizon, compared to an estimated 7.5 per cent at the end of 2016.
This worse-than-average result is driven mainly by the banks’ asset composition. Pakistani banks have a relatively low exposure to loans, roughly one third of total assets, while exposure to securities and investments, around half of the banks’ balance sheet, is considerably higher than most of its peers. The securities book is predominantly concentrated on government bonds of Pakistan, but its rating is relatively low and the implicit losses in a stressed situation potentially high.
The current sovereign rating is B3, and Moody’s assumes losses derived from a three-notch downgrade to Caa3. Security losses under the agency’s stress scenario are substantial and erode the sector’s capital, wiping more than 200 per cent of the banks’ initial capital. Under this scenario, pre-provision income, although contributing positively to capital levels, offers limited loss absorption due to lower net interest and non-interest income.
The result is also driven, to a lesser extent, by loan losses that wipe out around two thirds of the banks’ capital. It is assumed loan-loss provisions of around seven per cent of gross loans and an NPL ratio of around 30 per cent. This stress test is by design extremely severe and, as such, is not comparable with regulatory measures of stress capital, for example. Compared to other systems, the resilience to stress of the Pakistani financial system is weak. The median capital ratio after stress of all systems tested is around five per cent. The median result of Moody’s stress tests is a fall in the capital ratio of around eight percentage points, considerably less than the result obtained for the Pakistani banks.
Profitability will remain strong, supported by increased lending opportunities and contained credit costs, mitigating declining margins. Pakistani banks display strong profitability. They delivered an aggregate return on average assets (RoAA) of 1.3 per cent for the first nine months of 2016, a level which compares favourably with emerging market peers. Their profitability benefits from their high exposure to government securities which boost their net interest income and margins, and lower funding costs as a result of an increasing focus on low-cost current and savings accounts.
Over the next 12 to 18 months, Moody’s expects profitability to remain broadly stable, supported by rising loan volumes, higher fees and commissions and focus on increasing low cost deposits. Low provisioning costs, which are estimated at around one per cent of loans as problem loan formation declines, will also support bottom-line profitability.
These factors will mitigate the impact of declining margins. Profitability has been under pressure in recent quarters due to falling yields on government securities. The central bank has implemented six rounds of interest rate cuts since November 2014, reducing the benchmark rates to a 40-year low of 5.75 per cent as of May 2016. This development has led to margin compression. However, capital gains booked through the sale of long-dated government bonds (Pakistan Investment Bonds) have partly mitigated the pressure on profitability stemming from the drop in margins.
The lower interest rates and yields on government securities will continue to exert some downward pressure on the banks’ interest margins during 2017, with the banks’ net interest margins bottoming out to around 3.2 per cent. Nevertheless, interest margins should stabilise from 2018 as inflationary pressures rise to an expected five per cent by the end of FY2018, and monetary policy gradually tightens. The banks also carry significant unrealized capital gains on their books, which they can realise to partially offset the impact of declining margins.
Funding and Liquidity
Banks will maintain access to cheap deposit funding as banking penetration deepens and overseas workers continue to send money home. Remittances from workers overseas and deepening banking penetration provide Pakistani banks with a growing deposit base. Customer deposits will grow by around 12-15 per cent over Moody’s outlook period, and reliance on more volatile and costlier capital market funding will be minimal.
Remittances rose to around $19.9 billion in FY2016 and made up around seven per cent of GDP, supporting the repayment profiles of household borrowers. Although preliminary figures for the first six months of FY2017 show total remittances declining by two per cent, attributed to the economic slowdown in the Gulf Cooperation Council (GCC) countries which account for around 65 per cent of the remittances sent to Pakistan, flows are expected to remain broadly stable and continue to support Pakistani banks’ deposit bases.
Deepening banking penetration among the population is also fueling deposit growth as the banks intensify their efforts to broaden their networks. The expansion of branchless banking through the use of agents and mobile banking will also help to increase financial intermediation.
Market funding accounted for 14 per cent of total assets as of September 2016, primarily relating to borrowing from the central bank, which banks have used to purchase higher-yielding government bonds, so-called ‘carry trade’. The recent drop in government bond yields is making this a less profitable activity and this type of funding is expected to reduce over the outlook period.
The banks’ stock of liquid assets is expected to remain high. Core liquid assets, defined as cash and bank placements, accounted for around 11 per cent of total assets as of September 2016. These liquid assets are complemented by the banks’ significant investments in government securities–46 per cent of total assets, of which around 45 per cent are in short-term Treasury bills. The banks have limited scope to reduce such exposures, owing to the government’s sizeable deficit and consequent funding reliance on the local banking system. As such, we expect that the State Bank of Pakistan will maintain its repo facilities for government securities to provide the banks with access to liquidity, should the need arise.
The implementation of Basel III funding and liquidity standards, including the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NFSR), will also support the banks’ liquidity management. LCR will be phased in from March 2017, when the banks will need to meet the 80 per cent requirement, and will reach 100 per cent by the end of 2018. The banks must comply with NFSR in full by the end of 2017.
The Government is expected to support the rated banks, if needed, and the Pakistani government remains committed to supporting the country’s largest banks, given their role as the main source of financing for the government. As such, Moody’s incorporated one notch of support uplift to the ratings of one government-owned bank, National Bank of Pakistan, whose baseline credit assessment is positioned one notch below the government. This aligns its deposit ratings to the B3 government level.
Other rated banks do not benefit from government support uplift because their ratings are already level with the B3 government bond rating. The authorities are in the process of introducing a deposit insurance scheme, expected to be completed during 2017. Once operational, it will both strengthen confidence in the banking system and partly fund any required resolution costs, thus enhancing the authorities’ capacity to provide support.