Pakistan: Moody's downgrade: big surprise?

Downgrading of Pakistan's foreign and local currency bond ratings by one notch to Caa1 from B3 by Moody's Investors Service last week may not be surprising for those who have been watching the recent developments in country's economy closely. As is usually the case, the fresh assessment was claimed to be made on the basis of deterioration of certain key macroeconomic variables including worsening of country's balance of payments (BoP) position over the past year, the looming large repayments due to the International Monetary Fund, dwindling foreign exchange reserves and the institutional weaknesses stemming from political instability and constrained government finances. The main driver of Moody's one notch downgrade of the country's bond rating was the increasing strain on its external sector position as a result of a rising trade deficit and a decline in capital inflows. Weak government finances, structural inflationary pressures and domestic political uncertainties were also adding to Pakistan's vulnerabilities and other risks, thereby compounding the downward pressures on sovereign creditworthiness. In order to justify its action to downgrade Pakistan's credit rating, Moody's Service depended largely on the previous year's (2011-12) data which indicated several deteriorating trends in all the key areas of the economy. As part of the new rating action, Moody's has also revised Pakistan's foreign currency country ceiling to B3 from B1, foreign currency deposit ceiling to Caa2 from B3, and local currency bond and deposit ceilings to B1 from Baa2 and Ba2 respectively. The considerable change in the local currency ceilings reflect a downward assessment of Institutional Strength to "Very Low" from 'Low' in the assessment of sovereign risk. It needs to be remembered that Moody's is one of the three largest credit rating agencies in the world and the downgrade of Pakistan's foreign and local currency bond ratings from B3 to Caa1 - equal to the lowest rating Pakistan had ever gotten, cannot be easily dismissed and would have a considerable negative impact on the economy. Although, Pakistan's debt had generally been classified as "junk" but the position, in terms of ratings, was never as bad as declared in its latest report. Moody's highest-ever rating for Pakistan was B1 from November 2006 to May 2008 which was downgraded to B3, shortly before IMF rescue package for Pakistan came into effect. The rating agency had also downgraded Pakistan from B2 to B3 on the very day that Pakistan had conducted five nuclear weapon tests on May 28, 1998. Pakistan's downgrading to the new level of Caa1 shows that Moody's is now highly pessimistic about the prospects of the country's economy, particularly about its external sector. The present rating, in fact, is so poor that the country's debt rating has to go up seven notches in order to reach the lowest level of investment grade. Needless to say, that such an inferior rating by a highly reputed agency could be very harmful for the economy. In particular, foreign investors would avoid the country, external borrowings would be highly expensive and it would be more difficult for domestic banks to open LCs for imports. If the situation worsens further, foreign banks could demand cash for trade transactions which would be costly in financial terms and, in a way, humiliating for the country. All of this could have a negative impact on exchange rate, inflation, growth rate, employment and poverty level, etc. While Moody's has declared its new assessment, it could be plausibly argued that its action to downgrade our rating was rather hasty and ill-conceived. It is certainly a bit of a surprise that rating downgrade has been announced at a time when oil prices in the international market have dropped significantly, relations with the US have improved somewhat, exports to the EU countries could increase under the new policy regime, and home remittances are rising consistently. All these factors would have a positive impact on the external sector and reduce the risk of insolvency in the near future. Although, political tensions in the country are still high but unanimous agreement on the new Chief Election Commissioner suggests that the key players would prefer the system's continuity and shun direct confrontation. It also needs to be mentioned that Standard & Poor's has not changed Pakistan's credit rating so far and maintained its stable outlook. However, all of this does not mean that the country's economy is out of the woods. The government has already defaulted in its domestic sovereign obligations to the IPPs and could face problems in the foreign debt repayments in the next couple of years due mainly to the huge amount of principal and interest due for payment to the IMF. Whatever the future of the economy, authorities of the country, in our view, instead of disputing or worrying too much about the justification of Moody's latest move, need to concentrate wholeheartedly on reducing the vulnerabilities of economy through a bold reform process. If such a route is adopted, not only would our economy improve, the Moody's and others would also be forced to reassess Pakistan ratings.