Moody’s upgrades banking outlook

KARACHI:

Moody’s, the global rating agency, has upgraded Pakistan’s banking sector outlook from stable to positive and forecasts GDP growth to reach 3% in 2025, citing resilient financial performance and improving macroeconomic conditions. However, challenges persist, particularly concerning long-term debt sustainability and high exposure to government securities.

The shift from stable to positive reflects stronger government liquidity, a more stable external position, and a recovering economy, with GDP growth forecast at 3% in 2025. While long-term debt sustainability and government securities exposure remain concerns, Moody’s expects lower inflation and policy rate cuts to drive private-sector investment. The upgrade aligns with Pakistan’s sovereign rating outlook, signalling growing confidence in the country’s financial stability.

“This development will positively impact Pakistan’s economy by encouraging private-sector investment due to lower borrowing costs, boosting consumer spending, and enhancing financial sector confidence,” said Ali Najib, Head of Equity Sales at Insight Securities.

Moody’s has raised Pakistan’s rating to Caa2 positive, as the country’s banks hold nearly half of their assets in government securities. However, long-term debt sustainability remains a key risk due to Pakistan’s weak fiscal position and persistent liquidity and external vulnerability challenges.

Moody’s forecasts Pakistan’s GDP growth to reach 3% in 2025, up from 2.5% in 2024 and a contraction of -0.2% in 2023. Inflation is also projected to drop to 8% in 2025 from an average of 23% in 2024. Lower inflation and reduced borrowing costs will slow the formation of problem loans, though net interest margins are expected to narrow due to interest rate cuts. Despite high dividend payouts, banks are expected to maintain adequate capital buffers, supported by subdued loan growth and strong cash generation.

The approval of a 37-month, $7 billion International Monetary Fund (IMF) Extended Fund Facility in September 2024 has provided external financing stability. GDP growth is projected at 3% in 2025 and 4% in 2026, aided by a 10-percentage-point interest rate cut since June 2024. Inflation is expected to fall to 8% in 2025 from 23.4% in 2024, spurring private-sector investment.

“This rating upgrade reflects the improvement in the country’s macroeconomic indicators coupled with the strong financial performance of the banking sector in the outgoing year,” said Waqas Ghani Kukaswadia, Deputy Research Head at JS Global.

As of September 2024, government securities made up 55% of banks’ total assets, linking their stability to the sovereign. Problem loans rose to 8.4% of total loans, though overall loans represent just 23% of banking assets. Lending to private businesses grew by 5% year-over-year, driven by regulatory Advances to Deposit Ratio (ADR) requirements. However, with the ADR tax removal in 2025, lending pressure will ease, though demand may stay subdued despite lower borrowing costs. Small and Medium sized Enterprise (SME) financing initiatives are expected to support modest loan growth, while problem loans may remain at around 9% of gross loans.

With interest rates cut to 12%, net interest margins are expected to decline. Banks earn primarily from government securities, which now yield lower returns. Increased corporate tax rates (44% from 39%) will offset the ADR tax removal, and return on assets is forecasted at 0.9%-1.0% in 2025. Strong profitability and low credit growth have bolstered capital buffers, with Tier 1 capital improving to 17% and total capital-to-risk-weighted assets at 21.5%.

Customer deposits remain the primary funding source (60% of assets), with remittances boosting liquidity. While banks hold significant government securities as collateral, foreign exchange risks have eased with rising reserves. The government’s capacity to support banks has improved, driven by its upgraded sovereign rating and stronger fiscal position.