ISLAMABAD: Moody’s Inves­tor Service has changed the outlook for Pakistan’s banking sector to ‘negative’ from stable owing to the its over-exposure towards government lending amid higher fiscal deficit.

“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,” said Constantinos Kypreos, Senior Vice President of the New York based rating agency.

In a statement released on Monday, the investor service said banks’ large holdings of government bonds link their credit profiles to the low-rated government while slower economic growth will contain business opportunities for banks and stall improving trend in problem loans.

As a consequence, the agency changed its “outlook for the banking system in Pakistan (B3 negative) to negative from stable”, said a statement adding the Pakistani banks’ operating conditions will be difficult with the country’s real gross domestic product (GDP) growth slowing to 4.3 per cent in the fiscal year ending June 2019, down from 5.8pc in 2018.

Stable deposit base provides some strength

The Pakistani rupee has depreciated 30pc versus the US dollar, interest rates rose by 450 basis points between December 2017 and February 2019, and inflation is rising — all factors which affect business and consumer confidence and the private sector’s debt repayment capacities, it added.

It also pointed out that Pakistan’s banks face the risk of macroeconomic contagion through a range of channels. These included their large holdings of government securities, which cap their credit profiles to the sovereign, and, from the authorities’ weakening capacity to support the banks in case of need, as evidenced by the negative outlook on the sovereign rating.

“On a more positive note, the banks will continue to benefit from stable customer deposits and high liquidity,” added Kypreos. The negative outlook is based on Moody’s assessment of six drivers: operating environment (deteriorating); asset risk (deteriorating), capital (stable); profitability and efficiency (stable); funding and liquidity (stable); and government support (deteriorating).

Moody’s rates the five largest banks in Pakistan by assets. Together, these banks account for around 50pc of system deposits, the statement said. The rating agency said the declining trend in problem loans (8pc of gross loans as of September 2018) will stall, as challenging operating conditions and structural impediments hinder banks’ ability to resolve legacy non-performing loans.

Moreover, stable customer deposits and high liquidity will remain key strengths and customer deposits constitute approximately 71pc of total assets that will grow 10pc in 2019, providing ample low-cost funding to banks. The agency said cash and bank placements constitute about 15pc of total assets, while another 34pc is invested in government securities offering sound liquidity.

Expanding the low-cost deposit base remains a key area of focus for banks (low-cost current accounts accounted for about 40pc of customer deposits as of September 2018).

Encouraging higher savings and enhancing the deposit base (to 55pc of GDP from around 35pc currently) is also a key goal for the authorities.

The report adds Pakistani banks’ reliance on market funding has increased in recent years terming it a negative development. “This was primarily in the form of interbank and the central bank’s repo facilities, used for “carry trades” (ie buying government bonds funded by short-term borrowings). “Since the spreads on such transactions have narrowed, banks’ exposure to market funding has declined,” it said.

Published in Dawn, February 12th, 2019