Moody’s Investors Service on Thursday changed its outlook on Pakistan’s banking sector from “negative” to “stable” citing its solid profitability, stable funding and liquidity, which it said “provide an adequate buffer’ to withstand the country’s macroeconomic challenges and political turmoil.

The international rating agency — one of the top three global rating firms — said that the economic and fiscal pressures were easing for the country, as it forecasted that the economy would return to a 2 per cent growth rate in 2024 after subdued activity in 2023. The report also said it expected inflation to fall from 29pc to 23pc.

“Pakistani banks remain highly exposed to the government via large holdings of government securities that amount to around half of total banking assets, which links their credit strength to that of the sovereign,” the global rating agency said.

According to the report, the macroeconomic conditions remained weak while government liquidity risk and external vulnerability were high. It said the recovery from the 2022 floods and “low base effects” will support a modest economic recovery.

“However, high-interest rates and inflation will continue to curb private-sector spending and investment,” it said, adding that banks were financing the sovereign’s wide fiscal deficits, leaving little space to lend to the real economy “Initiatives to deepen financial inclusion and assistance for key sectors will only partly support credit demand,” it added.

The report said the banking sector’s asset risk was linked to high government securities exposure as government securities accounted for 51pc of Pakistani banks’ total assets and around nine times their equity, the highest levels for Moody’s rated banks globally.

“We expect problem loans to stabilise at around 9pc of gross loans, partly because of the banks’ reluctance to lend in this challenging environment,” it said.

It also said the capital will remain broadly stable as banks’ subdued growth and solid earnings offset dividend payouts.

The reported Tier 1 capital ratio for the rated Pakistani banks was 15.3pc of risk-weighted assets as of September 2023, up from 14.4pc in 2022 and well above the regulatory minimum, it said.

Moody’s capital metric, the tangible common equity to adjusted risk-weighted assets ratio, is a low 5.2pc, reflecting the 150pc risk weighting for government securities in line with the Caa3 sovereign rating, it added.

The report said that the profitability will gradually decline to normalised, adding that it expected Pakistani banks’ interest revenue to moderate in 2024, with monetary policy beginning to ease as inflation and interest rates gradually recede from 2023 peaks.

“Subdued business and lending activity will keep interest on lending and non-interest income in check. Operating expenses will likely stabilise in line with easing inflation and banks’ cost-control efforts. Persistently elevated tax rates and potentially higher loan-loss provisions will weigh on banks’ bottom-line profitability, with the return on average assets hovering around 3pc,” it said.

The report said that stable funding and liquidity were a strength for the country as deepening financial inclusion and remittances broadened domestic deposit inflows.

“Banks are mainly deposit-funded […] and have very low reliance on more volatile market funding given limited access to international debt markets,” the report said.

“However, the cost of funds is rising moderately as high-interest rates have driven a migration to interest-bearing deposits from non-interest-bearing deposits, which were down to 74pc of total system deposits as at end-2023 from 75.2pc a year earlier,” it said.

While Moody’s upgraded its outlook on Pakistan’s banking sector, it downgraded its outlook for the banking sector in a number of European countries.

It changed the outlook to negative from stable for the banking sectors of Germany, Britain and France, Belgium, the Netherlands, and Sweden.

“A deteriorating operating environment with low economic growth and high borrowing costs will hit credit growth as well as loan performance in the largest European countries, particularly in the corporate sector,” said Moody’s analyst Effie Tsotsani.