ISLAMABAD: Moody’s Investor Service on Thurs­day improved Pakistan’s banking sector outlook to ‘stable’ from ‘negative’ based on healthy profits arising out of record interest rates, sufficient funding buffers and the country’s expected return to modest growth.

“The banks’ solid profitability and stable funding and liquidity provide an adequate buffer to withstand the country’s macroeconomic challenges and political turmoil,” said the international rating agency, one of the top three global rating firms, while noting that economic and fiscal pressures were easing.

Moody’s also forecasts the Pakistani economy to return to modest growth of two per cent in 2024 after subdued activity last year and inflation to fall to around 23pc from 29pc last year.

The year-on-year Consu­mer Price Index (CPI) already dropped to 23.1pc in February 2024 from 28.3pc in January following a surprise correction in the rate of gas price hikes by half from over 1,100pc.

The average eight-month CPI, however, rem­ained close to 28pc this fiscal year, according to the Pakistan Bureau of Statistics. The gas prices have since increased another time, which would make its impact felt in next month’s CPI.

The rating agency in its Banking System Outlook, however, expected the private sector growth to remain subdued as the banks enjoy robust risk-free returns from the sovereign.

“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,” it said.

Therefore, it noted that persistent external pressures against a challenging operating backdrop will weigh slightly on the performance of Pakistani banks’ loan portfolios.

“Profitability will remain strong because of wide net interest margins (NIMs), but decline from 2023 peaks because of subdued business growth, increased funding costs on the back of higher rates, and elevated taxes,” it said, forecasting the banks’ modest capital ratios to remain stable, as strong earnings offset high dividend payouts. Banks’ stable deposit-based funding will continue to support financial stability.

The agency highlighted that downside risks persist, particularly from political uncertainty and challenging government finances that increase the risk of sovereign debt relief, potentially extending to commercial banks. It generally covers five top banks, including the National Bank of Pakistan, United Bank Limited, Habib Bank Limited, MCB Bank and Allied Bank Limited, for credit assessment.

“Government securities account for 51pc of Pakistani banks’ total assets and around nine times their equity, among the highest levels for Moody’s-rated banks globally. This exposure links banks’ credit profiles to that of the Caa3 Pakistani sovereign, for which concerns around debt restructuring persist, and banks will remain the main source of government fin­ancing” over the out­­look period, Moody’s said.

The problem loans ratio of the five Pakistani banks rose to 8.5pc as of September 2023, up from 7.3pc in December 2022, following severe shocks that subdued economic growth and as historically high inflation and interest rates erode borrowers’ repayment capacity. “We expect problem loans to stabilise at around 9pc of gross loans, partly because of the banks’ reluctance to lend in this challenging environment,” the rating agency said.

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. 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.

Profitability will gradually decline to normalised but still strong levels as these banks’ interest revenue — the largest contributor to operating income — will moderate in 2024, with monetary policy beginning to ease as inflation and interest rates gradually recede from 2023 peaks.

The report noted that deepening financial inclusion and remittances from non-resident Pakistanis were broadening domestic deposit inflows. Banks are mainly deposit-funded, with customer deposits accounting for 58pc of total assets as of September 2023, and have very low reliance on more volatile market funding (5.6pc of tangible assets as of December 2022) given limited access to international debt markets.

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 7pc of total system deposits as of end-2023 from 75.2pc a year earlier. The introduction of a Treasury Single Account — which requires government deposits to be held at the State Bank of Pakistan — will have only a modest impact on deposit outflows.

Published in Dawn, March 8th, 2024