OREANDA-NEWS. April 13, 2016. Fitch Ratings has affirmed Pakistan's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'B' with Stable Outlooks. The issue ratings on Pakistan's senior unsecured foreign- and local-currency bonds are also affirmed at 'B'. The agency has also affirmed the Short-Term Foreign-Currency IDR at 'B' and Country Ceiling at 'B'.

KEY RATING DRIVERS

The ratings reflect the following factors:

- Pakistan has made progress with fiscal consolidation, restoring foreign-reserve buffers, lowering inflation and initiating structural reforms after the country agreed to an Extended Fund Facility (EFF) with the International Monetary Fund (IMF) in September 2013. Nonetheless, a difficult political and security environment, high public debt and interest burden, and low per capita incomes weigh on Pakistan's rating.

- Official reserves shrank rapidly prior to the EFF, as Pakistan had to make large repayments due from previous IMF borrowing (USD1.3bn in 2012 and USD2.3bn in 2013). However the country's external liquidity position has strengthened markedly. Pakistan's official reserve assets rose to USD19.3bn at end-February 2016 from USD8.6bn at the inception of the latest IMF programme, supported by IMF disbursements, grants and Eurobond issuances totalling \\$3.5bn. There is limited pressure from external debt repayments in the near term. Projected principal repayments to the IMF for the EFF are stretched over a longer timeframe, starting with USD0.2bn in 2018 and rising to USD0.8bn in 2020, with the final payment due in 2025. An USD0.75bn bond due in June 2017 is the only Eurobond maturing until 2019. Repayments for official development assistance from the Paris Club begin in 2016, but are stretched over a 23-year period.

- Fitch considers external liquidity an ongoing vulnerability for Pakistan, despite a small current account deficit compared to peers (1% of GDP in the fiscal year to June 2015 (FY15) compared with 'B' median of 7.3%) and modest net external indebtedness. Net FDI inflows have averaged just 0.7% of GDP between 2010 and 2014, requiring Pakistan to access other forms of external financing, such as portfolio flows and multilateral support. Fitch expects FDI inflows to increase substantially in the future as plans for USD46bn worth of projects linked to the China-Pakistan Economic Corridor (CPEC) get underway. However, the extent the CPEC benefits the country's external finances will depend on the exact terms of projects, particularly financing plans and the import intensity of investments. Slower remittance growth from oil producers in the Middle East could add pressure to external finances.

- Pakistan's fiscal position is a key credit weakness. Interest payments amount to almost a third of general government revenues in FY15, compared to the 'B' median of 7.4%. High public indebtedness, the expensive cost of borrowing and a small tax base contribute to the government's interest burden. However, the budget deficit narrowed to 5.3% in FY15 from 8.4% in FY13, driven by a reduction in subsidies (0.6pp) and an increase in tax revenues (1.0pp).

- The power sector is a source of contingent liabilities for the government. Clearance of payment arrears accumulated by publicly owned utilities contributed 1.4pp to the budget deficit in FY13. Payment arrears amounted to 0.8% of GDP in FY15, but were not cleared by the government and not reflected in the budget numbers. The government plans to use the proceeds from the privatisation of power distribution companies to pay off the stock of arrears. However labour unrest and legal challenges over the privatisation of Pakistan International Airlines highlight the difficulty of the process. The stock of arrears could materialise on the general government balance sheet should privatisation plans fail, and the distribution companies continue to be loss-making. The build-up of arrears has slowed due to better receivables collection, reduction of losses from transmission and distribution, and the introduction of late payment surcharges.

- The ability of the Pakistan government to sustain structural improvements and maintain macroeconomic stability after the IMF programme is completed, due in September 2016, will be an important rating driver. The implementation of politically unpopular reforms could become more challenging in the run-up to the general election, expected in 2018. Low oil prices have also cushioned the cost to consumers of adjusting utility tariffs to more economic rates. Public opposition could be greater if tariffs were to rise sharply, for example in response to a stronger rebound in oil prices than Fitch expects,

- Pakistan is underdeveloped relative to 'B'-rated peers, with GDP per capita at USD1,422 in FY15 compared with the 'B' median of USD3,625. GDP growth over the past five years has averaged lower than peers despite the lower income level, constrained by a low investment rate and poor business environment. Structural reforms have gradually improved the availability and reliability of energy for businesses, and continued progress would create an environment more conducive to private investment. Private credit growth has accelerated since September 2015, driven, according to authorities, by fixed investments and working capital spending. Total private-sector credit only amounted to 15.1% of GDP at end-2015, compared to the 'B' median of 37.1%. Pakistani banks are well-capitalised and profitable, and should be able to facilitate greater provision of credit. Non-performing loans are high at 11.4% of gross loans, but the ratio has been declining since 2013.

- Civilian fatalities as a result of terrorist violence fell to around 940 in 2015 from over 3000 in 2013. However, the ongoing security risks faced by Pakistan were highlighted by the bombing in Lahore on 27 March 2016 that killed over 70 civilians, the highest number of fatalities from a terrorist incident in Pakistan since about 140 civilians were killed in the Peshawar school attack on 16 December 2014. An escalation of security concerns could lead to higher fiscal expenditure, loss of investor confidence and disrupt economic activity.

RATING SENSITIVITIES
The main factors that could, individually or collectively, lead to a negative rating action are:

- Policy slippage that leads to renewed pressure on economic and financial stability, which may be evident in a rapid loss of reserves or sharp rise in inflation.
- Deterioration in the fiscal position that leads to a sharp or sustained rise in government debt ratios, including contingent liabilities from state-owned entities.
- Political instability sufficient to damage the country's economic or financial stability

The main factors that could, individually or collectively, lead to a positive rating action are:

- Sustained fiscal consolidation, strengthening of the revenue base, reduction in government debt ratios and the smaller contingent liabilities from state-owned entities.
- Progress with structural reform that leads to improvement in the business environment, stronger economic growth and higher investment.
- An improved security situation and decreased political risk

KEY ASSUMPTIONS
- The ratings incorporate an assumption that Pakistan's relations with India do not deteriorate to the point of renewed armed conflict.
- The global economy is presumed to perform broadly in line with Fitch's latest Global Economic Outlook report.