Upgrade: Moody's revises Pakistani banks' outlook to positive, citing resilience

• Upgrade credited to strong macroeconomic indicators.
• Moody's warns long-term debt sustainability still a risk.
• Rating agency anticipates economy to expand by 3% in 2025.

Moody’s Ratings has revised its outlook on Pakistan’s banking sector to positive from stable, citing improved operating conditions and resilient financial performance, it said on Wednesday. 

The shift corresponds to the government’s (Caa2 positive) improved outlook, supported by banks’ significant exposure to sovereign debt.

“We have changed our outlook on Pakistan’s banking system to positive from stable to reflect the banks’ resilient financial performance as well as improving macroeconomic conditions from very weak levels a year ago,” according to the Moody's statement.

Moody's last downgraded Pakistan's banking sector on March 3, 2023, lowering the long-term deposit ratings of five major banks — Allied Bank Limited (ABL), Habib Bank Ltd. (HBL), MCB Bank Limited (MCB), National Bank of Pakistan (NBP), and United Bank Ltd. (UBL) — to Caa3 from Caa1.

“The positive outlook on the sector also mirrors the Government of Pakistan’s (Caa2 positive) positive outlook, with Pakistani banks having significant exposure to the sovereign through their large holdings of government securities, which account for around half of total banking assets.

“However, Pakistan’s long-term debt sustainability remains a key risk, with its still very weak fiscal position, high liquidity and external vulnerability risks,” according to the report.

The credit rating agency anticipates Pakistan's economy to expand by 3% in 2025, compared with 2.5% in 2024 and -0.2% in 2023.

“Inflation is also significantly easing, which we estimated at around 8% for 2025 from an average of 23% in 2024,” it said adding, “Problem loan formation will slow as borrowing costs and inflation reduce, although net interest margins will narrow on the back of interest rate cuts.”

“Banks will maintain adequate capital buffers, supported by subdued loan growth and solid cash generation, despite dividend payouts remaining high.”

Moody’s said the outlook revision to positive from stable reflects a better operating environment. “Pakistan’s economic outlook is improving from very weak levels, with enhanced government liquidity and external positions compared to 2024.”

Moody’s noted that Pakistan’s $7 billion, 37-month IMF programme, approved in September 2024, provides a credible external financing source for the coming years.

“We forecast GDP growth of 3% in 2025 and 4% in 2026, up from 2.5% in 2024, further driven by a 10 percentage point cut in interest rates since the start of the monetary policy easing cycle in June 2024.”

“We expect inflation to slow sharply to around 8% in 2025, from an average of 23.4% in 2024. We expect that lower inflation and policy rate cuts will spur private-sector spending and investment in Pakistan from current low levels.”

Moody’s however warned that banks' high exposure to government securities increases asset risk.

“As of September 2024, government securities accounted for 55% of banks’ total assets. This significant exposure links banks’ credit strength to that of the sovereign, which is improving from very weak levels.

“Although problem loans have deteriorated to 8.4% of total loans as of September 2024 from 7.6% in the prior year, overall loans account for only 23% of banks’ total assets,” it said.

Moody’s said the removal of the advance-to-deposit ratio (ADR) tax for 2025 was expected to ease pressure on banks to expand lending, while demand remains subdued despite lower borrowing costs.

It also noted that the ADR-linked tax incentive required banks to reach a 50% advance-to-deposit ratio by end-2024, with noncompliance triggering an additional 10-15% income tax.

Following recent interest rate cuts that have reduced the policy rate to 12%, margins will narrow as local banks derive the bulk of their earnings from the interest they receive on large investments in government securities, which are yielding lower returns compared with last year, it added.

“Concurrently, downward asset repricing will only be partly offset by lower funding costs, while growth in business activity and non-interest income will not fully counterbalance margin compression. “We expect banks’ return on assets to moderate to around 0.9%-1.0% in 2025,” it said.

The financial services provider said that Pakistan’s foreign exchange (FX) risks had reduced in response to a rise in State Bank of Pakistan's foreign exchange reserves since the unlocking of the IMF program.

In its report released in November last year, Moody’s said interest costs in Pakistan would account for close to 40% of total spending in 2025, up from around a quarter in 2021.

Last month, Fitch Ratings said, "Pakistan has continued to make headway in restoring economic stability and rebuilding external buffers."

It said progress on difficult structural reforms would be key to upcoming International Monetary Fund (IMF) programme reviews and continued financing from multilateral and bilateral lenders.

It wrote that rapid disinflation reflected fading base effects from earlier subsidy reforms and exchange rate stability, supported by a tight monetary stance that subdued domestic demand and external financing needs.

Economic activity is now benefiting from stability and falling interest rates, having absorbed tighter policy settings, Fitch added.

It expects real value-added growth of 3.0% in FY25, noting that private sector credit growth turned positive in real terms in October 2024 for the first time since June 2022.