The latest report from US credit rating agency Moody's shows that Pakistan's financial system is in good health. According to the rating agency, the outlook on Pakistan's banking system is "stable". Moody's has maintained B3 stable rating of Pakistan's banking system considering steady fund inflows and growing economy, but it said high exposure to government securities poses 'the biggest challenge' to the sector. To quote the rating agency, "The outlook for banks in Pakistan (B3 stable) is stable over the next 1218 months… driven by an accelerating economy and stable funding, while also taking into account the banks' large holdings of low-rated government bonds, modest capital levels and high asset risks".
Moody's has been maintaining a stable outlook on the banking system since November 2015. The agency said the economic growth - boosted by domestic demand and China-funded infrastructure projects - will stimulate lending and support a slight improvement in asset quality over the next 12-18 months. So, despite margin pressure, the banks' profitability should remain flat. Stable funding from customer deposits and high liquidity levels represent further strengths. However, the biggest challenge facing the banks is their large holdings of low-rated government bonds. Modest capital levels and high asset risks pose additional risks.
Significantly, the credit rating agency has projected real GDP growth at 5.5 percent for the fiscal year of 2017/18 and 5.6 percent for FY2019. According to Moody's, infrastructure investment and solid domestic demand will prove to be the main drivers of economic growth and will fuel lending growth of 12-15 percent for 2018. But the economy remains susceptible to political instability and a deterioration in domestic security. Moody's expects asset quality to improve in the current supportive macroeconomic environment, helped by the banks' diversified loan portfolios and low corporate debt. Non-performing loans constituted 9.2 percent of gross loans as of 30 September 2017. Asset risk also remains high due to weaknesses in the legal framework, inefficient foreclosure processes and scant information for assessing borrower creditworthiness. In addition, the banks' high exposure to low-rated government securities (44 percent of assets) continues to pose a major risk.
In Moody's view, the banks' capital ratios have declined, but will recover gradually once higher regulatory requirements kick in this year and the next. Capital will be boosted by higher profit retention, capital increases and capital optimisation measures. However, based on Moody's adjusted tier 1 ratio, the banks' capital buffers are modest. The credit rating agency is of the opinion that the banks' profitability will remain flat, despite margin pressure. The profits will be supported by strong lending growth, a focus on low-cost current accounts and moderate provisioning needs, despite interest margin compression. The interest margins should level off towards the end of 2018, once pressure from the reinvesting of legacy high-yielding Pakistan investment bonds reduces, as the remaining of these mature.
According to Moody's, stable customer deposits and high liquidity levels will remain the banks' key strengths. Customer deposits make up around 70 percent of total assets and they are expected to grow by 12-15 percent this year, providing plenty of low-cost funding. But the situation is not without its negative aspect. Problems will multiply if the trend towards private-sector lending is to continue. For one, domestic banks are still waiting for their slice of CPEC action. Moody's says that as growth picks up and CPEC-related investments gather momentum, the banks are likely to find more opportunities in the private sector.