Pakistan’s Fitch Ratings downgrade: What it means and what it doesn’t

A credit rating is an opinion, not fate.
Published December 26, 2018

Credit rating agency Fitch Ratings has recently downgraded Pakistan’s long-term foreign currency issuer default rating by one notch, from B to B-.

In its commentary on the downgrade, Fitch referred to Pakistan’s shrinking forex reserves and high debt burden among other factors.

The rating downgrade has pushed Pakistan to the lower end of the highly speculative grade.

This downgrade has made many headlines both in Pakistan and abroad. Here we explain in simple terms what it means for the country and, no less importantly, what it doesn't.

What’s in the rating?

Pakistan’s credit rating is a forward-looking opinion on the country’s ability to repay its debt. A country is rated when it requests a credit rating.

Rating agencies use letters, ranging from the highest AAA to the lowest C or D, to show relative ranking of credit-worthiness. The initial letters may be followed by further letters or numbers and a plus or minus sign.

In addition, a credit rating might also consist of a forecast that describes how a particular rating may change in the future. For example, a negative outlook may indicate a future downgrade.

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Earlier in June 2018, rating agency Moody’s changed Pakistan’s outlook from Stable to Negative while affirming its B3 rating, which corresponds to a B- by Standard & Poor's and Fitch.

According to Fitch, a B rating indicates that "material default risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment."

Where does Pakistan’s stand globally?

Some of the other countries rated B- by Fitch, in alphabetic order, are El Salvador, Iraq, Lebanon, Nicaragua, Surinam, Ukraine and Zambia.

India’s credit rating is BBB-, Bangladesh’s BB- and Sri Lanka’s B — better than Pakistan's in all three cases. Indonesia is at BBB, Turkey is at BB while Malaysia at A-.

Anything below BBB- is not considered investment grade. What this means is that many investors cannot invest in lower rating due to regulatory requirements and internal policies.

Research shows that there has been a steady rise in the proportion of non-investment-grade issuers due to downgrades and entry of riskier sovereign issuers in the rated pool.

At present, around half of the rated sovereigns are below investment-grade.

What's the implication of a downgrade?

A rating downgrade indicates a greater credit risk; therefore, it is likely to push up the return required from Pakistan when it goes to the international markets to raise debt.

This is a view shared by all three of the local investment analysts — Saad Hashmi, Taha Khan Javed and Muhammad Asim — we addressed this question to.

Although negative, the impact on Pakistan is unlikely to be drastic. One reason is that the downgrade was not a major move out of investment grade but one within the far lower speculative grade.

Much of the rationale underlying the downgrade had already become known and the downgrade was expected, as pointed out by Taha Khan and Saad Hashmi.

Moreover, Pakistan's access to international markets for financing is already closed given the poor state of its finances, so the downgrade doesn't matter, according to Ali Rehan, an analyst at an international asset management firm. The International Monetary Fund (IMF), however, will consider the rating in their assessment.

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Still, the negative impact of a downgrade could spill over to any corporate foreign borrowing. Worse, it affects investor sentiment at large.

The downgrade was described in the Financial Times, an influential publication, as follows: "Fitch has cut Pakistan’s debt rating deeper into junk territory as the cash-strapped country grapples with a lethal combination of low reserves, elevated debt repayments and a weakening fiscal position."

After reading such colourful commentary with the use of “junk”, “cash-strapped”, and “lethal”, all in a single sentence, the sentiment of any investor, including a retail investor at the Pakistan Stock Exchange, can only be dampened.

How credible are sovereign ratings?

The big three rating agencies — Standard & Poor's, Moody’s and Fitch Ratings — that dominate the rating market are commercially driven companies.

Their business models have inherent conflicts of interest that could affect their objectivity and they have lost much credibility after the 2008 financial crisis.

Each rating agency uses its own method to calculate its ratings. These methods take into account quantitative (e.g. budget deficit), qualitative (e.g. corruption perception) and context (e.g., changes in public finances for a country).

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A long-standing criticism facing the ratings is that they react to events rather than anticipate them, adding little value for investors. Another is that they exacerbate economic problems.

Sovereign ratings have been under debate since 2008, with the downgrades of Eurozone countries Greece and Spain, and that of the United States by Standard & Poor's in 2011. Yes, that’s right, even the US has had a rating downgrade, from AAA to AA+.

But the problems of the rating agencies and their practices should not lead us to ignore the economic message in the rating.

Indeed, research supports the view that rating agencies tend to be successful at sorting out potential defaulters among sovereigns.

How might Pakistan’s rating improve?

According to Fitch, Pakistan’s rating or outlook could improve by the following factors:

  • Implementation of an effective policy stance to address external imbalances and rebuilding of foreign exchange reserves;
  • Sustained fiscal consolidation sufficient to reduce debt over time; and
  • Improved export and growth prospects.

Note that none of these reforms can be implemented in the short term. Fitch also cautioned that rating or outlook could be worsened by the inability to mobilise sufficient external funding to reduce financing strains, for example, through an IMF programme or other forms of bilateral assistance.

What can Pakistan learn from rating changes in the past?

In 2015, Moody’s Investors Service revised the outlook (but not the rating) on Pakistan’s foreign currency government bond rating to positive from stable. The change attracted wide press coverage in the news media in Pakistan. However, in the context of wider political developments, the change of outlook was no more than a blip.

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In fact, since Pakistan started to get rated in the 1990's, the country has seen its credit rating move within and across highly speculative and substantial risks. In 1998-99, a period following nuclear tests, Pakistan was also deemed a defaulter.

The current rating is surely not the worse the country has survived. What we can safely learn from our past is that we have a tendency to read too much into a change in rating or outlook in either direction without putting it into a historical context.

What's the way forward on Pakistan’s credit rating?

A credit rating is an opinion, not fate.

There are many different challenges facing Pakistan and the worsening of credit rating is only a manifestation of these, particularly the economic ones.

There is no easy way out but where there is a will to reform, there is a way to reform. An improved credit rating is best seen as a consequence of sound economic management, not a policy objective.

What's at stake is not simply a cut in our debt-to-GDP ratio but how Pakistan can stand up to its challenges at large.

The more we can stand up to our problems, the less we would need to worry about our credit rating.

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