Moody’s Investors Services has projected that China Pakistan Economic Corridor (CPEC) will raise Pakistan government debt to around $222 billion by fiscal year 2017-18 (around 67 percent of country’s GDP). Moody’s latest issuer on CPEC, external liquidity pressures and the fiscal outlook states that CPEC will increase government debt and external pressures as CPEC-related imports contribute to a widening current account deficit and bilateral loans increased leverage.

Moody’s considers the July 5 devaluation and subsequent reversal an indicator of the policy challenges posed by rising external pressure. Greater exchange rate flexibility would sustain export competitiveness and contribute to a more durable accumulation of foreign exchange reserves over time, which would help strengthen external buffers. After nearly two years of stability, the Pakistani rupee depreciated by about 3 percent following foreign exchange market intervention by the central bank. Moody’s believes that the intervention responded to mounting external pressures and deterioration of export competitiveness, following persistent real effective exchange rate (REER) appreciation. The REER appreciation was driven primarily by a stronger depreciation in the currencies of Pakistan’s other trade partners against the US dollar. The Pakistani rupee has since retraced much of its recent depreciation.

Greater exchange rate flexibility would contribute to a more durable accumulation of foreign exchange reserves over time, which would help strengthen external buffers and export competitiveness. The resulting reduction in external vulnerabilities would support Pakistan’s credit profile.

However, while it believes this to be the central bank’s medium-term objective, Moody’s expects any shift in exchange rate management to be gradual as the government will likely want to avoid abrupt currency and other price movements, in particular in advance of the 2018 general election. Even if it had been sustained, the net depreciation would have been too small to appreciably add to interest-to-revenue ratios. At the same time, the recent currency devaluation would have had a small impact on the government’s debt stock and debt-servicing costs, as around 30 percent of government debt is foreign-currency-denominated.

The report further states that the widening deficit adds pressure to Pakistan’s balance of payments position and could weigh on future foreign-exchange reserves adequacy, which would increase external vulnerability risk. Moody’s expects further consolidation to be challenging, as revenue shortfalls and pressures for higher development spending in advance of the 2018 general election test fiscal discipline.

CPEC will affect the sovereign credit profile through its impact on medium-term growth, government debt and Pakistan’s external position. It further states that security-related issues and Pakistan’s weak track record of public project implementation suggest that the pace of CPEC project execution will be relatively slow. As such, while CPEC will support Pakistan’s growth and credit profile, Moody’s expects the economic impact to materialize more slowly than the government envisions, resulting in real GDP growth around 5.5 percent over the next two years, compared to the government’s forecast of 6 percent in fiscal year 2018 (fiscal year ending June 30, 2018), rising to 7 percent by fiscal year 2020. The report states that as of April 2017, the total notional value of CPEC-related investments was approximately $60 billion (around 22 percent of fiscal year 2016 GDP), of which nearly half ($28 billion) was allocated to “early harvest” projects in energy, transportation and other infrastructure, which the government intends to finish by 2018. The remaining investments will occur through 2030 and beyond. As regards the implications for government debt, the majority of early harvest projects will be financed through Foreign Direct Investment ($19 billion) and concessional loans ($7 billion).

The IMF estimates that a further $1.6 billion will be financed through commercial loans, and that a further $228 million will take the form of grants. Some CPEC priority projects are already under way. This has contributed to a pickup in FDI and external loans, as well as imports of machinery and industrial materials. Overall, Moody’s projected that CPEC will raise government debt to around $222 billion by fiscal year 2018. CPEC will also affect Pakistan’s credit profile by increasing balance of payments pressures, at least temporarily.

The report further projected that capital goods imports to raise as more CPEC-related projects are implemented, which will contribute to widening trade and current account deficits. According to the IMF, CPEC-related financial inflows will reach 2.2 percent of GDP by fiscal year 2020. Both FDI and portfolio flow financing will result in higher income payment outflows, which would put further pressure on the current account deficit.

The recent widening of the current account deficit shows that the external position remains vulnerable to an increase in imports and decline in remittances. Moreover, uncertainty surrounding the funding of wider current account deficits could amplify external liquidity constraints. As a net oil importer, Pakistan has benefited from lower global oil prices. However, last year’s uptick in prices, combined with an increase in imported capital goods in particular for CPEC projects, widened the trade and current account deficits.

Moody’s estimated the current account deficit to rise to around 2.7 percent of GDP in fiscal year 2017 and to 2.9 percent in fiscal year 2018, compared with 1.2 percent in fiscal year 2016. This will be driven by continued expansion of the trade deficit, subdued growth in remittance inflows from Gulf Cooperation Council (GCC) countries, and increased interest payments on external debt (related, in particular, to CPEC financing).

A further decline in remittances would be credit negative by dampening consumption and widening the current account deficit further. At the same time, it expects external debt interest payments to rise as a result of the financial inflows that will accompany CPEC projects. In addition to FDI inflows, project capital expenditure and imports will be partially financed through bilateral external loans and potentially debt issuance. Interest payments on such debt, the terms of which are not readily available, will contribute to a steady increase in income outflows, thereby exacerbating the current account deficit.

Unless offset by a rise in exports, this anticipated increase in CPEC-related external debt will weigh on future foreign-exchange reserves adequacy. Although foreign-exchange reserve buffers have increased nearly fourfold since the onset of the IMF program and cover more than the full amount of external debt payments, they are still low in relation to current account payments and have been declining since peaking around September 2016.

Economy-wide external and foreign-currency denominated debt is relatively low, at only around 26 percent of GDP, which mitigates repayment risks directly related to a depreciation of the currency. The larger risks relate to the impact of a weaker currency on inflation and thereby real incomes and profits, and domestic consumption and investment. The government achieved a significant reduction in fiscal deficits under the IMF program in 2013-16, but Moody’s expect that these deficits to widen modestly over the next two years and for government debt ratios to remain higher than the median for B-rated peers.

Moody’s estimates the fiscal deficit to widen to about 4.7 percent of GDP in fiscal year 2017 and 5 percent in fiscal year 2018 despite the government’s intention to advance fiscal consolidation.

Very low incomes, a high level of tax exemptions and weak tax compliance and enforcement, even after the IMF program reforms all restrict government revenues. Large fiscal deficits and a reliance on short-term debt have also contributed to very high gross borrowing requirements. At around 32 percent of GDP, Pakistan’s projected gross borrowing need for 2017 is among the highest of rated sovereigns. Meanwhile, with nearly 31 percent of outstanding government debt in foreign currency in fiscal year 2016, Pakistan is exposed to changes in the cost of refinancing debt, should the local currency weaken by significantly more than the 3 percent depreciation that took place earlier this month.

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