View from McLeod Road: How the downgrade can affect the economy

Move surprises analysts; most local observers see macroeconomic trends stabilising.

KARACHI:

This is one of the few advantages of the Pakistani financial system not being intertwined with global capital markets: the downgrading of the country’s sovereign credit rating by Moody’s is unlikely to become an immediate crisis, or have any serious short-term impact on the economy.

Moody’s decision to downgrade Pakistani government bonds from B3 to Caa1 comes as a surprise to most analysts, many of whom feel that the decision does not take into account recent improvements in the country’s macroeconomic stability – most notably the rapprochement with Washington – and falling international oil prices. Nonetheless, a downgrade is a downgrade, and the consequences are something the economy will now have to live with; especially since Moody’s has made it clear that they have no intention of revising Pakistan’s rating upwards anytime soon.

The most immediate impact is likely to be minimal: both the government of Pakistan as well as large Pakistani corporations borrow negligible amounts from international capital markets. The cost of borrowing will most definitely go up, but given the fact that Pakistan’s rating is already well into ‘junk’ territory, the one-notch downgrade is unlikely to make a massive difference.

Nor are international investors in Pakistan’s bond markets likely to be affected by this downgrade for one simple reason: there aren’t any. Pakistani investment bankers in the Middle East, as well as Pakistani asset management companies based in Karachi, have been trying to get international institutional investors to buy Pakistani rupee-denominated government bonds for at least the past five years, and have had almost no success.

While the yields on Pakistani treasury bills are much higher than the meagre rates on offer in most other parts of the world, their credit rating was too low even before this downgrade for institutional players to be interested. Institutional investors are mindful of the average rating of their overall portfolio. Many are not even allowed by their own rules to invest in junk-rated bonds. Even if buying Pakistani bonds would push up their yields, their average rating would be dragged too far down for it to be worth it.

The real damage to Pakistan’s economy is likely to come from the problems of perception of having that low a credit rating. The last time Moody’s decided this low a credit rating – after Pakistan’s nuclear tests in 1998 – the country’s economy was in a bad shape. Foreign investment slowed to a trickle and the rupee plunged over 40% in the following two years.

Some analysts worry that that may happen again. “It will likely add to the pressure on the Pakistani rupee, which is already down 5% since January,” said Burj Capital, an investment bank, in a note issued to clients.

Yet that is unlikely to happen. With the resumption of NATO supplies, Washington will once again resume Coalition Support Funds payments, which in turn will likely stabilise the rupee.

The real concern about the downgrade should come not from the announcement, but what led to it: the government of Pakistan’s persistent inability to pay its bills on time; the short attention spans of politicians who are too busy playing power games to actually govern the country; and the absolute unwillingness of virtually anyone in the country to pay their taxes.

There are many ways to fix the state of the economy, and most of them do not rely on Washington doling out money to Islamabad. But they do require Islamabad to speak the truth to its people: that the era of wasteful, untargeted, distorting subsidies is over and everybody needs to start paying their taxes. If we do that, even an investment grade rating is not out of the question; though one suspects that we may have to wait quite a while before that happens.

Published in The Express Tribune, July 14^th, 2012.