In August 2020, Moody’s confirmed a B3 credit rating for the Government of Pakistan. Looking back, Pakistan was rated Caa1 by Moody’s during 2012 to 2015 period, implying that Pakistan’s credit rating has improved since 2015. This article explores what these ratings really represent, how they are assessed and what impact they have on Pakistan.
What do credit ratings represent?
These credit ratings are an assessment of Pakistan’s creditworthiness – the country’s ability to repay its debt when it comes due, both principal amount and interest.
Therefore, it can be said that if a ratings agency like Moody’s lowers Pakistan’s credit rating, global financial markets now have less confidence in the country’s ability to back its debt and vice versa. Thereby, it can also be said that global financial markets expect that countries that have lower credit ratings are more likely default on their debt as compared to countries that have relatively higher credit ratings.
For illustrative purpose, we have compiled the credit ratings for a few countries as assessed by Moody’s below. “Investment Grade” ratings generally imply a good creditworthiness and “Non-investment grade” (often known as “junk” or “high-yield”) are known to have poor creditworthiness. With a B3 rating, Pakistan has junk status. It is riskier to lend to Pakistan, as compared to lending to Egypt, Nigeria or Senegal. Likewise, it is relatively safer to lend to Pakistan, as compared to Sri Lanka, Iraq or Lebanon.
Credit ratings of countries vs. Pakistan
Pakistan’s B3 rating reflects junk status with high credit risk as compared to other countries
|Minimal credit risk
|Very low credit risk
|United Arab Emirates
|Moderate credit risk
|Substantial credit risk
|Non-investment grade/High yield/Junk bonds
|High credit risk
|High credit risk
|Very high credit risk
Source: Moody’s, Fidelity
How is country risk measured?
Now let’s try to get some additional perspective on these credit ratings by bringing in some numbers in to the picture – primarily a country’s default risk as measured by Credit Default Swap (CDS) spreads. At first glance, we can clearly see that CDS spreads below are increasing as credit ratings worsen. Let’s see what is really happening here “behind the scenes”.
Credit Default Swap (CDS) Spreads (%) vs. Credit Ratings
A higher premium is required when investing in countries with lower credit ratings
Note: As at 1st Jan 2021
Source: Aswath Damodaran
Credit Default Swaps (CDS) are basically an insurance against default and we can think of the CDS spread as the insurance premium. For example, consider an investor who has lent USD 100,000 to the Government of Pakistan. Now that investor is worried that Pakistan will default, and they want to insure themselves against this event. They will buy a CDS to the value of USD 100,000 and will pay 4.51% per annum in premium. If Pakistan defaults (God forbid!), the investor will get back the USD 100,000.
As life insurance is more expensive for not-so-healthy people, CDS spread is higher for countries that are not as financially stable as others. The above chart clearly depicts this relationship – there is a higher insurance premium (i.e. CDS spread) for countries with lower credit ratings. This suggests that credit ratings are a meaningful tool to understand the financial health of a country and to gauge the risk of default. The CDS spread theoretically puts a number to that risk.
How are credit ratings assessed?
Now let’s explore what factors are considered when making a ratings assessment and what causes a ratings upgrade or downgrade.
The actual process to determine these ratings is perhaps quite complex however, without getting into those complexities; we can still understand what factors are considered in this assessment. Moody’s provides its detailed sovereign ratings methodology guide as per which a few of the quantitative factors it considers are:
- Average Real GDP growth;
- GDP per capita (at Purchasing Power Parity, in USD);
- Government debt (principal plus interest) as a percentage of GDP and/or revenue; and
- Balance of payments (current account deficits).
and a few of the qualitative factors considered by Moody’s in its assessment are:
- Strength of civil society and judiciary;
- Fiscal, monetary and macroeconomic policy effectiveness; and
- Domestic political and geopolitical risk.
Quantitative measures are relatively easier to grasp as this data can be found on various online platforms (such as Bloomberg). The qualitative measures require more judgement and Moody’s often uses proxy data to gauge the qualitative variables. For example, Moody’s considers high-level of income inequality as a possible source of “domestic political and geopolitical risk” and it uses the Gini Index to measure economic inequality. Higher Gini coefficients reflect greater inequality in wealth in an economy, which reflects higher political risk. An overview of how key economic metrics and Pakistan’s credit rating (as assessed by Moody’s) have evolved over the past 20 years is provided below.
Pakistan’s GDP per capita (USD) and Real GDP Growth (%) vs. Moody’s Rating
Growth in per capita GDP in early 2000s led to Pakistan’s rating increasing to B1 by 2006
Source: Moody’s, Economist Intelligence Unit, S&P Market Intelligence, Pakistan Bureau of Statistics
As seen above, between 2003 and 2007, Pakistan’s Real GDP growth rate was above 4% and GDP per capita was growing. Such positive economic highlights were reflected in credit ratings as they were adjusted upwards in 2003 (from Caa1 to B3) and in 2006 (from B2 to B1).
Pakistan’s Public Debt (PKR B) and Public Debt/GDP (%) vs. Moody’s Rating
Despite an increased level of debt, Pakistan’s credit ratings have remained steady since 2015
Note: Public debt is total debt (both local and foreign currency) owed by government to domestic residents, foreign nationals and multilateral institutions such as the IMF
Source: Moody’s, S&P Market Intelligence
Why didn’t Pakistan’s ratings worsen?
The chart above confirms a very common notion among Pakistanis that the country’s debt is ever-increasing. It also provides another statistic, the country’s debt as a percentage of the value of goods and services the country produces i.e. the debt to GDP ratio. The country’s debt to GDP ratio increased from 52.3% in 2012 to 68.7% in 2020. Multiple factors such as the fiscal and current account deficits have contributed toward this increase. However, there is one common conclusion – this is not a good sign for Pakistan’s economy. The growing debt/GDP ratio could be a contributing reason for Moody’s to not increase Pakistan’s credit rating between 2012 and 2018 despite the Real GDP growth being above 4% in this time period.
One can wonder why Pakistan’s credit rating has been stable at B3 in 2019 and 2020 even though real GDP growth was very low (negative in 2020) and debt to GDP ratio increased in these two years. An assessment of the country’s external balance can probably provide some perspective on this. Pakistan has controlled its imports quite well in recent years. Its current account balance to GDP ratio in 2019 and 2020 was –4.8% and -1.1%, respectively. Compare this to that of 2018 (-6.1%) and you can see why Moody’s could possibly have not downgraded Pakistan’s rating. The country’s foreign exchange reserves also tell a positive story – they stood at USD 12.1 billion in 2020 as compared to USD 7.3 billion in 2019. Improving trade deficit and strong foreign exchange reserves could have potentially saved Pakistan’s credit rating from a downgrade.
Pakistan’s Foreign Exchange Reserves (USD B) and Current Account Balance/GDP (%) v. Moody’s Rating
Improvement in external position in last 2 years could have saved Pakistan’s credit rating
Source: Moody’s, S&P Market Intelligence, State Bank of Pakistan
The impact of ratings on Pakistan: “The risk return trade-off”
At the core of economics and finance theory is the concept of “risk return trade-off”. This principle implies that if you are lending to a country (or a company) which has a higher risk of repaying your debt, you should be demanding a higher return (or interest) on your investment. Therefore, investors lending to countries with good credit ratings (e.g. United States or New Zealand) would expect to get a lower interest rate on their investment as compared to those lending to countries with relatively poor credit rating (e.g. Bangladesh or Sri Lanka).
Pakistan being rated as “non-investment grade” and having a lower credit rating than many of its emerging market peers (such as India, Kazakhstan, Bangladesh and Turkey) is bound to provide higher returns otherwise investors will not be willing to invest in the country.
An investment case for overseas Pakistanis – Naya Pakistan Certificates
The recently launched Naya Pakistan Certificates are said to be offering ‘tremendously attractive’ rates of returns for overseas Pakistani’s. The return offered on a 5-year USD certificate is 7%. Overseas Pakistanis have the option to invest in these certificates, while they also have other similar investment options e.g. investing in bonds of other emerging market economies (this can easily be done via exchange traded funds).
To truly gauge whether the returns on Naya Pakistan Certificates are ‘tremendously attractive’, let’s compare these returns to those of other emerging market bonds while considering the risk of investing in these countries as measured by their credit ratings.
Comparison of 5-year average bond returns vs. 5-year Naya Pakistan Certificates
Given the lower credit rating of Naya Pakistan Certificates, their high returns are justified
|5-year pre-tax return
|Average Credit Rating
|Invesco Emerging Markets Sovereign Debt ETF
|Vanguard Emerging Markets Government Bond ETF
|iShares J.P. Morgan USD Emerging Markets Bond ETF
|iShares J.P. Morgan EM High Yield Bond ETF
|Naya Pakistan Certificates
Source: Invesco, Vanguard, iShares, SBP
Note: The above-mentioned bond returns are average returns from historical years and does not guarantee future results.
The above table confirms our theoretical notion that higher risk (as measured here by credit ratings) require higher returns. As credit ratings worsen, returns on investments generally increase except for EMB, as it has the lowest risk but the third lowest return. As for Naya Pakistan Certificates, they offer very high returns (perhaps the highest) but those returns are justified by the additional risk that comes with investing in Pakistan. Considering this risk-return trade-off, the returns on Naya Pakistan Certificates are ‘justified’ and ‘reasonable’ and not ‘tremendously attractive’.
Important Distinction: Bonds v. Certificate of Deposits
An important distinction to keep in mind is that Naya Pakistan Certificates are Certificate of Deposits (CDs) and not bonds. There is a key difference in how these two provide returns to their investors. When interest rates in the market change, bond prices change which has an impact on their returns. Alternatively, with CDs the return is fixed and changing market interest rates has no impact on the price of a CD (or the return it offers). While this does not render the above analysis irrelevant, it is an important distinction to consider.