The exposure of emerging markets banks to sovereign debt is at an all-time high, and tighter financial conditions are putting pressure on government finances. Pakistan has one of the most highly exposed banking systems in emerging markets – half of its banking assets are sovereign exposures, equivalent to over 8x of the equity.
Banks have enjoyed high yields on these assets, but the risks are now growing. The government's funding needs are rising and accessing funding is becoming harder. Hefty fuel subsidies and delays in IMF negotiations are further worsening the situation.
In this report, we look at the exposure of Pakistan banks to sovereign debt, some recent developments that have affected the government’s financial position and the implications for investors.
Pakistan banks have one the highest levels of sovereign exposure in EM
Pakistan banks are heavily reliant on government securities, around half of banking assets are sovereign exposures. Government securities are 42% of assets while public sector loans are another 8%. The private sector has been largely crowded out (28% of total assets) as government funding requirement has remained high historically.
In the emerging markets context, Pakistan stands out as having high levels of sovereign indebtedness and bank exposure to government debt. Pakistan banks hold government securities worth 8.6x times of their tier 1 capital, compared with a median 1.4x for other emerging markets.
The government’s funding situation is worsening
Pakistan's government has historically relied on banks and the central bank – the State Bank of Pakistan (SBP) to fund its budget deficit. However, recent developments have brought unprecedented pressure on government finances. These include:
The government's increasing borrowing needs. The rising fiscal and current account deficits are increasing the government’s financing needs. Fuel subsidies are exacerbating the situation, as the government is losing cPKR120bn (US$620mn) per month on subsidising petroleum products. In addition, the hefty financing shortfall in the energy chain (ie circular debt) also requires periodic injections from the government to keep the system functional.
Central bank borrowings are no longer allowed. The SBP Amendment Act 2021 has barred the government from borrowing from the central bank, limiting its ability to print money for budgetary support.
A huge amount needs to be repaid to the SBP. The current stock of government securities with the central bank, which is significant at cPKR6tn as of the end of 2021 (27% of the government’s domestic debt), will not be rolled over after maturity. The government will need to finance this amount through other channels, such as the banks.
Commercial banks’ liquidity is squeezed. The SBP’s liquidity injections into the banking system (through open market operations) currently stand at cPKR4tn, equivalent to 13% of banking assets, and are increasing (they stood at cPKR2tn at the end of 2021). If, for any reason (eg IMF conditions or to control the money supply), the SBP decides to put a brake on these liquidity injections, the government would come under severe pressure.
Banks are being pushed to increase private sector lending. Higher taxes on banks with low advances-to-deposits ratios (ADR), and targets for housing finance are some of the ways that banks are being forced to increase their lending to the private sector. This limits their ability to lend to the government.
Which Pakistan banks are most exposed to sovereign debt?
Allied Bank appears to be most exposed to the public sector; 66% of its assets are parked in government securities and public sector loans. Meezan Bank has the least exposure (37% of assets).
Compared with 2020 levels, Meezan Bank has increased its government exposure, while Bank Al Habib and Habib Bank have trimmed theirs.
Pakistan’s external funding situation is even worse, its banks also have some exposure to eurobonds
Pakistan has even bigger challenges regarding its external account and reserves positions. The current account deficit is expected to stand at over 5% of GDP in 2022 (according to the IMF) and its FX reserves are now equivalent to just 1.4 months of imports. The yield on Pakistan eurobonds (maturing in 2024) has jumped from 5.1% at the start of the year to 17.9% currently, and the risk of default on external loans has increased in light of the delays to the IMF negotiations.
Pakistan banks have exposure to the country’s eurobonds as well. Although this exposure is much smaller than to the local currency bonds, for some banks, notably UBL and BAHL, it is still meaningful, at c15-20% of their equity.
Private sector lending could continue to suffer. The government’s high borrowing appetite and its narrowing options are likely to mean banks will remain the key financiers of the government, which means banks will have limited room to grow their lending portfolios.
Pakistan banks would be extremely vulnerable to a sovereign restructuring. According to the IMF, a 30% haircut (based on historical experiences) can be expected in the event of a sovereign restructuring, but Pakistan banks have much less room. A 15% haircut would be enough to wipe out the equity of most banks in Pakistan, while only around a 5% haircut could breach the regulatory minimum CET1 capital ratio.
IFRS9 could require banks to take provisions on sovereign exposure. Our initial analysis, based on experiences in other markets such as Nigeria, suggests that these impairments (if required) may not be very significant. However, if the government's financial position worsens, the impairments in Pakistan could be higher than in other markets.
Government-backed institutions may face challenges in raising funds. Banks may take a cautious approach in lending to government-backed institutes. The major reason commercial banks still continue to lend to most of these entities, despite losses, is the government guarantee and provisioning exemption. State-owned entities, infrastructure projects and the power sector (where the majority of debt is government guaranteed) could suffer.
The government’s borrowing costs could remain elevated. Banks’ squeezed liquidity and the government’s high funding appetite are likely to keep the government’s borrowing costs high.
The government may need to curb its spending. To manage its fiscal position, the government might need to curtail further spending on development. The cement and steel sectors’ volumes might be impacted in such a scenario.
Radical reforms are required on taxation and exports. Improvements to the fiscal and external positions are key to the Pakistan investment thesis. On the fiscal side, the economy needs to immediately increase its revenues; real estate taxation reforms and expanding the tax net are two much-needed steps. On the external side, the technology sector has huge potential.
Pakistan banks are trading at a discount to historical valuations
Pakistan bank stocks have underperformed over the past few years. Currently, they are trading at a median 4.8x PE and 0.7x PB, 40% and 30% discounts to the past five years' average, respectively. The central bank has raised the policy rate by 525bps since September 2021, but this has not helped share price performance thus far.
We think investors are pricing in some of the risks we have highlighted above, but a sovereign restructuring – an extreme scenario – is probably still not in the price.