Moody’s revised its outlook on Pakistan’s banking sector to positive from stable, citing improved operating conditions and resilient financial performance, the ratings agency said. 

The shift aligns with the government’s (Caa2 positive) improved outlook, supported by banks’ significant exposure to sovereign debt, the rating company added.

“We have changed our outlook on Pakistan’s banking system to positive from stable to reflect the banks’ resilient financial performance as well as improving macroeconomic conditions from very weak levels a year ago,” according to the Moody’s statement.

“The positive outlook on the sector also mirrors the Government of Pakistan’s (Caa2 positive) positive outlook, with Pakistani banks having significant exposure to the sovereign through their large holdings of government securities, which account for around half of total banking assets.

“However, Pakistan’s long-term debt sustainability remains a key risk, with its still very weak fiscal position, high liquidity and external vulnerability risks,” according to the report.

The credit rating agency anticipates Pakistan’s economy to expand by 3% in 2025, compared with 2.5% in 2024 and -0.2% in 2023.

“Inflation is also significantly easing, which we estimated at around 8% for 2025 from an average of 23% in 2024,” it said adding, “Problem loan formation will slow as borrowing costs and inflation reduce, although net interest margins will narrow on the back of interest rate cuts.”

“Banks will maintain adequate capital buffers, supported by subdued loan growth and solid cash generation, despite dividend payouts remaining high.”

Moody’s said the outlook revision to positive from stable reflects a better operating environment.

“Pakistan’s economic outlook is improving from very weak levels, with enhanced government liquidity and external positions compared to 2024.”

Moody’s noted that Pakistan’s $7 billion, 37-month IMF programme, approved in September 2024, provides a credible external financing source for the coming years.

“We forecast GDP growth of 3% in 2025 and 4% in 2026, up from 2.5% in 2024, further driven by a 10 percentage point cut in interest rates since the start of the monetary policy easing cycle in June 2024.”

“We expect inflation to slow sharply to around 8% in 2025, from an average of 23.4% in 2024. We expect that lower inflation and policy rate cuts will spur private-sector spending and investment in Pakistan from current low levels.”

Moody’s however warned that banks’ high exposure to government securities increases asset risk.

“As of September 2024, government securities accounted for 55% of banks’ total assets. This significant exposure links banks’ credit strength to that of the sovereign, which is improving from very weak levels.

“Although problem loans have deteriorated to 8.4% of total loans as of September 2024 from 7.6% in the prior year, overall loans account for only 23% of banks’ total assets,” it said.

The report was of the view that with the removal of ADR tax for 2025, “we expect lower pressure on banks to increase financing, while demand remains relatively subdued despite lower borrowing costs”.

The ADR-linked tax incentive introduced by the government required banks to achieve a 50% advance-to-deposit ratio (ADR) by the end of 2024, with noncompliance resulting in an additional income tax ranging from 10% to 15%.

Moody’s further said that following recent interest rate cuts that have reduced the policy rate to 12%, margins will narrow as local banks derive the bulk of their earnings from the interest they receive on large investments in government securities, which are yielding lower returns compared with last year.

“Concurrently, downward asset repricing will only be partly offset by lower funding costs, while growth in business activity and non-interest income will not fully counterbalance margin compression. “We expect banks’ return on assets to moderate to around 0.9%-1.0% in 2025,” it said.

The financial services provider also noted that Pakistan’s foreign exchange (FX) risks have reduced in response to a rise in SBP’s FX reserves since the unlocking of the IMF program.

Laster year, Moody’s said interest costs in Pakistan will account for close to 40% of total spending in 2025, up from around a quarter in 2021.