Banks’ overall credit rating is determined by a number of factors. Commenting on the recently announced Federal Budget for FY19, Moody’s Investors Service has termed one-year extension of a 4 percent special tax on banks’ taxable income as credit negative that will continue to weigh on banks’ profits and add to the ongoing profitability challenges. The Pakistani authorities first imposed this tax in 2015, equalling 4 percent of banks’ taxable income for the last accounting year; and it was imposed on banks’ semi-annual results. Together with a uniform tax rate of 35 percent on all sources of income (including dividends and capital gains), the effective tax rate on banks amounted to 39 percent which was a big drag on their earnings. Profitability is also likely to be reduced due to narrowing margins from lower yields on government securities in which the banks invest roughly half of their balance sheets and higher pension costs ordered by the Supreme Court. Moody’s expects all the Pakistani banks to be affected by the tax extension which is estimated to lower the banks’ return-on-equity ratios by approximately one percent. However, as part of the budget, the authorities have also announced the gradual phasing out of the tax by one percentage point annually beginning in fiscal 2019. Once fully eliminated after 2021, the banks’ effective tax rate will return to around 35 percent.

We feel that there could be hardly any disagreement with the Moody’s observation about the impact of special tax on banks’ taxable income and overall profitability but the way the issue has been highlighted does not make any greater sense. It is obvious that the government is constrained to maintain the present tax rate of 4 percent due to budgetary constraints and Pakistani banks are better positioned to absorb this tax due to their stronger profitability and better capitalization. Moreover, the announcement of one percent reduction in tax rate every year should give confidence to the banks that the government is serious about maintaining their financial position in good health. The concern of the Moody’s that this special tax will be credit negative is not well founded as the financial sector of the economy is doing exceptionally well and the imposition of this small tax would not make much difference on their creditworthiness. According to the latest available data released by the SBP, banking sector has earned profits (before tax) of Rs 266.8 billion during October-December, 2017, with ROA of 1.6 percent and ROE of 19.5 percent. Net Interest Income (NII) has improved during the last few years while Capital Adequacy Ratio (CAR), which is the main indicator of the soundness and credit rating of the financial institutions, has soared to 15.8 percent, which is well above the minimum required CAR of 11.275 percent. Asset quality has also improved as NPLs to gross loans (infection) rate was recorded at only 8.4 percent at the end of December, 2017, touching the lowest level in a decade. It is also hoped that profitability of banks would continue to rise amid potentially rising interest rates in the coming year and NPLs could further decrease due to higher investment in government securities. The budget announcement for FY19 includes authorities’ planned increase in borrowings from banks by about 70 percent or more than Rs 1 trillion which suggests that banks will continue to invest in high yielding government securities without any risk. Such a scenario augurs well for the continued sound performance of the banking sector and the imposition of the special tax could, in our view, only make a marginal difference on the rating of banks.