The outlook for the banking system of Pakistan was upgraded by Moody’s Investors Service to stable on Wednesday. The credit rating agency previously had a negative outlook on the country’s banking system.

The improving economic growth prospects of Pakistan prompted Moody’s to change its rating for the country’s banking system. The rating agency noted the Pakistani government’s committee to implement economic reforms under the program of the International Monetary Fund (IMF).

Pakistan Banking System Outlook Upgraded To Stable By Moody's

Elena Panayiotou, assistant vice president at Moody’s and lead analyst for Pakistani banks, said, “We expect the strengthening economy, together with the central bank’s accommodative monetary policy, to stimulate lending growth and support the banking sector’s loan performance over the next 12-18 months.”

Pakistan GDP expected to grow 4%

Moody’s estimated that the real gross domestic product (GDP) will grow by 4% in the fiscal year ending June 2016. GDP is one of the primary indicators used to determine the health of the country’s economy. The rating agency noted that Pakistan’s economy was sluggish from 2008 to 2013 given its 2.8% real GDP growth.

According to Moody’s, Pakistan’s GDP expansion is primarily driven by higher spending on infrastructure projects as the government aims to alleviate energy shortages. The government also aims to implement projects connected to the China-Pakistan Economic Corridor (CPEC).

The CPEC is an extension of China’s Silk Road Economic Belt and 21st-Century Maritime Silk Road. The total estimated cost of the development project under the CPEC was approximately $46 billion.

The CPEC would connect the Gwadar Port in southwestern Pakistan and Xinjiang, the northwestern autonomous region of China through a network of highways, railways, and pipelines to transport oil.

The economic corridor is vital to the relationship between Pakistan and China. The Pakistani government said the CPEC is also a corridor of unity—uniting the country’s people, provinces, and regions in a quest for prosperity through different projects.

Pakistan’s problem loans expected to decline

Moody’s noted that the strengthening of Pakistan’s domestic economy would contribute to the improvement of the quality of bank’s assets in the country.

The level of credit risk will remain high as banks are heavily exposed to the low-rated sovereign (B3, stable) through holdings of securities and government-related loans, which are equivalent in size to 7.3x Tier 1 capital, exposing banks to event risk.

According to Ms. Panayiotou, “We expect problem loans will decline to around 12% of total loans by the end of 2016 compared with 12.4% for the end of June 2015. Banks, however, will remain heavily exposed to the low-rated Pakistan sovereign, linking the banks’ creditworthiness to that of the sovereign’.”

When it comes to capital, Moody’s expected buffers to under pressure due to moderate asset growth and lower internal capital generation—a result of weaker profitability.

The credit rating agency also expected earnings to ease slightly during the outlook period. The primary reasons include the lower coupon on government securities in a declining interest rate environment, and the market perception of the risk profile of Pakistan improved (from Caa1 on June 11, 2015, to B3).

Additionally, Moody’s said the higher loan volumes and capital gains booked through the sale of government securities will partially offset the pressure on profitability.

Furthermore, the rating agency expected banks in Pakistan to maintain sufficient liquidity and continue to benefit from large volumes of low-cost and stable customer deposits.

“The Pakistani banks’ deposit-based funding structure remains a credit strength. We expect inflows of remittances from migrant workers will continue to drive the growth in bank deposits and support banks’ funding bases,” said Ms Panayiotou.

Moody’s expected Pakistan’s banking sectors to maintain strong liquidity buffers, with core liquid assets—cash and bank placement— at 12% of total assets and liquid securitie—more broadly defined, at 41% of total assets as of June 2015. Pakistani banks are expected to use a portion of liquid assets to fund lending.