ACRA affirms LT AA to the Czech Republic, outlook Stable

ACRA has affirmed the following ratings to the Government of the Czech Republic (hereinafter, the Czech Republic, or the country) under the international scale:

  • Long-term foreign currency credit rating at AA and local currency credit rating at AA;
  • Short-term foreign currency credit rating at S1+ and local currency credit rating at S1+.

The outlook on the long-term foreign currency credit rating is Stable and local currency credit rating is Stable. This reflects the resilience of the country’s macroeconomic and external positions to the COVID-19 shock and slightly weakening public finance position, which however has not driven the country’s credit rating down. The Stable outlook assumes that the rating will most likely stay unchanged within the 12 to 18-month horizon.

Credit rating rationale

The Czech Republic’s AA sovereign credit rating is supported by a wealthy economy, strong, though slightly weakening, fiscal position, efficient monetary policy, and a solid external position. The rating is constrained by the country’s small economy that is highly concentrated on a narrow range of trade partners, shows high reliance on a particular industry, and has a tight labor market. The economy has a high share of manufacturing in gross value added and is open. The latter makes the country highly vulnerable to the negative consequences of the COVID-19 pandemic. The high cost of an aging population is also a constraining factor.

Following 2.5% GDP growth in 2019, the Czech economy, whose GDP PPP per capita stood at 92% of the EU average in 2018, is going to slide into recession in 2020. ACRA expects the country’s GDP to decline in the range of 6.5%–10.0%. This is mainly due to the economic consequences of the COVID-19 pandemic, which negatively affects the Czech Republic’s economy and the economies of its trade partners.

The country’s openness — the average ratio of exports and imports to GDP was 72.7% in 2019 — makes it exposed to the economic downturn of its main trade partners in the EU, particularly Germany, whose GDP is expected to fall by 6.3% in 2020 according the latest EU Commission forecast. Though there have been signs of recovery in the end of Q2 and Q3, a second wave of coronavirus cases, which so far has appeared to be stronger than the first one according to the number of new cases per million, could slow down the recovery. 

The prevalence of manufacturing (especially the automobile industry) in the country’s gross value added (GVA), (manufacturing accounted for 24.9% of GVA in 2019) has made the impact of the pandemic particularly strong. Nearly 90% of production has been badly affected by the crisis, whereas 30% of production has been halted. A minor mitigating factor for the country’s economic downturn is the slightly lower share of services and SMEs in the country’s GDP structure compared to CEE peers (62.4% of GVA in 2019 and 55.4% of GVA at factor costs in 2019, respectively). These sectors have been hit the most by the pandemic worldwide. In the long term, beyond the crisis, the country is facing the challenges of electric vehicles, growth of the sharing economy, and the emergence of self-driving cars.

The Czech National Bank (CNB) swiftly responded to the crisis caused by the pandemic. It slashed the key rate twice by 200 bp in total and set the policy rate at 0.25%. It also released additional liquidity for banks by lowering the countercyclical capital buffer by 125 bp to 0.5%, loosened conditions on mortgages, and signaled its readiness to provide support with foreign currency liquidity and conduct quantitative easing operations. ACRA believes that the CNB’s actions should help to contain the negative impacts of the crisis on the economy. Historically, the CNB has shown that it is able to achieve its goals and act efficiently. The case in point is the seamless abandonment of the currency floor in 2017, which did not cause any spikes in local currency and therefore inflation volatility. Prior the crisis, the CNB stopped the rate hiking cycle, which it launched in 2017 with the aim of keeping inflation within the target band of 1–3%. This gave it space for monetary easing at the onset of the COVID-19 crisis.

Although the Czech Republic’s public finance position is set to weaken in 2020, the country’s efforts to reduce the public debt burden in previous years give it sufficient fiscal space to withstand the virus shock. The Ministry of Finance estimates general government deficit at a record low 6.4% of GDP, or CZK 355 bln (compared to a surplus of 0.3% of GDP in 2019). The deficit will be driven by a shortfall in tax collection and a fiscal package to support demand. The total package amounts to 19.4% of the country’s GDP (one of the largest packages in the CEE region), and consists of guarantees (14.5% of GDP), direct fiscal support (4.4% of GDP), and liquidity facilities (0.5% of GDP). The 2020 budget deficit will push public debt up, but from a low level. ACRA expects the debt to GDP ratio to increase to 38.6% at the end of 2020 from 30.8% at the end of 2019. For 9M 2020, the central budget deficit, the core of the country’s consolidated budget, amounted to CZK 253 bln. This indicates a conservative approach to budget deficit for 2020. Despite the expected recovery next year, which is estimated by officials at 3.9%, the government is going to run its budget deficit at 5.5% of GDP, or CZK 320 bln. This figure does not include CZK 60−70 bln in tax cuts, which have been discussed recently. Therefore, ACRA expects government debt to increase to 41.4% of GDP in 2021.

ACRA believes that the government will not encounter problems financing its deficit on affordable terms to withstand the shock. According to the Ministry of Finance, during H1 2020, it already pre-financed 77% of the budget needs for this year. The government relies primarily on bonds in local currency to finance its needs and plans to issue foreign denominated issues only to refinance maturing bonds. To secure financing sources, the government started to issue short term papers (bills) in March 2020, which has reduced the average maturity of the new debt. The share of bills in domestic government securities was safe at 5.3% of total local currency debt (CZK 2.1 tln) in August 2020 and is supported by a strong banking system (the main source of short-term funds). Accumulated cash balances of 13.6% of GDP as of Q1 2020 also support budget needs. Moreover, the Czech Republic can rely on EU money from the Coronavirus Response Investment Initiative, which allows the country to utilize funding worth around EUR 5.2 bln (2.4% of GDP).

ACRA expects the Czech Republic’s guarantees to increase in size by the end of 2020. As part of the anti-crisis package, the government has committed to guarantees aimed at supporting liquidity in the SME sector worth 16.3% of GDP, with the guarantees being the main instrument to support businesses. At the end of 2018 (latest available data) the government’s total contingent liabilities amounted to 12.2% of GDP; by size they were among the smallest in the EU.

The crisis will test the resilience of the country’s banking sector. The fundamentals of the banking industry looked solid prior to the crisis. The Czech Republic’s banks were well capitalized, had a low share of non-performing loans, and met liquidity requirements. The macroprudential rules are strong. In particular, the CNB was one of the first regulators in Europe to introduce countercyclical measures, thus strengthening banking regulatory framework. However, an abrupt halt of economic activity due the pandemic could dent household income. The Ministry of Finance expects unemployment to increase to 2.6% this year compared to 2.0% in 2019, which might have a negative impact on citizens’ ability to repay loans, in particular mortgages. This risk is mitigated by the solid metrics of the banking sector on the one hand, and a set of national and EU anti-crisis measures to provide liquidity to employers, households and banks, on the other. For example, wage compensation for employees at companies that have halted or decreased production, six-month holidays on social payments, and a moratorium on the repayment of loans and mortgages. Recent numbers do not show significant credit expansion, thus limiting credit risks for banks. Credit to residents has grown by 4.1% year-on-year as of August 2020, including credit growth to households by 6.2% and non-financial sector by 2.1%.

Other contingencies, although on a longer-term horizon, are the country’s aging population, which poses a challenge to its public finances. The Czechs face some of the highest costs among CEE peers to support elderly people due to poor demographics.

The Czech Republic’s ability to withstand external shocks is high. After a significant slump in April and March, exports have recovered to average levels in the following months. German recovery will help sustain exports. At the same time, imports have also decreased and the primary account deficit has improved, resulting in the current account being in deficit only in April 2020. In H1 2020, the current account was in surplus at EUR 3.2 bln, compared to EUR 2.7 bln in H1 2019. At the end of Q2 2020 the country’s foreign currency reserves covered 82.3% of total external debt, whereas short-term external and FX debt were 12.0x and 159.0% covered, respectively. In Q2 2020, the country’s net international investment position (NIIP) reached -13.3% of GDP, which was one of the strongest among its CEE peers. The country’s free floating exchange rate regime is likely to keep the current account balanced as the contraction of exports will be compensated by a fall in imports due to a weaker currency and squeezed consumption. At the same time, the primary deficit will improve as foreign subsidiaries record lower profitability and as a result transfer less money abroad. The local currency’s depreciation since the beginning of crisis has been manageable, and international reserves have been kept intact.

The country’s institutional framework is robust and is the strongest among peers. Almost all of the Czech Republic’s governance indicators have been historically strong, with some having slightly improved in recent years. However, the European Court of Justice’s recent ruling on the country’s refusal to take in migrants could put downward pressure on certain indicators.

Sovereign model application results

The AA Indicative credit rating was used to obtain the Final credit rating, even though the core part of the rating model put the Czech Republic at AA+. According to ACRA’s methodology, this conservative correction was made because the indicative score crossed the AA+ lower boundary by a marginal amount.

A number of modifiers in the modifiers part of the model allow the Indicative credit rating to be increased. These include the following, which are determined by the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale:

  • Efficacy of structural, economic and monetary policies;
  • Fiscal policy framework and fiscal flexibility;
  • Debt sustainability.

A negative modifier is the following:

  • Sustainability of economic growth.

In view of the abovementioned modifiers, the Czech Republic’s credit rating has not been changed. Therefore, a Final credit rating of AA has been assigned. There are no extraordinary factors that could adjust the Final rating. In connection with this, the Assigned credit rating remains at AA.

Potential rating downgrade factors

  • External vulnerabilities;
  • Weakening of the external position caused by a potential negative current account balance;
  • Further reliance on non-residents to finance the budget.

Potential rating upgrade factors

  • Stronger than expected growth;
  • Improvement in budget position in the coming years;
  • Targeting of aging cost issues.

Issue ratings

No outstanding issues have been rated.

Regulatory disclosure

The sovereign credit ratings have been assigned to the Czech Republic under the international scale based on the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale and the Key Concepts Used by the Analytical Credit Rating Agency Within the Scope of Its Rating Activities.

The sovereign credit ratings of the Czech Republic were published by ACRA for the first time on October 29, 2019. The sovereign credit ratings and their outlook are expected to be revised within 182 days following the publication date of this press release as per the Calendar of planned sovereign credit rating revisions and publications.

The sovereign credit ratings are based on information from publicly available sources, as well as ACRA’s own databases. The sovereign credit ratings are unsolicited. The Government of the Czech Republic did not participate in the credit rating assignment.

ACRA provided no additional services to the Government of the Czech Republic. No conflicts of interest were discovered in the course of the sovereign credit rating assignment.

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