Scope Ratings AG has today confirmed the Czech Republic’s long-term local-currency issuer rating at AA, following the release of its revised sovereign rating methodology, and converted its status from subscription to public. The agency has also assigned a long-term foreign-currency issuer rating of AA, along with a short-term issuer rating of S-1+ in both local and foreign currency. The sovereign’s senior unsecured debt in local and foreign currency is also rated at AA. All Outlooks are Stable.

Rating drivers

The AA rating is underpinned by a benign outlook for debt, a broad and diversified economy, strong domestic financing and a healthy banking sector. These credit strengths outweigh a high degree of exchange rate sensitivity, heavy dependence on capital inflows, the continued use of the koruna and challenges presented by an ageing population. While government policy remains on track to reduce debt, taking advantage of the low interest rates, there is also a need to place greater emphasis on increasing worker productivity and hence growth potential.

The Czech economy is broadly diversified with strong manufacturing activity centred on machinery and electrical equipment. Growth is supported by very low unemployment and rising wages, which translate into strong consumer demand. The supply side of the economy is tightly integrated into global supply chains. There are no major distortions in the economy, which is open to foreign investment and shows strong product and labour market flexibility, with little labour market dualism between high-skilled and low-skilled workers, despite some skill mismatches. The economy is heavily export-oriented, with exports at 80% of GDP and net exports trending upwards. The structure of growth has been one of the expansion of existing good exports to and product diversification in existing markets. The sophistication of goods exported is also increasing, alleviating the negative effects of concentration. An ageing population, however, has led to a skilled-labour shortage. Unemployment is very low and labour participation rates are very high, resulting in constrained growth.

The recent removal of the floor on the koruna-euro exchange rate, originally implemented in 2013 to protect industry from exchange rate variations, was orderly and did not lead to major swings in the currency, despite relatively large speculative inflows into the Czech Republic in advance. The Czech National Bank (CNB) is strongly committed to financial stability and, while the koruna has appreciated against major trading partners, the CNB remains active to ensure that foreign-exchange movements are moderate.

The rating is supported by sound progress in fiscal consolidation and a strengthening fiscal framework. The general government balance turned positive in 2016, reaching 0.6% of GDP, an improvement of more than 1 percentage point compared to 2015. This surplus was underpinned by steady revenue growth from taxes and social contributions, aided by strong wage growth and capital underspending. Government financing needs are under 10% of GDP, with net interest payments as a percentage of revenue at 1.9% and general government gross debt at 37.7% of GDP in 2016. A new fiscal law was passed in January 2017 aimed at creating an independent fiscal council to assess compliance with fiscal rules and evaluate the long-term sustainability of public finances, setting fiscal limits for both central and local governments. The fiscal rules include a structural balance rule of -1% of GDP; debt brakes for general government, capping debt net of cash reserves at 55% of GDP; a 60% debt-to-revenue limit for local government, with penalties for violations; as well as stricter requirements on individual government entities if numerical rules prove to be ineffective.

The government’s improving fiscal position has permitted a significant reduction in government debt, down to 37.2% of GDP in 2016 from 40.3% in 2015. Scope believes that debt is sustainable even under stress conditions. The events of the last financial crisis did not compel the Czech government to expand government debt, leaving the country well placed in its peer group. Scope’s debt sustainability analysis sees debt being drawn down to under 30% of GDP in 2022 under normal circumstances. While debt for a Scope stress scenario is no longer reduced, it does not exceed 40% and remains well under recent historical highs.

The Czech economy benefits from a sound external position. The current account reached a surplus of 1.1% of GDP in 2016, up from 0.9% in 2015. Large surpluses in goods balances are offset by deficits in income, driven by returns on a large FDI stock. External debt is moderate (75% of GDP in 2016) and largely long-term, reflecting loans across affiliated corporations. Scope believes that the economy is, on the whole, resilient to short-term shocks, albeit with vulnerabilities to downturns in the economies of major trading and investment partners.

The ratings are supported by the country’s robust and profitable banking sector. The sector is highly concentrated with virtually no small or medium-sized banks, the result of a strong consolidation process following bank privatisation and the subsequent clearing-out of non-performing loans. Banks are highly capitalised, margins are among the strongest in Europe and, overall, the banking sector displays high profitability. Largely domestically oriented, the banking sector was not affected substantially by the last financial crisis, but did suffer the indirect effects of lowered demand from trading partners. Some cyclical and structural risks exist due to increases in maturity deposits and loans, an increasing share of non-residents in the domestic debt-securities market and a growing concentration of bank exposure to residential and commercial properties.

Scope views the political situation in the Czech Republic as stable, despite recent political tensions within the government. Elections are planned for October 2017. The government coalition of CSSD, KDU-SL and ANO represents a broad, centrist programme, and centre-right opposition parties are currently polling at under 10%. The government must balance further debt reduction with the implementation of numerous reforms aimed at improving long-term planning, reducing bureaucratic overheads, enhancing government transparency (and hence curtailing corruption) and bringing the Czech transportation infrastructure up to euro-area norms. While Scope believes that the Czech Republic faces some geopolitical risks due to a heavy usage of natural gas and dependence on supplies from Russia, these risks are not elevated.

Despite these strengths, the Czech Republic faces a number of challenges. These include a high labour tax wedge and shortage of skilled labour. Long-term healthcare costs, pensions and infrastructure for an ageing society are also potential problems going forward. Czech demographic trends are challenging, largely due to negative workforce growth rates, which, despite very high participation rates and very low unemployment, place limits on economic growth. Immigration faces significant bureaucratic hurdles and, while wages show strong growth, they average out at 87% of the EU average.

Strong wage growth and increases in the number of households have led to a build-up in financial imbalances through a strong growth in household debt, with potential overheating stemming from the housing market. The high level of households’ debt burden increases vulnerability to shocks, such as a decline in income, an abrupt increase in interest rates and/or a sudden turnaround in the buoyant housing market. However, the Czech central bank has responded to risks arising from the housing market by tightening limits on loan-to-value ratios, mitigating potential risks.

Sovereign rating scorecard (CVS) and qualitative scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative (a) rating range for the Czech sovereign. This indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on analysts’ qualitative findings.

For the Czech Republic, the QS signals relative credit strengths for the following analytical categories: i) strong economic outlook with good growth potential; ii) good economic policy framework; iii) good macroeconomic stability; iv) strong flexible fiscal performance; v) strong debt sustainability; vi) very good market access and funding sources; vii) resilience against current account vulnerability; viii) resilience against short-term shocks; ix) good recent policy decisions; x) good financial sector performance and oversight; and xi) resilience to macro-financial vulnerabilities and fragility. Relative credit weaknesses are not signalled.

Combined relative credit strengths and weaknesses generate a three-notch adjustment and signal a sovereign rating of AA for the Czech Republic.

A rating committee discussed and confirmed these results.

For further details, please see Appendix 2 in the rating report.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that the challenges faced by the Czech Republic are broadly balanced.

The ratings could be upgraded if: in the event of i) a sustained reduction in government debt; ii) an acceleration of structural reforms; or iii) increased productivity gains, generating higher-than-expected growth.

The ratings could be downgraded if: i) a persistent negative shock to GDP leads to a significant increase in debt; ii) a significant increase in government debt results from fiscal loosening; or iii) important reforms are delayed further.

For the detailed research report, please click here.

Rating committee

The main points discussed during the rating committee were: i) The Czech Republic’s economic outlook, ii) the fiscal performance and debt sustainability, iii) banking sector performance and soundness, iv) the declining population and pressures this creates on the reform programme and investments. The committee also discussed the dependency of the Czech Republic on foreign capital inflows and its exposure to exchange rate shocks.

Methodology

The methodology applicable for this rating and/or rating outlook, Public Finance Sovereign Ratings, is available on www.scoperatings.com.

Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/governance-and-policies/regulatory/esma-registration. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default, and definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.

The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.

Rating prepared by John F. Opie, Lead Analyst

Person responsible for approval of the rating: Karlo Stefan Fuchs, Executive Director

The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The subscription ratings/outlooks were last updated on 05.05.2017.

The senior unsecured debt ratings as well as the short term issuer ratings were assigned by Scope for the first time.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the Czech Republic are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of ratings under review, in order to conclude the review and disclose ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.

The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: Czech National Bank, BIS, Ministry of Finance, IMF, OECD, ECB, European Commission, Eurostat, Haver Analytics.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability
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