Scope Ratings GmbH today affirmed the Czech Republic’s long-term, local-currency issuer rating at AA. The agency also affirms the long-term, foreign-currency issuer rating of AA, along with the 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 supported by a broad and diversified economy, sound public finances, resilient current-account balance and a healthy banking system. These credit strengths outweigh demographic challenges, and rising household financial vulnerability. The government’s progress in fiscal consolidation continues to further reduce the already low level of public debt, but Scope believes there is a need for reforms aimed at improving productivity and public investments to help bolster structural growth.

The Czech economy continues to grow steadily. Scope expects GDP growth in 2017 to accelerate to 4.3%, driven by robust domestic demand and a dynamic external sector. Growth is set to slow to 3.0% in 2018, constrained by slightly above long-term average capacity utilisation and the limited availability of skilled workers. The Czech economy remains heavily export oriented, with exports increasing at over 4% in Q2 2017, following the recovering trend in core European trading partner markets. Imports are also rising, but at a lesser rate, leading to net exports providing a positive contribution to GDP expansion. Notwithstanding strong external demand, domestic demand remains the main driver of growth, spurred by household disposable income, in turn benefitting from rising wages, sustained low inflation and extremely low unemployment. The positive output gap and increased wage growth are contributing to rising inflationary pressures; the central bank began its tightening cycle in August 2017 which is expected to continue until the end of 2019.

Scope views public finances in the Czech Republic as sound, as they benefit from low indebtedness, a healthy economic growth outlook, and prudent fiscal policy. Overall, the debt-to-GDP ratio is one of the lowest among EU countries and is projected to decrease to 32.5% of GDP in 2019 from a high of 44.9% in 2013. The current political standstill and election calendar has not impacted the budget process which entails increases in fiscal spending financed by higher tax revenues, based on improving worker productivity, growing wages and a rise in corporate profits. Debt metrics are particularly favourable for sustainability, with only 14% of short-term debt and only 13% denominated in foreign currency at year-end 2016.

The rating is supported by a positive trajectory in fiscal consolidation, with continued strengthening of the fiscal framework. A new fiscal law was passed in 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 general government balance is expected to remain in surplus over the medium term, averaging 0.5% in 2017 and 0.6% in 2018, underpinned by steady revenue growth from taxes and social contributions, aided by strong wage growth and capital underspending. The primary surplus will be higher, with a positive balance of more than 1% in both years. Government financing needs in 2018 are manageable at around 7% of GDP, with net interest payments expected to remain below 1% of GDP.

The Czech economy benefits from a resilient current-account balance. The current-account balance recorded a surplus of 0.6% of GDP in 2017, down from 1.1% in 2016, and has been in surplus since 2014. Large surpluses in goods balances are offset by deficits in income, driven by returns on a large foreign direct investment stock. External debt is moderate (91.2% of GDP in Q3 2017) and largely short-term, reflecting loans across affiliated corporations. Scope believes that the economy is, overall, resilient to short-term shocks, albeit with vulnerabilities to downturns in the economies of major trading and investment partners. The level of official reserves further corroborates the external position assessment, with reserves in excess of short-term external debt (79.3% in H1 2017).

The country’s robust, liquid and profitable banking sector also supports the rating. The banking sector is liquid, with a loan-to-deposit ratio of 80%, and well capitalised with a Tier 1 ratio of 16.95 %. In order to address growing real estate exposures and strong price developments, particularly in Prague, banks have further tightened credit standards for residential mortgage loans in line with tougher macroprudential measures implemented by the Czech National Bank. At the same time, banks’ costs of funds have increased due to developments in financial markets and greater risks in housing markets. Loan loss provisioning, though decreasing, remains high, reaching 73.8% in Q3 2017, while regulatory capital to risk-weighted assets was 17.37% in September 2017. Improvements in banks’ average interest margins are limited by stiff competition, but margins remain among the strongest in Europe and the banking sector enjoys high profitability.

Despite these strengths, the Czech Republic faces several challenges. These include significant demographic restraints. Low unemployment rates are largely the result of decreases in the overall working-age population, which is also reflected in a worsening age-dependency ratio. Scope expects this trend to persist due to low fertility and immigration rates. Upward pressure on the pension deficit could be avoided through changes to the retirement age.

Vigorous wage growth and increases in the number of households have led to a build-up in financial imbalances, with mounting concerns over ongoing house price hikes, particularly in Prague (with a 18.8% increase in Q4 2017, versus 4.7% countrywide). Household debt burdens raises 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 raising the capital conservation buffer to 2.5% as a precautionary measure; banks have also tightened credit standards for residential mortgage loans.

Scope views the immediate political situation in the Czech Republic as developing, as the outcome of the October parliamentary elections and the mid-January presidential elections did not result in a decisive majority or the formation of a strong government. Scope believes that risks arising from the political situation are neutral in the near term. Fiscal policy for 2018 was already approved by the previous administration, and Scope does not expect any significant departure going forward. In addition, despite relatively deep Eurosceptic sentiment, discussions about a potential EU membership referendum no longer seem to be a consideration.

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) growth potential for the economy; ii) economic policy framework; iii) macroeconomic stability; iv) fiscal performance; v) debt sustainability; vi) market access and funding sources; vii) current-account vulnerability; viii) vulnerability to short-term shocks; and ix) financial sector oversight and governance. Relative credit weaknesses are not signalled.

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

A rating committee has 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 in the event of: i) an acceleration of reforms; ii) strong increases in investments; iii) further strengthening of structural growth factors.

The ratings could be downgraded in the event of: i) significant slowing of growth; ii) fiscal slippage; iii) further delays to reforms.

For the detailed research report, please click HERE.¹

Rating committee

The main points discussed by the rating committee were: i) the Czech Republic’s economic outlook; ii) fiscal performance and debt sustainability; iii) banking sector performance and soundness; and iv) the declining population and pressures this creates on the reform programme and investments; v) foreign capital inflows and 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.

¹ Editor's note: This sentence was added subsequent to the publication of the press release, as the rating report was published on a later date, 29 January 2018.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Monica Bertodatto, Lead Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Head of Public Finance

The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 28.07.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were assigned by Scope in July 2017.
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, Czech Statistical Office, 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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Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 161306, Managing Director(s):Torsten Hinrichs (CEO), Dr. Stefan Bund.