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Rating action

Scope Ratings GmbH has today affirmed the Czech Republic’s AA long-term issuer and senior unsecured local- and foreign-currency ratings and affirmed the Stable Outlook. The agency has also affirmed the short-term issuer rating of S-1+ in both local and foreign currency and affirmed the Stable Outlook.

Summary and Outlook

The affirmation of the Czech Republic’s long-term sovereign ratings at AA/Stable reflect the fundamental strengths and increased resilience of a high-income European economy with moderate levels of public debt. The affirmation of the Stable Outlook reflects Scope’s view that

1. the economic repercussions from the Covid-19 shock remain manageable in the short-term and allow for a relatively smooth recovery going forward. Growth projections in 2021 are supported by sizeable grant (4% of 2019 GDP) and loan allocations (7%) from the EU Recovery Fund, ample fiscal support, and a competitive economy entering the crisis with a real growth potential of above 2% per year; and
    
2. a moderate debt-to-GDP ratio and favourable debt structure generate sufficient fiscal space for authorities to mitigate immediate economic impacts from the health crisis. Compared to rating peers, the Czech Republic entered the crisis with low public debt levels at around 30% of GDP and a track record of fiscal consolidation. Sustainable levels of private sector debt and increased household incomes further facilitate a reversal of a rising public debt trajectory over the medium-term.

The Czech Republic’s sovereign ratings are constrained by an ageing society, which raises medium-term pressures on public finances, and the economy’s reliance on global supply chains and external demand for goods with increasing risks of becoming stranded assets longer term.

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months. The ratings/Outlook could be upgraded if, individually or collectively: i) the government addresses the demographic pressures; and/or ii) structural reforms reduce reliance on external demand and bolster investment into innovation and education, underpinning macro-economic stability.

Alternatively, the ratings/Outlook could be downgraded if, individually or collectively: i) an external shock weighs on the medium-term growth outlook; ii) a change to the fiscal framework results in materially higher budget deficits and an increasing public debt-to-GDP trend; and/or iii) internal economic policies undermine macro-economic stability.

Rating rationale

The Czech Republic’s AA credit ratings are supported by the country’s robust and steady economic development, which has contributed to constant income convergence over the past decade from 75% of the EU-15’s GDP per capita in 2009 to 85% in 2019. This convergence has expanded the country’s tax base and contributed to the rise in fiscal revenues from 38.7% of GDP in 2009 to 42.1% of GDP in 2019, supporting the government’s ability to expand public services.

Compared to peers, the Czech economy has proven its competitiveness, observing moderate wage growth for many years since the global financial crisis and has positioned itself as an attractive location for foreign investment. This has led to a record-low unemployment rate of below 3% in the previous two years and high employment levels of above 80% of the active working-age population. Strong investment at around 25.1% of GDP in 2019 - mainly driven by FDI inflows - has further supported a high growth potential of between 2-3% since 2015. The resulting increase in GDP per capita levels from EUR 16,000 to EUR 20,000 between 2015-19 has fuelled domestic final consumption (public and private), which contributed 2pp to annual GDP since 2015 and is expected to stabilise the economy during this downturn despite a significant negative contribution of 3.2 percentage points to GDP in Q2 2020 amid the ongoing global health crisis.

The Covid-19 shock has hit the small, open and supply-chain dependent economy, with an expected output decline of around 8% of GDP this year and a moderate growth recovery at around 4.5% in 2021. However, the output shock is mitigated by an industrialised economy that was operating at almost full potential entering this crisis, with a robust labour market and ample fiscal and monetary policy space able to support the most hard-hit sectors over the crisis. The country’s inflation rate is expected to remain above 3% over 2020 amid domestic inflationary pressures and a weaker Czech koruna (CZK). Industrial production declined sharply during the first half of 2020 (-5% yoy in July) while hard-hit automotive production output showed some recovery in July by reaching almost the same monthly production volume as in July 2019. Bold government action to secure employment and corporate activity with government stimulus estimated at around 9% of GDP in 2020 (including partial use of guarantees and liquidity support) contributes to a softer annual decline of economic activity compared to in many harder hit countries of the EU-27.

Another key rating strength are the Czech Republic’s robust public finances and sound fiscal policies. The country entered this year’s Covid-19 crisis with considerable fiscal space, with a debt-to-GDP ratio of 30.2%, following a forceful consolidation by 10pp in only four years from 39.7% of GDP in 2015. This debt reduction was achieved by a combination of consecutive years of primary fiscal surpluses and high nominal growth of around 5.8% on average over the 2015-19 period. The Finance Ministry projects the country’s gross financing needs at around 13.2% of GDP for 2020, including the approved state budget deficit of around 8% of 2019 GDP (CZK 500bn). Even if the government finances the full amount of the approved deficit this year, gross financing needs remain very low compared to that of high-income economy rating peers (19.5% of GDP) and in line with the average of its Visegrád neighbours (12.7% of GDP). The Czech Republic’s public finances also benefit from a favourable debt structure with an average term to maturity of around 6 years and a small and decreasing share of foreign denominated bonds at around 2.3% of expected 2020 GDP. The debt management strategy aims to further develop the domestic capital market with future issuance of koruna- as well as euro-denominated bonds.

Finally, the mostly foreign-owned Czech banking sector entered the coronavirus crisis with a robust capital position, strong profitability and high liquidity ratios, which underpin the domestic banking sector’s resilience to rising impairment losses and the impact of the central bank’s policy rate cuts on interest profits. In addition, the sector benefits from high asset quality, with the ratio of non-performing loans to total loans at 2.1% at the end of 2019, its lowest level since 2007, which, combined with the measures taken by the government and the central bank to mitigate the economic impacts of the coronavirus crisis, reduce the risk of rapid materialisation of credit risks on domestic banks’ balance sheets. Gross external debt stood at moderate levels of 77.9% of GDP in Q1 2020.

Despite these credit strengths, the Czech Republic still faces several challenges. The country’s ageing population constrains potential growth. The Czech working age population (defined as those aged 15 to 64 years old) had already been declining steadily over recent years, with a decrease of over 579 000 (-7.8%) from 2008 to 2019. These demographic pressures are due to accelerate longer term. The United Nations projects a rise in the old age dependency ratio of 25.7 percentage points from 33.8% in 2020 to 59.5% in 2060, compared with two ratings peers: worse than that for Finland (+16.2pps to 56.3%) but less severe than that for Estonia (+32.1pps to 67.0%). However, these estimates are contingent on the country maintaining positive net migration over the forecast horizon. If zero net migration is assumed, the old age dependency ratio for the Czech Republic would rise faster than that of peers and reach higher levels by 2060. A declining workforce will exacerbate the country’s pre-existing labour shortages. From January 2014 to June 2020, unfilled vacancies rose eightfold while the unemployment rate dropped to 2.7%, the lowest rate among EU-27 members. Labour shortages are thus becoming a substantial structural constraint to further economic growth, as recently highlighted by the European Commission.The economic repercussions of the Covid-19 will increase slack in the jobs market and labour shortages will become less prominent short term. Still, increasing labour force participation (among women especially), reducing skills mismatches and improving R&D and innovation policies are needed to raise productivity and offset the adverse impact of rising demographic pressures, as highlighted by the OECD. An ageing society will also place increasing pressure on the Czech Republic’s public finances due to rising pension and healthcare costs.The European Commission estimates that pension, healthcare and long-term care costs will rise by 5.3% of GDP over 2020-70, among the highest such increases in the EU and well above those for Finland (+2.7% of GDP) and Estonia (-0.6pps) as well as the EU average (+2.3pps). Rising expenditure pressures are compounded by recent policy measures. The government decided not to link the statutory retirement age with expected gains in life expectancy and made the pension indexation formula more generous, both weighing upon the long-term sustainability of the pension system.

Another key challenge for the Czech Republic is the economy’s reliance on external demand and strong linkages with global supply chains in the automotive industry. With exports of goods and services representing close to 73% of GDP, the Czech Republic is one of the most open economies in the EU. This leaves the country exposed to deterioration in the external environment short term with major trading partners such as Germany (32% of total Czech exports in 2019), Slovakia (8%), Poland (6%), France (5%) and the UK (4%) all expected to face severe recessions in 2020. The Czech Republic’s integration in global supply chains linked to the automotive industry, the backbone of the Czech economy, will further magnify the impact of worsening external demand. In 2017, the sector accounted for around 25% of gross total output, 18% of total value added, 13% of total employment and 35% of total exports in industry . The country is likely to be affected by revenue pressures in the car industry resulting from an estimated drop of 20% in domestic car productions this year due to closures caused by the pandemic. Long-term structural changes in the industry linked to revised CO2 standards, increasing demand for electric cars and automation present notable risks to the Czech Republic’s growth model. The country faces rising need for highly skilled labour and investments in equipment. Implementing the country’s long-term plan for education and designing a recovery plan that favours investment and innovation will be key to maintaining the economy’s competitiveness and supporting potential growth.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the ratings process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, in which the Czech Republic has high scores on a composite index of six World Bank Worldwide Governance Indicators. Social factors are reflected in the Czech Republic’s comparatively moderate GDP per capita compared to AA-rated peers, low rates of unemployment, and the economy’s high and rising old age dependency ratio, the latter which is a key rating constraint. Labour force participation of women remains a credit challenge. Finally, environmental factors were considered during the rating process but did not play a direct role in this rating action. However, Scope notes that the strong reliance of the manufacturing sector on the automotive industry raises medium-term risks to the country’s economic strengths if such industries turn gradually into stranded assets.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative ‘aa’ rating range for the Czech Republic. This indicative rating range 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 qualitative analysis.

For the Czech Republic, the following relative credit strengths have been identified: i) growth potential of the economy, ii) fiscal policy framework, and iii) debt sustainability. Relative credit weaknesses are: i) macro-economic stability and sustainability, ii) vulnerability to short-term external shocks, and iii) financial imbalances and financial fragility. The combined relative credit strengths and weaknesses generate no adjustment to the indicative rating and result in a sovereign rating of AA for the Czech Republic. A rating committee has discussed and confirmed these results.

Rating committee
The main points discussed by the rating committee were: i) growth potential; ii) debt sustainability; iii) demographics; and iv) peers.

Rating driver references
1. Ministry of Finance – Macroeconomic Forecast of the Czech Republic
2. Ministry of Finance –The Czech Republic funding and debt management strategy 
3. European Commission – Country Report Czech Republic 2020
4. International Monetary Fund – Staff Report 2019 on the Czech Republic 
5. European Commission – Czech Republic – Health care & long-term care systems 

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, published on 21 April 2020, is available on https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rating process was conducted:
With Rated Entity or Related Third Party Participation              NO 
With Access to Internal Documents                                           NO
With Access to Management                                                     NO
The following substantially material sources of information were used to prepare the credit rating: public domain.
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 the issuance of the rating or outlook action, 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.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Rating prepared by Bernhard Bartels, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Sovereign and Public Sector
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 26 January 2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5, D-10785 Berlin.

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