For the updated report accompanying this review, click here.

Rating action

Scope Ratings GmbH (Scope) has today affirmed the Czech Republic’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at AA. Scope has also affirmed the short-term issuer ratings at S-1+ in local and foreign currency. All Outlooks are Stable.

Summary and Outlook

The affirmation of the Czech Republic’s AA ratings reflects the country’s: i) robust public finances with a good record of fiscal consolidation and a moderate level of debt; and ii) steady economic performance with a competitive industrial base and solid growth prospects. The rating is constrained by: i) an economic structure reliant on global supply chains and external demand, which exposes the country to external shocks and weighs on macroeconomic sustainability; and ii) adverse demographic trends related to the country’s rapidly ageing population, and labour shortages that limit potential growth and increase medium-term pressures on public finances.

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 downgraded if, individually or collectively: i) Scope observed materially higher debt ratios than projected as a result of fading commitment to fiscal discipline, for example; and/or ii) growth potential significantly weakened because of a structural decline in foreign demand and/or prolonged disruptions to global supply chains.

Conversely, the ratings/Outlook could be upgraded if, individually or collectively: i) structural reforms are implemented, strengthening macroeconomic sustainability; and/or ii) fiscal performance improved, resulting in a significant decline in the public debt ratio.

Rating rationale

The affirmation of the Czech Republic’s AA ratings reflects a strong record of steady, robust economic performance and a competitive industrial base, as evidenced by high FDI inflows – creating high value-added jobs and supporting growth potential, as well as Scope’s expectation of a robust economic recovery from 2022 onwards.

The Czech Republic entered the pandemic on a sound economic footing, with high investment of around 25.1% of GDP in 2019 supported by the country’s geographical proximity to core EU markets, wage competitiveness, and the inflow of EU funds and FDI inflows. These factors have further supported high growth potential of 2%-3% since 2015, productivity and employment growth and have contributed to sustained income convergence over the past decade, from 75% of the EU-15’s GDP per capita in 2009 to 85% in 2019. This is a lower income level compared to peers, however. Another critical development contributing to the Czech Republic’s economic strength is rising services exports (up 7.3% per year on average over 2014-19), reflecting the country’s improving competitiveness in commercial services and the rise of the service sector across economies globally.

The Czech Republic’s small, open, supply-chain dependent economy was severely affected by the Covid-19 pandemic and associated mitigation measures, leading to an output decline of 5.8% of GDP in 2020. A large and effective set of fiscal interventions to support the healthcare sector, businesses and households has cushioned the blow, including supply-side disruptions, and has contained unemployment at 2.3% as of November 2021, the lowest level in the EU.

Scope forecasts annual GDP to grow by 4.7% in 2022 amid elevated inflation, following a moderate recovery in growth estimated at 3.0% in 2021. The improving economic outlook is supported by pent-up demand boosting private consumption, recovering net exports, low unemployment and increased EU funds. Scope projects inflation to remain elevated in 2022 driven by structural factors including high energy prices, persistent labour and housing market pressures, and cyclical factors given the strong recovery in domestic demand during the second half of 2021. Global supply chain distortions should be resolved by mid-2022. Public consumption is set to taper off as fiscal support measures are carefully scaled back in view of an uncertain outlook due to the pandemic. The Czech National Bank has appropriately started to raise its policy rate, increasing its key interest rate by one percentage point in December 2021 to 3.75%, the fifth increase since June for a total of 350 bps. Moreover, the policy response to support the economy during the pandemic came predominately in the form of fiscal stimulus. Monetary policy support included significant rate cuts and the loosening of some macroprudential measures to support the predominately foreign owned, profitable and well capitalised banking system.

Going forward, Scope expects growth to slow to a solid 4.0% in 2023 as output returns closer to its potential and monetary support is gradually withdrawn further. Due to significant fiscal policy support through grants via the Multiannual Financial Framework (EUR 31.4bn) and EU transfers from the Recovery and Resilience Facility (EUR 7.1bn or about 3% of GDP in 2021) allocated to the Czech Republic over 2021-27, Scope expects investment to grow markedly from current levels. These factors underpin Scope’s expectation of a robust economic recovery from 2022 onwards.

The affirmation of the Czech Republic’s AA ratings is also supported by robust public finances, sound fiscal policies and a substantial liquidity buffer. The country entered the Covid-19 crisis with considerable fiscal space and a debt-to-GDP ratio of around 30% in 2019, following a consolidation of 10 pp since 2015. Scope projects the country’s gross financing needs at 8.5% of GDP for 2022, including a modified state budget deficit of around CZK 300bn (EUR 11.4bn or 4.3% of GDP) and public debt redemptions of CZK 273.5bn (EUR 11.3bn or about 4.2% of GDP).

The country’s debt profile benefits from significant liquid public sector deposits (13.7% of GDP as of Q3 2021), reflecting a cautious financing strategy. The government pre-financed significant financing operations for 2021 early in the pandemic, without tapping international markets. Even if the government finances the full amount of the approved deficit this year, gross financing needs remain low compared to those of rating peers with high-income economies (19.5% of GDP). In addition, the newly installed Fiala government has announced its intention to revise the current budget and reduce the deficit by around CZK 80bn, though exact cuts have yet to be put forward. Although most of the government’s exceptional support measures are expected to be phased out early in 2022, the consolidation is being slowed down by a decrease in revenue caused by the 2021 tax package, which brought about a permanent decrease in the personal income tax. Higher inflation is to push up several expenditure items including pensions.

Despite the recent increase in public debt, its level as a share of GDP is still among the lowest in the EU, supporting fiscal space. Scope expects the debt-to-GDP ratio to gradually increase to 49% in 2025 after reaching 42% in 2021. This is still well below the Stability and Growth Pact’s 60% limit, however. Going forward, Scope expects fiscal space to be supported by: i) a low interest-payment burden; ii) a resilient debt structure with an average term to maturity of 6.4 years in 2021, up from 5.0 years in 2017, and a small share of foreign currency-denominated bonds at around 2% of total government securities in 2021; and iii) a favourable interest rate environment, allowing the refinancing of previously issued securities at lower rates. These factors should also allow the Czech government to meet additional financing needs that could stem from adverse scenarios, such as the need for additional pandemic-related support measures. The debt management strategy aims to further develop the domestic capital market with future issuances of koruna- and euro-denominated bonds.

Finally, the Czech Republic’s net international investment position has improved steadily in recent years, to negative 11.7% of GDP in 2020 from negative 26.1% of GDP in 2016, with gross external debt at moderate levels of 71.9% of GDP in September 2021. External liabilities mostly consist of foreign direct investment and equity rather than debt-creating flows, making the country more resilient to sudden changes in investor sentiment. Scope expects the Czech Republic’s external debt burden to gradually decline to 60% of GDP by 2026, supported by a continuation of successive external surpluses.

Despite these credit-positive developments, the Czech Republic’s ratings remain constrained by: i) an economic structure reliant on foreign funding, global supply chains and external demand, exposing the country to external shocks and weighing on macroeconomic sustainability; and ii) adverse demographic trends related to the country’s rapidly ageing population, and structural labour shortages that limit potential growth and raise medium-term pressures on public finances.

A key challenge for the Czech Republic is the economy’s reliance on external demand and strong linkages with global supply chains coupled with structural labour shortages. With exports of goods and services representing close to 71% of GDP in 2020, the Czech Republic is one of the most open economies in the EU. This leaves the country exposed to a short-term deterioration in the external environment in case of a structural decline in foreign demand or prolonged disruptions to global supply chains. However, major trading partners such as Germany (32% of total Czech exports in 2019), Slovakia (8%), Poland (6%) and France (5%) are all expected to face economic upswings in 2022.

The Czech Republic’s integration in global supply chains linked to the automotive industry, the backbone of the Czech economy, highlights the economy’s reliance on external investment and demand. In 2018, the sector accounted for around 13% of total employment and 24% of total exports. The Czech automotive industry faces long-term challenges linked to the transition away from the internal combustion engine, as electric vehicles currently represent only around 10% of cars produced in the country. Key developments in this area are dependent on the strategies and performance of foreign groups, which control the bulk of local automotive production capacity (Volkswagen, Hyundai, Continental, Toyota, etc).

Another key challenge is the country’s rapidly ageing population, which limits potential growth and places growing pressure on public finances due to rising healthcare and pension costs. The Czech working age population (defined as those aged 15 to 64 years old) has been declining steadily for more than a decade, with a decrease of over 579,000 (7.8%) from 2008 to 2019. These demographic pressures are due to accelerate in the longer term. The European Commission (2021) estimates that pension, healthcare, education and long-term care costs will rise by 6.1% of GDP over 2019-70. This is among the highest of such increases in the EU and well above the EU average (1.9%). Rising expenditure pressures are compounded by a generous pension indexation formula under which the statutory retirement age is not linked to expected gains in life expectancy. This weighs on the sustainability of the pension system.

Finally, labour shortages are becoming a substantial structural constraint to further economic growth. While the general labour market situation has been improving in the Czech Republic in recent years, the country’s long-term competitiveness is eroding due to structural employment gaps. The country faces a rising need for highly skilled labour and investments in equipment and a structural competitiveness gap between large and small enterprises as well as between foreign-owned and domestic enterprises. Implementing a national recovery plan that favours investment and innovation will be key to maintaining the economy’s competitiveness and supporting potential growth.

Core Variable 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 rating of ‘aa’ for the Czech Republic. The Qualitative Scorecard (QS) can adjust this indicative rating by up to three notches depending on the size of relative qualitative credit strengths or weaknesses versus a peer group of countries.

For the Czech Republic, the following relative credit strengths have been identified: i) fiscal policy framework; and ii) external debt structure. Relative credit weaknesses are: i) macroeconomic stability and sustainability; ii) resilience to short-term shocks; and iii) environmental risks.

The combined relative credit strengths and weaknesses indicate a sovereign rating of AA for the Czech Republic.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) and in the qualitative overlay (QS).

With respect to environmental risks, the Czech Republic scores low in the CVS for CO2 emissions per GDP and receives high CVS scores for having low natural disaster risk with a moderate biocapacity deficit. Scope assesses the Czech Republic’s QS adjustment for ‘environmental risks’ as ‘weak’ due to meaningful transition risks as a carbon-intensive economy and transit country with a high share of manufacturing. Greenhouse gas emissions are elevated at 9.6 metric tonnes per capita versus the EU average of 6.4. It is reliant on fossil fuels, especially coal (one third of total energy supply) and has been slow to transition to renewable sources (15% of its energy mix, with a 2030 target of 22%). The new government has announced plans to phase out coal from energy production by 2033, partly through an increase in nuclear energy capacity.

Regarding social risks, the Czech Republic receives high CVS scores for limited income inequality and high labour force participation, but it scores low in the CVS for having a high old-age dependency ratio. Scope assesses the Czech Republic’s QS adjustment for ‘social risks’ as ‘neutral’. Social-related credit strengths are mainly associated with the country’s strong labour market, which generates elevated employment and participation rates, though they only partially offset long-term challenges linked to adverse demographic trends and structural employment gaps. Moreover, an ageing society will place growing pressure on the Czech Republic’s public finances due to rising pension and healthcare costs.

With respect to governance risks, the Czech Republic receives high CVS scores on a composite index of six World Bank Worldwide Governance Indicators. Scope assesses the Czech Republic’s QS adjustment for governance risks as ‘neutral’. The October 2021 parliamentary election led to the swearing-in of centre-right Prime Minister Petr Fiala in December, after a period of relative uncertainty. The new government has set out its priorities, including digitalising the economy and accelerating the fiscal consolidation process. It also signalled its intention to restore the Czech Republic’s relationship with Brussels. Despite a broad parliamentary majority that the new government expects to rely on (108 MPs out of 200), instability could stem from ideological disagreements among the five parties that make up the coalition.

Rating Committee
The main points discussed by the rating committee were: i) economic and fiscal performance; ii) the impact of the pandemic; iii) growth potential, external environment, financial stability and macroeconomic sustainability; and iv) institutional developments and reform progress.

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings’, 8 October 2021), is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other 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 Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit 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 factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit 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 Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Jakob Suwalski, Director
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 2 October 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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