For the associated rating report, click here.

Rating action

Scope Ratings GmbH (Scope) has today affirmed Czech Republic’s long-term local and foreign currency issuer and senior unsecured ratings to AA and has revised the Outlook to Negative, from Stable. Czech Republic’s short-term issuer ratings were affirmed at S-1+ in local and foreign currencies, with Stable Outlooks.

Rating drivers

The revision of the Outlook to Negative on Czech Republic’s AA sovereign credit ratings reflects Scope’s view that the country’s medium-term growth outlook has deteriorated materially in the wake of supply chain disruptions and high levels of inflation caused by the Ukraine conflict, interrupting the economic recovery from the Covid-19 pandemic and weighing on the fiscal consolidation process. The Czech economy’s high degree of integration in global supply chains and elevated dependence on Russian energy make it exposed to the shock from the war in Ukraine.

The Outlook revision reflects updated Scope assessments of the Czech Republic under the ‘domestic economic risk’ and ‘external economic risk’ categories of its sovereign methodology.

The Negative Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are tilted to the downside.

The ratings/Outlook could be downgraded if, individually or collectively: i) there was further notable worsening in medium-run growth prospects, due, for example, to supply-chain disruptions, such as energy supply disruptions, weighing on the country’s macroeconomic sustainability and/or fiscal metrics; and/or ii) debt sustainability weakens materially as a result of a protracted period of loosened fiscal stance.

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 revision of the Outlook to Negative on Czech Republic’s AA rating reflects the material weakening of the country’s medium term growth prospects due to the economic repercussions related to the Russia-Ukraine war and supply-chains disruptions. This will add pressure on the budgetary position in the near-to-medium run. The Czech Republic counts among the most exposed countries to international supply chains and the fallout from the Ukraine conflict, in view of its reliance on Russian energy coupled with an economic structure dominated by energy intensive businesses with complex value chains such as the automotive industry.

After a modest recovery from the Covid-19 shock, with GDP growth at 3.3% in 2021, Scope expects the Czech economy to experience a marked slowdown in 2022, down to a real growth rate of around 1.6%. The reduced growth prospects compared to Scope’s previous review in January (4.7%) reflect lower private consumption due to high inflation, which is weighing on real wages, alongside lower investment due to the heightened global uncertainty. In addition to lower net exports caused by supply-side shortages, Scope expects that the Czech Republic will face a significant weakening of external demand due to the slowdown experienced by key trading partners, including Germany (AAA/Stable) as well as other Central and Eastern European countries. Scope expects growth to recover to 2.7% in 2023 and trending back towards the medium-term potential in subsequent years, which Scope estimates at 2.5% annually.

The medium-term headwinds are compounded with some structural vulnerabilities affecting the Czech economy, related to its reliance on external demand, strong linkages with global supply chains coupled with the country’s reliance on Russian energy. The Czech Republic is highly dependent on energy intensive industries with complex supply chains such as the automotive sector, which accounts for around 10% of GDP, 13% of total employment and 24% of total exports. 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 and makes the country’s growth prospects dependent on strategies and performance of foreign groups. The country’s reliance on Russian energy imports is elevated compared to similarly rated peers, with Russian energy imports covering about 24% of gross available energy in 2020, according to Eurostat estimates. This includes almost all the natural gas used in the country, as well as a third of its oil consumption.

Similarly to other peers, the Czech Republic was already experiencing rising inflationary pressures at the beginning of the year, in a context of elevated energy prices which pushed the headline inflation rate (HICP) to 8.8% year-on-year in January 2022. The shock from the conflict fuelled further price increases through 2022 H1, up to a record high 15.2% rate in May. Domestic price dynamics have also picked up significantly, in part reflecting the tight state of the labour market.

Beyond these medium-term adverse developments, the country is faced with significant, adverse demographic dynamics which add to pressures related to labour shortages and represent a significant constraint on long-term growth prospects. The Czech Republic’s population is ageing rapidly, with the old age dependency ratio expected to nearly double in coming years, from 33.0 in 2019 to 59.2 by 2060 according to estimates from the European Commission. These factors create significant constraints on potential growth and place growing pressures on public finances due to rising healthcare and pension costs. The IMF estimates the NPV of additional pension and health expenditures over the 2021-50 period at 31.6% and 25.1% of GDP, respectively.

Despite these structural weaknesses, Czech Republic retains considerable credit strengths.

First, Czech Republic’s AA rating is supported by solid public finances, sound fiscal policies and a substantial liquidity buffer. From 2016 to 2019, generated modest budget surpluses, leading the debt-to-GDP ratio to decrease to 30.1% in 2019, down from above 44% in 2013. This allowed the Czech government to build significant fiscal space in the years leading up to the pandemic. Despite the significant increase following the pandemic shock (+11.9pps between 2019 and 2021), the debt-to-GDP ratio remains among the lowest in the European Union and well below the Maastricht criteria’s 60% limit.

The government recently reaffirmed its commitment to fiscal discipline by enacting a near CZK 100bn (around 1.5% of GDP) cut to the government deficit. Scope expects fiscal space to be supported by a low interest-payment burden and a resilient debt structure. However, the worsening macroeconomic situation will have implications for the fiscal consolidation strategy in view of reduced growth prospects which add pressure on budgetary revenues and increased spending requirements to provide support measures in the context of high energy prices.

Second, the country’s external position had improved materially in the period leading up to the crisis, generating steady current account surpluses, averaging at 1.2% of GDP over 2014-20. This allowed for a significant decrease in the country’s negative net international investment position, from 44% of GDP in 2012 to about 15% by end-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.

Finally, the Czech Republic’s rating is underpinned by a strong record of robust economic performance and a competitive industrial base, as evidenced by high FDI inflows, supporting the creation of high value-added jobs. FDI inflows have remained robust despite the worsening economic outlook and averaged at 3.4% of GDP in the twelve months to March 2022.

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 a first indicative rating, which was approved by the rating committee at ‘aa’ for the Czech Republic. The ‘aa’ indicative rating can be adjusted by the qualitative scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Czech Republic, the following QS relative credit strength has been identified: i) Fiscal policy framework and ii) External debt structure. The following QS relative credit weaknesses have been identified: i) Macro-economic stability and sustainability; ii) resilience to short-term shocks; iii) environmental risks.

The QS generates no adjustment and indicates AA long-term ratings for 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 the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as 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%). Additional concerns stem from the country’s heavy dependence on Russian energy imports, which cover nearly the entirety of the Czech Republic’s natural gas consumption. The Fiala 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 has also worked towards improving relations with European Union institutions, which had become fraught under the previous Babiš premiership. Despite significant ideological disagreements, the five-party coalition supporting the government has proven broadly stable to date.

Rating Committee
The main points discussed by the rating committee were: i) economic and fiscal performance; ii) the impact of the Ukraine conflict; iii) growth potential, financial stability and macroeconomic sustainability; and iv) institutional development 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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 is/are UK-endorsed.
Lead analyst: Jakob Suwalski, Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on January 2003. The Credit Ratings/Outlooks were last updated on 21 January 2022.

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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