ACRA AFFIRMS LT AA TO THE CZECH REPUBLIC, OUTLOOK TO STABLE

The following ratings to the Government of the Czech Republic (hereinafter, the Czech Republic, or the country) have been affirmed under the international scale:

• Long-term foreign currency credit rating at AA and local currency credit rating at AA;

• Short-term foreign currency rating at S1+ and local currency credit rating at S1+.

The outlooks on the long-term foreign currency credit rating and the local currency credit rating are Stable. The Stable outlook assumes that the rating will most likely stay unchanged within the 12 to 18-month horizon.

Positive rating assessment factors

• Relatively high level of welfare.

• Moderate level of public debt with a relatively deep domestic market.

• Prudent monetary policy.

• Strong external position.

• Small size and high openness of the economy.

• Low diversification of the industrial sector.

• High dependence on the key trade partner.

ACRA expects the Czech economy to demonstrate recovery growth at 3.0% and 4.5% in 2021 and 2022, respectively, after recording the second deepest fall in GDP in the CEE region (-5.8%) in 2020. In Q2 2021, the economy demonstrated strong growth at 8.9% y-o-y, mainly due to a lower base (-10.8% contraction in Q2 2020). This growth was driven by consumption (by 4.2 pps) and manufacturing (by 6.0 p.p. to gross value added). The downside risk arising from a potential lockdown and restrictions is limited, as 54.9% of population has been vaccinated with two doses as of September 15, 2021. However, the risk of new vaccine-resistant COVID-19 strains developing remains. In the coming years the economy will grow above its potential, which is estimated by ACRA at 2.0%.

In the long term, the country’s GDP growth is constrained primarily by the high concentration on the automotive industry, which accounts for 10% of output and 23.3% of total exports. It exposes the country to industry-specific risks and risks associated with global trade tensions and environmental policies. Moreover, carmakers may be susceptible to major changes in the industry with the larger focus on electric vehicles, self-driving cars, and car sharing. Relatively high R&D expenditures (around 2.0% of GDP in 2019) and a high share of investments (27% of GDP) could mitigate these risks.

The Czech Republic is a very open economy. Exports and imports of goods and services exceed 120% GDP. At the same time, the country exports primarily to the EU (84% of total export of goods in 2020), with Germany being the largest trade partner (33% of total export of goods in 2020). Thus, the economy is vulnerable to external shocks and depends on German economic performance.

The Czech Republic will benefit from EU funds. According to the new EU 2021–2027 budget, the country will receive around 20% of its GDP in funds over the next seven years — significantly higher than the amount received under the previous seven-year EU budget.

Inflation has been accelerating since February 2021. In August 2021, it reached 4.1%, which is above not only the inflation target (2.0%), but also the upper tolerance level of the target (3.0%). The main drivers are housing, water, energy, fuel, which together contributed 0.9 p.p. to the increase, as well as transport, which alone is responsible for 0.9 p.p. as well. Since February, the Czech National Bank (CNB) has hiked the key rate twice by a total of 50 bp and set it at 0.75%. This helped to keep one-year inflation expectations at 2.4%. The CNB historically implements prudent monetary policy, which ensures that policy targets will be met.

ACRA expects the general government debt to reach a moderate 42.6% of GDP by the end of 2022 compared to the low 37.8% recorded at the end of 2020. This debt rise is explained by expected continuation of deficit budgets in 2021 and 2022 at 7.0% and 4.5% of GDP, respectively, after a 6.1% of GDP budget deficit in 2020. The budget deficits have a structural nature and are due to previous government decisions on personal tax cuts, increasing social benefits, higher salaries, and social transfers. The upcoming 2021 parliamentary elections are also partially responsible for the elevation of social expenditures. Persistent structural deficits and the challenges of fighting them may lead to deterioration of the country’s fiscal position in the future. However, a mitigating factor is liquid assets accumulated by the government, which amounted to around 16% of GDP by the end of 2020.

Despite the debt rise, debt affordability remains high with the ratio of interest payment to revenues low at 1.9% in 2020. ACRA expects this ratio to stay at 2.3% in 2021.

ACRA believes that the government will comfortably cover its increased financing needs with borrowings. Thanks to a developed and relatively deep domestic market, the budget deficit was successfully financed mostly by fixed-rate, local currency-denominated notes and bonds. Unlike other central banks in the CEE region, the CNB did not buy government bonds in the secondary market. In 2019, the government started to issue a limited amount of foreign currency-denominated bonds, but has no plans to increase their issuance. Potential new issues will be used only for refinancing needs. Besides this, the Ministry of Finance stated that it is ready to issue Eurobonds if necessary. Taking into account the fact that the last Eurobond issuance was in 2012, demand for a potential new issuance will be strong. Non-resident investors were more active on the government bond market this year. The share of their holdings in government bonds reached 31.0% in July 2021 compared to 29.2% in December 2020.

A long-term challenge for the country is the increasing cost of its aging population in terms of pensions, healthcare costs, long-term care, and education. According to the EU 2021 Aging Report, these costs will increase by 6.1 p.p. and reach 24.7% of GDP in 2070 vs. 18.6% of GDP currently. This increase of costs is the third largest among peers, after Slovakia and Slovenia.

The banking sector seems to have weathered the 2020 crisis well. The fundamentals of the country’s banking industry were solid prior to the crisis. Forbearance measures such as six-month holidays for social payments and a moratorium on the repayment of loans and mortgages were lifted at the end of 2020, but the ratio of NPLs to gross loans only increased to 2.6% in July 2021, compared to the lowest level (2.4%) in October 2020. Outstanding bank loans of the private sector have increased by 8.3% as of the end of July 2021 compared to July 2020. Out of this, mortgages have risen by 10.8%, driven by low rates. By the end of Q2 2021, residential property prices had risen by 8.0% y-o-y, driven by supply shortages of housing stock. Capitalization remains strong (the regulatory capital to RWA ratio was 21.3% in Q1 2021). The banking sector’s profitability fell substantially; ROA declined from 1.2% in 2019 to 0.6% in Q1 2021. Lower profitability is likely associated with higher provisions, which will allow potential asset quality risks to be weathered. Recently, the CNB ran a stress test, which showed that in both scenarios (base and adverse) there is no need for additional capital. In ACRA’s opinion, there will be no need for the government to support the banking sector.

Due to external sector recovery, in H1 2021, exports and imports (of goods and services) increased year-on-year by 15.6% and 17.0%, respectively (seasonally unadjusted). Strong 30%+ growth rates were recorded in Q2 2021 (31.9% for exports, 32.7% for imports). The main drivers of both exports and imports were machinery and transport equipment, and manufactured goods and articles. The overall current account surplus improved to USD 5.2 bln compared to USD 4.3 bln in the first half of 2020.

The Czech Republic’s ability to withstand external shocks is backed by a high level of reserves — EUR 140.8 bln (62.7% of GDP in July 2021). In Q1 2021, the country’s foreign currency reserves covered 84.9% of total external debt, short-term (due in one year) external debt is covered by 8.0x (in 2020); taking into account the short-term deposits of non-residents coverage is 2.8x (in 2020). Since 2019, external debt has fallen by 4.5% and totaled EUR 164.8 bln by the end of Q1 2021.

The country’s institutional framework is robust and the strongest among the CEE peers. Almost all of the Czech Republic’s governance indicators have been historically strong, with some having slightly improved in recent years. Since June 2021, the popularity of the ruling party (ANO) has been recovering before the parliamentary elections in October 2021. Although it is likely that the centrist Pirates and Mayors and the center-right Together Alliance will form a coalition, ACRA expects continuity in the country’s strong economic policies.

Sovereign model application results

The Czech Republic has been assigned an AA- Indicative credit rating in accordance with the core part of ACRA’s sovereign model. A number of modifiers in the modifiers part of the model allow the Indicative credit rating to be increased. These include the following, which are determined by the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale:

• Monetary policy efficiency;

• Fiscal policy and fiscal flexibility.

In view of the abovementioned modifiers, the Czech Republic’s Indicative credit rating has been raised. A Final credit rating of AA has been assigned. There are no analytical adjustments and limitations that could result in an adjustment of the Final rating. In connection with this, the long-term foreign currency credit rating remains at AA.

Potential outlook or rating change factors

A positive rating action may be prompted by:

• Stronger than expected growth;

• Improvement in the budget position in the coming years;

• Alleviating costs of aging and economic competitiveness issues.

A negative rating action may be prompted by:

• Further worsening of the fiscal position;

• Lower than expected growth.

Regulatory disclosure

The sovereign credit ratings have been assigned to the Czech Republic under the international scale based on the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale and the Key Concepts Used by the Analytical Credit Rating Agency Within the Scope of Its Rating Activities.

The sovereign credit ratings of the Czech Republic were published by ACRA for the first time on October 29, 2019. The sovereign credit ratings and their outlooks are expected to be revised within 182 days following the publication date of this press release as per the Calendar of sovereign credit rating revisions and publications.

The sovereign credit ratings are based on information from publicly available sources and ACRA’s own databases. The sovereign credit ratings are unsolicited. The Government of the Czech Republic did not participate in the sovereign credit rating assignment.

In assigning the credit ratings, ACRA used only information, the quality and reliability of which was, in ACRA’s opinion, appropriate and sufficient to apply the methodologies.

ACRA provided no additional services to the Government of the Czech Republic. No conflicts of interest were discovered in the course of the sovereign credit rating assignment.