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      FRIDAY, 26/05/2023 - Scope Ratings GmbH
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      Scope downgrades Czech Republic's credit ratings to AA-; Outlook revised to Stable

      Weakened medium-term growth prospects and deteriorated fiscal metrics drive the downgrade. A robust fiscal policy framework and favourable debt profile are key credit strenghts.

      Rating action

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

      Summary and Outlook

      The downgrade of Czech Republic’s credit ratings to AA- from AA reflects two main drivers:

      1. The ongoing Russia-Ukraine conflict has significantly impacted the country’s medium-term growth prospects, resulting in enduring inflationary pressures and weakened supply chain stability. The Czech economy, with its reliance on exports and energy-intensive industries, has encountered substantial challenges due to the energy crisis, further exacerbated by notably high inflation levels compared to rating peers. Additionally, the aging population and labour market tightness raise concerns about the long-term growth outlook.
      1. The sustained weakening of fiscal metrics, reflected in persistent fiscal deficits that have disrupted the previously favourable trajectory that existed prior to the Covid-19 crisis. As a result, fiscal deficits have accumulated, and the debt-to-GDP ratio has been steadily increasing over the past three years. The implementation of necessary government measures to consolidate public finances in the medium term may face challenges due to the subdued economic growth and less favourable financing conditions.

      The downgrade reflects changes in Scope’s assessments in the ‘domestic economic risk’ and ‘public finance risk’ categories of its sovereign methodology.

      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) fiscal performance improved materially, resulting in a significant decline in the public debt ratio; and/or i) the country’s resilience to external shocks strengthened notably, supporting macroeconomic sustainability.

      Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) persistently high inflation levels exceeding expectations continue to hinder medium-term growth; and/or ii) ongoing fiscal deficits result in a continuous rise in the general government debt-to-GDP ratio.

      Rating rationale

      The first driver underpinning the downgrade of the Czech Republic's credit ratings to AA- from AA is the material weakening of the country's medium-term growth prospects. This deterioration is primarily due to the economic repercussions stemming from the Russia-Ukraine war and a less reliable supply chain infrastructure. Although the Czech Republic has made efforts to diversify its energy imports and decrease dependence on Russian gas, the country still faces significant vulnerability to energy and supply chain disruptions, particularly considering the ongoing Ukraine conflict and its consequences. The Czech Republic's vulnerability is compounded by its economic structure, as the country faces significant transition risks and would benefit from shifting away from energy-intensive sectors towards industries that are less resource-dependent.

      By the end of 2022, the Czech Republic stands out among European countries as it has not yet surpassed its GDP level from the fourth quarter of 2019. This is evident in key economic sectors such as industry, construction, trade and transportation, which have experienced a decline in gross value added since 2019. After experiencing a moderate recovery from the impact of the Covid-19 pandemic, with economic output growing by 3.5% in 2021, the Czech economy faced a slowdown, recording a growth rate of 2.5% last year. The expansion of economic output was predominantly fuelled by a rise in fixed capital investments and inventory accumulation, while consumption remained subdued due to the impact of high inflation on purchasing power.

      Scope anticipates a modest growth rate of 0.2% for the current year, attributed to lower inventory levels, weak external demand, and households contending with limited real disposable income amid ongoing inflationary pressures and high interest rates. The two-week repo rate has been stable at 7% since June 2022. As inflation gradually eases, export conditions improve and capital investments improve, Scope anticipates economic growth to recover to 3% in 2024. Beyond that, growth is projected to stabilise around the medium-term potential of 2.5% in the following years, although it will still be below pre-crisis levels.

      Headline HICP inflation reached its peak at 19.1% in January, primarily driven by increases in energy and food prices. Subsequently, inflationary pressures have gradually started to ease as global inflationary conditions improve. However, the headline inflation rate remained elevated at 14.3% year-on-year in April, significantly surpassing rating peers and surpassing the EU average of 8.1%. Furthermore, the combined impact of other goods and services and consistent wage growth in the midst of a tight labour market will continue to keep inflation at elevated levels, thereby requiring the maintenance of tight monetary policy conditions throughout the current year. According to the central bank's projections, inflation is expected to approach the 2% target only by mid- 2024, later compared to previous expectations of inflation close to the 2% target in early 2024.

      The Czech economy faces medium-term challenges compounded by structural vulnerabilities related to its reliance on external demand and energy-intensive industries with complex supply chains, particularly the automotive sector, which contributes approximately 10% to GDP, employs 13% of the workforce, and accounts for 24% of total exports. In contrast to the overall decline in supply disruptions, the automotive sector has been contending with a shortage of chips, resulting in production halts and reduced operational capacity in some plants this year. The Czech Republic's dependence on the automotive sector, which is highly energy-intensive, not only increases long-term energy transition risks but also exposes the country to potential short-term setbacks in the external environment. These setbacks could include structural declines in foreign demand or prolonged disruptions to global supply chains. As a result, the growth prospects of the Czech Republic become contingent on the strategies and performance of foreign entities, further underscoring the need for proactive measures to address these challenges.

      Labour market tightness is another constraint on the country's medium-to-long-term output growth and competitiveness. The Czech labour market demonstrates a high employment rate, standing at 75.6% in Q1 2023, and one of the lowest unemployment rates in the EU, at 2.5% as of March 2023. However, there are persistent imbalances between labour supply and demand, despite recent relief from the substantial influx of Ukrainian refugees. Ongoing labour shortages have been contributing to wage growth, averaging 7.9% in Q4 2022 across the economy.

      In addition to the medium-term challenges, the Czech Republic is confronted with unfavourable demographic dynamics that exacerbate the pressures stemming from labour shortages and pose a substantial constraint on long-term competitiveness and growth prospects. The country's population is undergoing rapid aging, with the old age dependency ratio projected to nearly double in the coming years, increasing from 33.0 in 2019 to 59.2 by 2060, according to estimates from the European Commission. These factors impose significant limitations on potential growth.

      The second driver contributing to the downgrade of the Czech Republic's credit rating to AA- relates to the sustained weakening of fiscal metrics over the last three years. This has been reflected in persistent fiscal deficits that reversed the favourable fiscal trajectory prior to the Covid-19 crisis.

      After registering a fiscal deficit of 5.1% of GDP in 2021, the deficit narrowed to 3.6% last year, supported in part by strong tax revenue and social contributions. However, these positive factors only partially offset the substantial government assistance extended to households and businesses in response to elevated energy expenses, which accounted for 0.7% of GDP, and the provision of humanitarian aid to Ukrainian refugees.

      As a result, the debt-to-GDP ratio has remained on a steep upward trajectory, rising from 30% in 2019 to 44.1% in 2022. Scope anticipates that the general government headline budget deficit will remain at 3.6% of GDP in 2023, considering the prolonged support provided to households and businesses, such as price caps, expected to reach 1.3% of GDP. The rising interest rate environment is likely to exert medium-term pressures: amid increasing borrowing costs, the interest burden is expected to increase from 1.2% of GDP to 1.4% of GDP by 2026. In relation to fiscal revenues, interest spending is projected to continue rising as well, from 2.8% in 2022 to 3.3% in 2023 and 2024.

      Furthermore, the Czech Republic's rapidly aging population will impose significant strain on public finances in the medium and long term, primarily due to escalating healthcare and pension expenses. According to the IMF, the net present value (NPV) of additional pension and health expenditures from 2021 to 2050 is estimated to reach 31.6% and 25.1% of GDP, respectively. These projections highlight the considerable financial burden associated with addressing the needs of an aging population and underscore the importance of implementing sustainable policies to manage these rising costs effectively.

      The government's recently announced fiscal consolidation package, which is contingent upon parliamentary approval and set to be implemented from January 2024, is a substantial initiative aimed at stabilizing the country's public finances. It addresses fiscal pressures in the medium term and serves as a foundation for Scope's expectation of stable credit ratings for the Czech Republic in the coming 12 to 18 months.

      The package seeks to reduce the budget deficit by CZK 147.5bn over the period of 2024-2025 through various measures, including e.g. raising personal and corporate income tax rates, cutting national subsidies, reducing public sector salaries volume and operating costs, and implementing pension reforms. Additionally, adjustments to consumption taxes, such as those on tobacco and alcohol, along with the elimination of certain tax exemptions, should support fiscal revenue.

      While the government's commitment to fiscal discipline is crucial, the effective implementation of the consolidation measures may encounter challenges given the current economic downturn. According to Scope's projections, the fiscal budget is expected to remain in a deficit position until 2028, gradually improving to -1.8% of GDP in 2024 and -1.7% in 2025. The debt-to-GDP ratio is projected to decrease slightly to 43% in 2023, from 44.1% in 2022, before reaching 40.6% of GDP in 2025 and maintaining a similar level by 2028.

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

      First, Czech Republic’s AA- rating is supported by a strong fiscal policy framework and a resilient debt profile. The implementation of sound fiscal policies and the generation of modest budget surpluses in the years preceding the pandemic enabled the Czech government to establish a substantial fiscal buffer for interventions in adverse scenarios. Despite the recent rise in public debt, the debt-to-GDP ratio of the Czech Republic continues to be among the lowest in the European Union.

      As of 2022, 75% of the public debt was held by domestic investors, and 89% was denominated in the national currency, which helps mitigate foreign exchange risks. The average debt maturity has consistently increased since 2017, reaching 6.2 years in 2022. The favourable debt profile is further supported by significant liquid assets in the form of public sector deposits. Despite the persistence of fiscal deficits and the projected rise in interest spending, which is reflected in the increased borrowing costs observed over the past year, the total financing needs are expected to remain at moderate levels. According to the estimates from the Ministry of Finance, these needs are projected to decline to 9.2% of GDP in 2023, down from 9.5% of GDP last year, and further decrease to 6.5% of GDP by 2025.

      Second, the Czech Republic's external position showed improvement in the period leading up to the crisis, resulting in consistent current account surpluses averaging 1.0% of GDP from 2014 to 2020. This progress contributed to a substantial reduction in the country's negative net international investment position, which decreased to approximately 20% by the end of 2022 from 45% of GDP in 2012. However, the current account balance turned negative in 2021 and 2022 due to weakened export performance, driven by rising commodity and transportation prices, as well as an expanding primary income deficit caused by dividend distributions from foreign-controlled companies. As price pressures in the industry and energy sector gradually subside and supply chain stability improves, coupled with the recovery of major trading partners, Scope anticipates the current account balance to remain below pre-pandemic levels but gradually improve over the next two years. The country's external liabilities primarily consist of foreign direct investment and equity rather than debt, which enhances its resilience to sudden shifts in investor sentiment. Additionally, the Czech Republic maintains adequate levels of foreign currency reserves, totalling USD 141bn as of March 2023, and has benefited from the recent appreciation of the koruna, further strengthening its ability to absorb external shocks.

      Finally, the Czech Republic's credit rating is further supported by its competitive industrial base, which is evident in the significant inflows of foreign direct investment (FDI) that have bolstered the creation of high value-added jobs. Despite the challenging economic outlook, FDI inflows into the country have remained resilient, averaging 4.1% of GDP in 2022. The influx of FDI contributes to the country's economic growth, enhances its productive capacity, and strengthens its position within the global market.

      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 approved by the rating committee at ‘a+’ for the Czech Republic. The ‘a+’ 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 strengths has been identified: i) Fiscal policy framework; ii) Debt sustainability; iii) External debt structure; and iv) Banking sector performance. The following relative credit weakness has been identified: i) Environmental factors.

      The QS generates 1-notch 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 standalone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and a 20% weighting in the qualitative overlay (QS).

      In terms of environmental risks, the Czech Republic ranks unfavourably in the Climate Vulnerability Score (CVS) for its CO2 emissions per GDP and greenhouse gas (GHG) emissions per capita. However, it receives favourable CVS scores for its low natural disaster risk and moderate biocapacity deficit. Scope's assessment of the Czech Republic's adjustment for "environmental risks" is categorised as "weak" due to significant transition risks associated with its carbon-intensive economy and its role as a transit country with a significant energy-intensive manufacturing sector. The country's greenhouse gas emissions are notably high, standing at 12.4 metric tonnes per capita compared to the EU average of 9.5. It also relies on fossil fuels, particularly coal, which accounts for one-third of its total energy supply. The transition to renewable energy sources has been slow, representing only 15% of its energy mix, despite a 2030 target of 22%. The government aims to reduce GHG emissions by 26% by 2030 and phase out coal from the energy mix by 2033, five years earlier than the original 2038 target recommended by the government's Coal Commission.

      In terms of social risks, the Czech Republic receives favourable CVS scores for limited income inequality and high labour force participation. However, it scores unfavorably in the CVS for its high old-age dependency ratio. Scope's assessment of the Czech Republic's adjustment for "social risks" is classified as "neutral." The country's strong labour market contributes to its social-related credit strengths, characterised by high employment and participation rates. However, these strengths only partially offset the long-term challenges arising from adverse demographic trends and structural employment gaps. Furthermore, an aging society will exert increasing pressure on the Czech Republic's public finances due to rising pension and healthcare costs.

      Regarding governance risks, the Czech Republic receives favourable CVS scores based on a composite index of six World Bank Worldwide Governance Indicators. Scope's assessment of the Czech Republic's adjustment for "governance risks" is classified as "neutral." The parliamentary election in October 2021 resulted in the appointment of Prime Minister Petr Fiala in December 2021, ending a period of relative uncertainty. Fiala’s government priorities include digitalizing the economy and accelerating the fiscal consolidation process. Efforts have also been made to improve relations with European Union institutions. The previous strain experienced during the Babiš premiership has been replaced by a more pro-European stance, with the appointment of Petr Pavel as President in March 2023.

      Rating Committee
      The main points discussed by the rating committee were: i) domestic economic risks; ii) public finance risks; iii) external economic risks; and iv) environmental, social and governance risks.

      Methodology
      The methodology used for these Credit Ratings and Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
      The model used for these Credit Ratings and Outlooks is (Core Variable Scorecard, version 2.1), available in Scope Ratings’ list of models, published under 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 Outlooks and the principal grounds on which the Credit Ratings and Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

      Regulatory disclosures
      These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlooks are UK-endorsed.
      Lead analyst: Jakob Suwalski, Senior 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 8 July 2022.

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

      Conditions of use / exclusion of liability
      © 2023 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis 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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