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Rating Action:

Moody's changes Czech Republic's outlook to negative from stable, affirms Aa3 ratings

05 Aug 2022

Frankfurt am Main, August 05, 2022 -- Moody's Investors Service ("Moody's") has today changed the outlook on the Government of the Czech Republic to negative from stable. Concurrently, Moody's has affirmed the long-term issuer and senior unsecured debt ratings at Aa3. The Czech Republic's senior unsecured MTN programme rating of (P)Aa3 and the other short-term rating of (P)P-1 have also been affirmed.

The decision to change the outlook on the Czech Republic to negative from stable reflects the increased risk of the materialization of prolonged, severe gas supply disruptions from Russia which could lead to rationing and push the country's economy in a deep recession with negative implications for trend growth and a material weakening of fiscal metrics.

The affirmation of the Aa3 ratings reflects the Czech Republic's fundamental credit strengths - including the country's competitive economy, a strong institutional set-up and favorable fiscal metrics - and moderate exposure to event risks.

The Czech Republic's local and foreign currency country ceilings remain unchanged at Aaa. The three-notch gap to the sovereign rating is supported by the limited government footprint in the economy, the high degree of reliability and predictability of government actions, as well as low political risk. In addition, the very high capital account openness and moderate external indebtedness inform the zero notch gap between local currency and foreign currency ceiling. These ceilings typically act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country.

RATINGS RATIONALE

RATIONALE FOR CHANGING THE OUTLOOK TO NEGATIVE FROM STABLE

The decision to change the outlook on the Czech Republic to negative is the increased risk of a materialization of a prolonged, severe gas supply disruption from Russia amid Czech Republic's high dependency on gas supplies from Russia in combination with limited substitution possibilities in the near term. Russia materially reduced gas supply to the European Union (EU, Aaa stable) in recent weeks, and several EU countries experienced either complete shutoffs or significantly curtailed supply from Russia in early July.

A prolonged, severe gas supply disruption from Russia would have a material negative impact on the Czech Republic's trend growth and fiscal metrics and therefore on Moody's assessment of economic and fiscal strength putting pressure on the country's Aa3 ratings. Moody's estimates trend growth of the Czech Republic amounting to an average 1.9% over 2017-2026 and that a materialization of a severe gas supply disruption scenario could lower trend growth by 1.0-1.5 percentage points.

Moody's already revised its GDP growth forecast to 2.3% for 2022 and to 1.0% for 2023 compared to Moody's earlier expectation of 3.5% and 3.2% as of 9 February 2022, respectively, before the beginning of the military conflict between Russia and Ukraine (Caa3 negative). The pre-pandemic GDP level will probably be reached in 2022 again which is later compared to the majority of EU countries as 17 out of 27 EU countries already reached their pre-pandemic levels in 2021.

The main drivers for lowering GDP growth forecasts for the Czech Republic are soaring energy costs and uncertainty on energy supply from Russia weighing on business investments, higher than initially expected consumer price inflation that is denting private consumption, ongoing global supply-chain frictions and a continuous weakening of the growth outlook in Czech Republic's main trading partners, in particular Germany (Aaa stable). Moody's economic and fiscal outlook for the Czech Republic for 2022 and 2023 is highly uncertain because of the ongoing Russia-Ukraine military conflict as well as energy supply disruptions from Russia.

In particular, there are substantial risks to Moody's economic and fiscal forecasts in the event of a complete shutoff of gas flows from Russia, given the high dependency on gas imports from Russia as well as current lack of access to LNG terminals and the country's large industry sector. The industry sector of the Czech Republic accounted for 25.2% of GDP in 2021 which is above the EU-wide average of 17.8%.[1]

In the event of a prolonged, complete cutoff of natural gas supply in the near term, the Czech Republic would face the risk of rationing of gas across the board which would push the country's economy in a deep recession. That said, the country's sizeable gas storage capacity would provide some buffer for the near term, which were filled by 79% accounting for 38% of annual consumption, being above the EU level of gas storage being filled by 71% accounting for 19% of consumption on 2 August 2022.[2] Adequate gas for the heating needs of households and usage in critical infrastructure would likely be prioritized under a rationing plan leaving the industry sector in a vulnerable position. In a scenario of severe gas supply disruptions from Russia, external demand will also be materially lower because most other EU countries would be also in a recession.

Moreover, the policy actions on the national level and on the EU level on reducing the dependency on gas imports from Russia will be crucial, but it will take time to replace the majority of Russian gas imports with alternate sources, given limited capacity among OPEC and non-OPEC producers and liquefaction capacity as well as limits placed by existing energy infrastructure. On the supply side, Czech authorities in cooperation with the majority state-owned CEZ, a.s. (Baa1 stable) secured capacities for potential supply of 3bcm of gas (or about one-third of gas supply from Russia) through a floating LNG terminal in Eemshaven in the Netherlands (Aaa stable), which is planned to be operational in September 2022, and the required transport capacity.[3] Negotiations with LNG suppliers are ongoing, and the plan of the Czech authorities is to secure as much LNG as possible, including imports through terminals in other EU countries.

RATIONALE FOR AFFIRMING THE RATINGS AT Aa3

The rating affirmation takes into account the Czech Republic's fundamental credit strengths including the country's competitive economy, a strong institutional set-up and government balance sheet, and moderate exposure to event risks.

The affirmation of the Aa3 ratings also reflects Czech Republic's ongoing reform and investment projects in the context of the country's National Recovery and Resilience Plan (NRRP).[4] The NRRP was adopted by the Council on 8 September 2021 and €915 million (0.4% of GDP) or 13% of the total amount of grants were disbursed to the Czech Republic on 28 September 2021. The operational agreement between the Czech Republic and the European Commission was signed on 4 July 2022.[5] The Czech Republic's national RRP relies on almost CZK200 billion (about €7.8 billion, or 3.3% of GDP) provided mainly in the form of grants (€7.0 billion or 3.0% of GDP) from the EU's Recovery and Resilience Facility (RRF) and national sources. The plan has six main pillars: 46% of the overall RRF grants will be spent on infrastructure and green transition; 23% on education and the labour market; 15% on digital transformation; 7% on healthcare; 5% on research and development (R&D) and innovation; and 4% on improving the efficiency of public administration and on business support.

More generally, the Czech Republic's economic strength results from its medium-sized economy, high GDP per-capita and trend growth of 1.9% over 2017-2026 being in line with the Aa3-rated median. The Czech Republic's per-capita income in purchasing power terms was 85% of the EU weighted average in 2021, a significant improvement from 66% in 1995. That said, longer-term structural challenges relate to the economy's heavy reliance on the automotive sector, which accounts for 5% of gross value added in 2021 being the highest level in the EU and faces significant structural changes, and uncertainties about the country's ability to foster productivity growth and move up the value chain to more innovation-driven growth.[6]

Moreover, a strong institutional set-up supports the credit profile of the Czech Republic and is in line with the Aa3-rated median because of the overall high quality of institutions and policy effectiveness in the country. The government's balance sheet and debt affordability metrics are strong, too. The debt-to-GDP ratio of 41.9% of GDP in 2021 is high compared to the Aa3-rated median of 32.2% of GDP, but low compared to the debt-to-GDP levels of rating peers Belgium (Aa3 stable) and the United Kingdom (Aa3 stable) with levels of above 100%. [7]

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

The Czech Republic's ESG Credit Impact Score is neutral-to-low (CIS-2), reflecting low exposure to environmental and social risks, and a very strong governance profile that supports the capacity to respond to shocks.

Its overall E issuer profile score is neutral to low (E-2), reflecting low exposure to environmental risks across all categories.

Moody's assesses its S issuer profile score as neutral to low (S-2), reflecting low exposure to social risks across most categories. Demographic change in the form of relatively fast population ageing poses a long-term fiscal sustainability challenge to the Czech Republic and entails a moderately negative social risk. Without further pension and healthcare reforms the very strong government balance sheet could deteriorate significantly from the mid-2030s. While overall unemployment rates are low, persistent skills mismatches could lead to rising challenges for new entrants to the labor market and labor and income considerations therefore pose a moderately negative social risk as well.

The Czech Republic's very strong institutions and governance profile support its rating, and this is captured by a positive G issuer profile score (G-1). The country has an overall strong institutional framework (despite some concerns about the control of corruption). Czech Republic also benefits from independent and high-quality monetary policy, and fiscal policy formulation and implementation are overall prudent and transparent. Coupled with high wealth levels and strong government financial position, this supports a high degree of resilience, mitigating further already low E and S risks.

GDP per capita (PPP basis, US$): 43,837 (2021 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 3.5% (2021 Actual) (also known as GDP Growth)

Inflation Rate (HICP, % change Dec/Dec): 5.4% (2021 Actual)

Gen. Gov. Financial Balance/GDP: -5.9% (2021 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -0.8% (2021 Actual) (also known as External Balance)

External debt/GDP: 73.2% (2021 Actual)

Economic resiliency: a1

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 03 August 2022, a rating committee was called to discuss the rating of the Czech Republic, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutions and governance strength, have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer's susceptibility to event risks has not materially changed.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

WHAT COULD CHANGE THE RATINGS UP

The negative outlook signals that the rating is unlikely to be upgraded in the near time. However, the outlook would likely be returned to stable if energy supply tensions were to abate materially reducing the risk for prolonged, severe disruption of gas supply from Russia. Policy actions on the national level and on the EU level that would successfully reduce the Czech Republic's exposure to gas supply from Russia via substitution of gas, securing alternative supply sources and/or lowering demand, would also be credit positive. Finally, evidence that the energy cuts do not lead to permanent negative effects on Czech Republic's economic and fiscal metrics would be credit positive, too.

WHAT COULD CHANGE THE RATINGS DOWN

Czech Republic's rating could be downgraded in case of a materialization of a prolonged, significant cut off from Russian gas that would result in a material negative impact on Czech Republic's trend growth and at the same time significantly weaken fiscal metrics and therefore lower the country's economic and fiscal strength. No or only very limited progress on the diversification away from Russian gas imports over the next one to two years would weigh on Moody's assessment of institutions and government strength. In addition, a significant rise in the event risk exposure would also be credit negative. While a rather remote scenario in Moody's view, an escalation of the Russia-Ukraine military conflict into a war involving NATO members would exert very significant downward rating pressure.

The principal methodology used in these ratings was Sovereign Ratings Methodology published in November 2019 and available at https://ratings.moodys.com/api/rmc-documents/63168. Alternatively, please see the Rating Methodologies page on https://ratings.moodys.com for a copy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

REGULATORY DISCLOSURES

For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found on https://ratings.moodys.com/rating-definitions.

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the issuer/deal page for the respective issuer on https://ratings.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.

These ratings are solicited. Please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website https://ratings.moodys.com.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at https://ratings.moodys.com/documents/PBC_1288235.

The Global Scale Credit Rating on this Credit Rating Announcement was issued by one of Moody's affiliates outside the UK and is endorsed by Moody's Investors Service Limited, One Canada Square, Canary Wharf, London E14 5FA under the law applicable to credit rating agencies in the UK. Further information on the UK endorsement status and on the Moody's office that issued the credit rating is available on https://ratings.moodys.com.

REFERENCES/CITATIONS

[1] Eurostat 29-Jul-2022

[2] AGSI+, https://agsi.gie.eu/ 29-Jul-2022

[3] Ministry of Industry and Trade, https://www.mpo.cz/en/guidepost/for-the-media/press-releases/following-the-acquisition-of-the-share-in-the-lng-terminal--the-czechia-also-secured-the-necessary-transport-capacity--it-covers-up-to-a-third-of-the---268734/ 29-Jul-2022

[4] Národní plán obnovy, https://www.planobnovycr.cz/, 29-Jul-2022

[5] European Commission, Recovery and Resilience Scoreboard, https://ec.europa.eu/economy_finance/recovery-and-resilience-scoreboard/index.html, 29-Jul-2022

[6] Eurostat 29-Jul-2022

[7] Ministry of Finance of the Czech Republic 29-Jul-2022

Please see https://ratings.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the issuer/deal page on https://ratings.moodys.com for additional regulatory disclosures for each credit rating.

Heiko Peters
Vice President - Senior Analyst
Sovereign Risk Group
Moody's Deutschland GmbH
An der Welle 5
Frankfurt am Main, 60322
Germany
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Alejandro Olivo
MD-Sovereign/Sub Sovereign
Sovereign Risk Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's Deutschland GmbH
An der Welle 5
Frankfurt am Main, 60322
Germany
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
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