DBRS Morningstar Confirms Republic of Poland at “A”, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Poland’s Long-Term Foreign and Local Currency – Issuer Ratings at “A”. At the same time, DBRS Morningstar confirmed the Republic of Poland’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The Trend confirmations reflect DBRS Morningstar’s view that Poland’s past track record of strong macroeconomic performance mitigates against the risks arising from the unprecedented shock triggered by the Coronavirus Disease (COVID-19). The government’s sizeable budgetary support package is expected to alleviate the adverse impact of the pandemic’s consequences on the private sector, and the economy’s GDP is projected to rebound from the second half of 2020. A timely recovery is likely to reduce risks that could have emerged from a more long-lasting economic loss bringing subsequent an adverse impact on the debt sustainability. Poland is expected to be among the European countries least economically affected by COVID-19 with a GDP contraction of 4.3% forecast for this year. However, it will come at a cost of a significant deterioration in the fiscal deficit leading to an increase in the public debt ratio to around 58.5% of GDP in 2020 from 46.0% of GDP in 2019.

The ratings are supported by Poland’s recent strong macroeconomic performance, a relatively low public debt-to-GDP ratio, a sound monetary policy framework, a flexible exchange rate regime, and its integration within the European Union (EU). Despite these strengths, Poland’s ratings are constrained by a still relatively low GDP per capita level and unfavorable demographic trends. In addition, DBRS Morningstar is also monitoring Poland’s relations with the European Commission (EC) in the context of the Rule of Law recommendations that could affect the country’s future EU funding. EU funds have historically been an important driver of growth for Poland.

RATING DRIVERS

Due to the current pandemic upward pressure on the ratings is unlikely, but one or a combination of the following factors could lead to an upgrade: (1) fiscal consolidation leading to a significant reduction in the structural deficit and in the public debt-to-GDP ratio in the medium-term; (2) a stronger than expected economic rebound resulting in substantial convergence to the EU average GDP per capita level; (3) progress in implementing growth enhancing reforms accompanied by an improvement in the institutional framework and in respect of the Rule of Law.

One or a combination of the following factors could lead to a downgrade: (1) a weaker than expected recovery leading to a further deterioration in the fiscal metrics resulting in a higher than expected public debt-to-GDP ratio in the medium-term; (2) a less predictable policy framework possibly leading to a more confrontational stance with the EU authorities.
RATING RATIONALE

A Large Fiscal Package is Projected to Ease the Consequences of the Lockdown

After two years of very low budget deficits, the magnitude of the current economic shock has prompted the government to unleash a sizeable fiscal support package to stabilize the economy and to provide liquidity to the private sector. The deterioration in fiscal accounts will be unprecedented, but if temporary and followed by a prudent fiscal policy in conjunction with the recovery, it will not fundamentally alter the public debt profile of Poland. However, DBRS Morningstar is of the view that the consequences of the pandemic along with the high uncertainty about the timing and extent of the recovery cloud Poland’s government fiscal outlook. This weighed negatively on the qualitative “Fiscal Management and Policy” building block assessment.

According to the EC, the budget deficit is expected to widen to 9.5% of GDP from 0.7% in 2019, before declining to 3.8% next year. This reflects the combination of measures introduced prior to the crisis, lower revenues mainly because of the recession and higher spending to counteract the negative shock on the economy. The government’s fiscal package comprises both a set of discretionary measures including wage subsidies, household income support, postponement or cancellation of social insurance contributions, higher spending on healthcare, guarantees and through the Polish Development Fund (PFR) a supplement of a PLN 100 billion (4.5% of GDP) of grant loans, guarantees and sureties to Micro-enterprises, SMEs and Large Corporates. Using the PFR could allow the government to not exceed the 55% ratio of debt-to-GDP (in the national definition) threshold that would trigger fiscal consolidation measures according to the debt rule. Nevertheless, up to 60 percent of the financing could be retained by the enterprises as non-refundable, increasing the fiscal deficit, according to the EC, by 2.75% of GDP in 2020. In DBRS Morningstar’s view, although additional measures are likely to be implemented, and the government has already announced a temporary suspension of the expenditure rule, the main risks to fiscal balance stem from a weaker recovery. This could lower the government’s appetite for reducing the structural deficit in the medium-term - cyclical conditions rather than structural measures have led to the improvement in the deficit in recent years.

The Ratings Benefit From a Robust Economic Position

Since mid-March, the government has introduced several containment measures including closure of schools, travel restrictions, cancellation of public events and domestic lockdown of all non-essential business activities. This has helped to contain the number of infections and deaths to around 25,000 and 1,100, respectively, but at a cost of materially lower economic activity. A gradual resumption of activity has started since the end of April, but private consumption will likely be constrained by social distancing measures and the deterioration in the labour market. The mild recession of -0.4% q/q in Q1, will likely be followed by a sharp contraction in Q2. The EC projects a GDP decline of 4.3% for the whole year, less harsh than the EU average of 7.4%, before rebounding to 4.1% in 2021. However, there is a considerable level of uncertainty, and risks are tilted to the downside.

Sectors most vulnerable to social distancing measures include micro firms which represent around 41% of total employment. These are mainly self-employed individuals in the service sector without permanent contracts. The transport, hospitality, art and culture sectors will likely suffer the most and the recovery is expected to be uneven. The government support package aims to mitigate the impact of the pandemic on the labour market, but total employment may contract visibly in the second quarter. The unemployment rate has increased to 5.8% in April from 5.4% in March, but some delays in laying off people could not reflect yet the magnitude of the shock at this stage.

Nevertheless, DBRS Morningstar is of the view that sound economic fundamentals will help the economy weather the shock and mitigate against the risk of a prolonged loss in growth potential. Poland has shown resilience to economic shocks in the past and it was one of the top economic performers in Europe, with annual real GDP growth averaging 4.1% during the 2004-19 period. The country benefits from an important contribution to domestic demand from GDP per capita dynamics which in purchasing power terms increased from 50% to around 72% of the EU average over the same period. This dynamic is expected to remain supportive despite lower wage growth in the near term because of a weaker labour market. If not hampered by a resurgence of stringent measures in response to a second wave of the virus, risks of a long-lasting impact on growth appear modest. Moreover, the economy will continue to benefit in the medium term from the sizable allocation of EU funds also after the end of the current Multiannual Financial Framework (2014-2020) because of the N+3 years spending rule.

Looking at Poland’s long-term growth prospects, regional disparities, adverse demographics and the decline in the working-age population could weigh on the country’s potential growth. At the same time, due to the important contribution of immigrant workers from Eastern Europe, potential migration outflows might have a negative impact on Poland’s GDP potential. This means that additional structural reforms may be needed to sustain labor participation which is constrained by a fast ageing population and the relatively low statutory retirement age.

The Risk of An Additional Rise in Public Debt is Limited by A Prudent Fiscal Framework and Likely Sound Recovery

After a steady decline in the public debt-to-GDP ratio in recent years, the economic effect of the pandemic along with the sharp rise in the fiscal deficit will result in a significant increase in the public debt ratio to 58.5% of GDP in 2020 from 46.0% last year. DBRS Morningstar takes the view that Poland’s prudent fiscal framework should mitigate against a further deterioration in public finances. Poland’s constitution limits the public debt-to-GDP ratio (measured with the national definition) to 60% of GDP. Moreover, sound economic recovery will likely resume, contributing to the stabilization and then a reduction in the debt-ratio in the medium-term.

Poland’s public debt profile is benefiting from the low interest rate environment, and the State budget borrowing requirements for 2020 according to the Budget Act are fully funded as of end of April 2020. The average time to maturity of the State treasury debt has remained stable at around five years over the last three years. Exchange rate and interest rate risks are partially mitigated as 72.7% of State Treasury debt is denominated in local currency and 76.1% at fixed interest rates as of March 2020. While the relatively high share of foreign investors in State Treasury debt of 39.3% makes Poland vulnerable to bouts of volatility in risk-off environments, the well-diversified investor base somewhat reduces that risk.

Weaker External Demand Weighs on Exports, but Recession Will Limit the Imbalance in the Current Account

Poland’s external position has improved over the past years and benefits from a high level of competitiveness, reflected in a growing export market share of goods and services and declining external debt as a share of GDP. Like its East European counterparts, Poland benefits from its integration into the regional supply chain and manufactures a diverse range of high value-added components for machinery and transport equipment, electronics, and other sectors. Service exports related to the development of business processing centers along with an improvement in goods exports, has contributed to Poland’s current account deficit narrowing to 0.3% of GDP over the last four years from annual average deficits of about 5.0% during 2004-2012.

The decline in oil prices along with shrinking domestic demand reducing imports is expected to mitigate against the impact of weaker external demand from Poland’s major trading partners on exports. The EC projects a marginal improvement in the current account surplus to 0.6% of GDP in 2020 compared with 0.5% last year, but the uncertainty over the disruption in the global value chains along with lower transport services demand risks could put negative pressure on the current account, shifting the surplus to a small deficit in DBRS Morningstar’s view. The net flow of Foreign Direct Investment (FDI) is expected to decline due to the global downturn, but Poland’s flexible exchange rate regime is an important tool to cushion the external shock and to contain the growth of external imbalances.

External debt is high, but it has been declining at 58.3% of GDP at end-2019 from 74.9% in Q1 2016. Risks are largely offset by the elevated level of foreign exchange reserves at USD 118.5 billion in May 2020, up from USD 89.4 billion at the end of 2015, and a high share of foreign direct investment including inter-company debts. This makes the system more resilient to potential capital outflows.

The Monetary Framework is Strong but Banking Profitability Will be Hampered by the Consequences of the Shock

Poland’s ratings are also supported by the credibility of its monetary policy framework and its solid institutions. In response to the pandemic, the National Bank of Poland (NBP) has implemented several accommodative monetary policy measures. The most important include a cut by an overall 140bps its policy interest rate, repo operations to provide liquidity and a cut in the required reserve ratio from 3.5% to 0.5%. In parallel, the NBP launched a secondary market asset purchase program of Polish Treasury securities and eligible assets guaranteed by the State Treasury. These monetary policy measures should improve liquidity in the banking system and reduce deflationary risks. Inflation, after hovering above the upper bound of the target (2.5% y/y +/- 1 percentage point) in the first months of 2020, mainly due to higher tariffs and unprocessed food price increases, now is moderating. According to preliminary figures, consumer prices fell to 2.9% in May from the peak of 4.7% registered in February and reduced domestic demand, underpinned by the deterioration in the labour market amongst other factors, could place additional negative pressure on inflation.

The banking sector remains stable and liquid, but Polish banks will likely face rising costs of risk and non-performing loans as a consequence of the pandemic. In DBRS Morningstar’s view, depending on the speed of the recovery as well as the response of the authorities, the sound position of the Polish financial sector should mitigate against the risk stemming from the pandemic. The private sector has a low level of indebtedness with both household and non-financial corporations accounting for around 119% of GDP compared with the Euro area average level of 165% at the end of 2019. At the same time, the legal consequences of the European Court of Justice’s ruling on the specific case of the legacy exposure on mortgages indexed in Swiss francs of last year, represent an uncertainty. However, depending on the Polish courts’ verdicts and the number of legal claims, profitability is expected to be negatively impacted, although over time. Against this background, the Polish banking system Tier 1 capital ratio of 16.0% as of December 2019 is an important buffer to absorb losses. Moreover, the current funding structure of banks adds stability to the system due to its reliance on household deposits rather than market funding.

Uncertainty Remains in Poland’s Relations with the EU Regarding the Rule of Law

Disputes between the Polish government and the EC over the respect of the Rule of Law are expected to persist, but will unlikely weaken Poland’s commitment to the EU. Over the last four years, the governing Law and Justice Party (PiS)’s recurrent changes to the judicial system have prompted the EC to trigger Article 7 of the Treaty of the EU along with a series of infringement procedures against Poland for allegedly undermining judicial independence. DBRS Morningstar is of the view that the Polish government will not assume an overly confrontational stance against the EU authorities, although the tensions will continue. However, the government’s stance concerning the respect of the rule of law and state interventionism risk undermining Poland’s institutional independence. This weighed negatively on the qualitative “Political Environment” building block assessment. Poland’s presidential election, originally scheduled for May 10, was not held due to concerns around the ongoing pandemic. On June 4, the government motioned and passed a confidence vote in the lower house (Sejm) with the aim to strengthen its position ahead of the upcoming vote, which the lower house has rescheduled for the end of June. The incumbent president Mr Duda leads in the polls.

DBRS Morningstar continues to monitor negotiations over the 2021-27 EU Budget, also known as the MFF as well as the EC proposal for the post-pandemic recovery called Next generation EU. This could have important implications for Poland in particular if EU funds’ disburse is linked to respect of the rule of law.

ESG CONSIDERATIONS
Human Capital and Human Rights (S) and Institutional Strength, Governance and Transparency (G) were among key drivers behind this rating action. Poland’s GDP per capita is relatively low compared with the EU average at around $15,000 in 2019. According to World Bank Governance Indicators 2018, Poland ranks in the 67th percentile for Rule of Law and in the 72th percentile for Voice and Accountability. These factors have been taken into account within the following building blocks: Economic Structure and Performance and Political Environment.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/362114.

Notes:
All figures are in Polish Zloty unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (17 September 2019): https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Ministry of Finance, Ministry of Finance (Convergence Programme April 2020), Ministry of Finance (State Treasury debt March 2020 newsletter), National Bank of Poland, National Bank of Poland (Financial Stability December 2019), CSO (GSU), Eurostat, European Commission, EBRD (Regional Economic Prospects May 2020), ECB, IMF WEO (October 2019 and April 2020), IMF BOP, BIS, IFS, EBA, IMF Fiscal Monitor (April 2020), World Bank, UNDP, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/362110.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: December 11, 2015
Last Rating Date: December 6, 2019
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