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 confirmation reflects DBRS Morningstar’s view that Poland’s strong macroeconomic fundamentals mitigate against the risks arising from the unprecedented shock triggered by the Coronavirus Disease (COVID-19). Poland is expected to be among the European countries least economically affected by the coronavirus pandemic with a GDP contraction of 3.6% this year. The pandemic is not expected to have large long-lasting implications on Poland’s economic growth in the medium-term, but recent severe rise in infections led to the resumption of some restrictions which will likely translate into a negative carry over in 2021. The sizeable fiscal space because of the relatively low level of public debt prior to the pandemic has enabled Poland to weather the shock by implementing one of the largest fiscal stabilisation packages in Central and Eastern Europe. However, public debt will increase substantially this year to 56.6% of GDP from 45.7% in 2019 before broadly stabilising, according to European Commission (EC) forecasts.

Concerns over the approval of the next Multiannual Financial Framework (MFF) and Next Generation EU (NGEU) are rising because some member states, including Poland, are threatening the veto because opposing the conditionality mechanism linking the disbursement of EU funds and respect of the rule of law. DBRS Morningstar projects, however, that a compromise will eventually be achieved as the economic and social costs of not approving the EU package could be significant, albeit the risk of a delay is rising.

The ratings are supported by Poland’s track record of 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 EU. Despite these strengths, Poland’s ratings are constrained by what remains a relatively low GDP per capita level and unfavourable demographic trends. In addition, some frictions with the EC have emerged in particular after some adopted policies regarding judicial independence in Poland. This represents a concern for the respect of the rule of law and could ultimately result in lower EU funding for Poland in the future. EU funds have historically been an important driver of growth for the country.

RATING DRIVERS

As a result of the coronavirus 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) stronger than expected economic growth resulting in substantial convergence to the EU average GDP per capita level; (3) progress in implementing growth enhancing reforms accompanied by improvement in the institutional framework.

One or a combination of the following factors could lead to a downgrade: (1) a weaker than expected recovery hampering significantly the expected fiscal consolidation or a materialization of a large amount of contingent liabilities; (2) a less predictable policy framework possibly leading to a more confrontational stance with the EU authorities and subsequently to a significantly lower level of future EU funding.

RATING RATIONALE

The Risk of Losing EU Funds in the Future is Increasing but A Compromise is Expected

Benefitting from its EU membership, Poland has received a sizeable amount of EU resources mainly in the form of cohesion policy funds from MFFs. Accounting on average for around 1.8% of GDP since 2004, these funds have helped the Polish economy to be one of the top performers in Europe, with annual real GDP growth averaging 4.1% during the 2004-19 period. This has mirrored the GDP per capita convergence that in purchasing power terms has increased from 50% to around 73% of the EU average in the same period. In light of the current shock, although the economy is expected to return to solid growth, EU funds will likely remain an key element in providing further impulse not just with regard to the post-pandemic recovery but also to a reform agenda in digitalization and green transition through the NGEU programme.

However, the uncertainty over the agreement on the next MFF and on NGEU has increased, and Poland could end up receiving less funds than anticipated. Beyond the prospect of no agreement, which would entail an EU provisional budget, the clause linking the EU disbursements to the respect of the rule of law generates further uncertainty. Multiple changes implemented by the governing Law and Justice Party (PiS) to the judicial system have created frictions between the EC and the Polish government. In DBRS Morningstar’s view, some of the measures increase the risk of state interventionism and could weaken the independence of the judiciary. This weighed negatively on the Political Environment building block assessment.

Depending on the final mechanism to assess the respect of the rule of law and the subsequent potential sanctions, future EU resources could require the adoption of different policies from the government in Poland. After around EUR 77 billion of cohesions funds allocated to Poland in the current MFF (2014-2020), the country is projected to remain one of the largest beneficiaries from the next MFF (2021-2027) with around EUR 72 billion of cohesion resources. This represents an important incentive to achieve a compromise in light also of the around EUR 23 billion (in 2018 prices) of non-returnable aids from the NGEU. A recent survey conducted by the European Parliament in October points to about 72% of Polish citizens agreeing or tending to agree that EU funds should be disbursed conditionally upon the government’s implementation of the rule of law and democratic principles. Should Poland receive significantly less EU funding, this could weigh on the ratings.

Fiscal Space Has Enabled the Government to Put in Place A Large Support Package

After two years of very low budget deficits, averaging around 0.5% of GDP, the magnitude of the current economic shock has prompted the government to deliver a sizeable stabilisation package including liquidity support 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 Poland’s debt sustainability.

A government amendment to the expenditure rule will lead to a significant rise in the deficit this year before a gradual decline starting from 2021 as the economic situation normalises. The government’s support package comprises a set of discretionary measures amounting to around 5% of GDP along with up to PLN 100 billion of grants and loans provided by the Polish Development Fund (PFR). Using the PFR is expected to 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, about 1.8% of GDP (as a support from PFR programme treated as non-returnable – grant or subsidy) has been recorded as expenditure of the general government sector and included in the general government deficit. The government expects the fiscal deficit to be 11.8% of GDP in 2020 before declining to 6.0% in 2021. A second set of distancing measures put in place since October have led to the government extending some support policies but these are more selective and are targeting the most affected sectors. However, they will put additional pressure on fiscal accounts. In DBRS Morningstar’s view, Poland has space for larger deficits in the near term, but a weaker-than-expected economic recovery could pose risks. Weak growth could lower the government’s appetite for reducing the structural deficit in the medium term. In recent years (prior to the pandemic), cyclical conditions rather than structural measures have led to the improvement in the deficit.

Lower Activity In the Last Quarter of 2020 Will Weigh on 2021 But Poland’s Growth Fundamentals Remain Sound

Current stringent measures will inevitably weigh on economic activity for the remainder of the year and if extended will likely pose some downside risk to a swift recovery in the first part of 2021. Since September, a second wave of infections related to the coronavirus disease has led the government to reimpose some restrictions to contain its spread and hospital saturation. Recently the number of new cases has begun to decline following the implementation of new confinement measures aimed at specific sectors of the economy in late October. This has paved the way to the lifting of some restrictions ahead of Christmas. However, the scenario of a further rise in cases and subsequent mobility limitations remain a possibility in coming months before authorities can achieve widespread distribution of vaccines.

Polish GDP rebounded by 7.9% quarter-on-quarter in Q3 (seasonal adjusted). This left real GDP only 1.8% lower than that registered in the last quarter of 2019, and provided some reassurance on the high degree of resilience of the Polish economy. High frequency indicators are pointing to new activity contraction in the final part of 2020. Nevertheless, Poland is expected to be among the least affected country in the EU by the economic consequences of the pandemic this year. This mainly reflects lower reliance on tourism and services sectors compared with other most affected EU economies, and stronger export demand coupled with the large fiscal package. The EC projects a GDP fall of 3.6% in Poland which compares well with a contraction of around 7.4% projected for the Union. A rebound of 3.3% is projected in 2021, but risks are tilted to downside depending on the evolution of the pandemic that could result in an extension of the limitations in the first part of 2021.

As the situation improves with the availability and distribution of a vaccine, DBRS Morningstar expects the Polish economy to remain among the top growth performers in the EU. The country has shown itself to be resilient and benefiting from solid domestic demand that should mitigate the risk from a prolonged period of uncertainty, which hampers consumption and investment. Despite the large drop in GDP, Poland’s unemployment rate has increased only modestly to 6.1% of the workforce in October from 5.2% in December 2019, as firms were able to keep employment and benefit from government support measures.

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, because of 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 labour participation, which is constrained by a quickly 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. The EC projects debt to rise to 56.6% of GDP in 2020 from 45.7% last year. DBRS Morningstar takes the view that Poland’s prudent fiscal framework should mitigate against a further deterioration in public finances because Poland’s constitution limits the public debt-to-GDP ratio (measured with the national definition) to 60% of GDP. Moreover, sound economic growth will likely resume, contributing to the stabilisation and then a reduction in the debt-ratio in the medium term. Conversely, should the economic recovery be weaker than expected, contingent liabilities could materialise, contributing to further deterioration of Poland’s public finances.

Poland’s public debt profile is benefiting from low interest rate costs which further declined as a result of the asset purchase programme implemented by the National Bank of Poland (NBP). Although the average time to maturity of the State Treasury debt has slightly declined over the last few months to 4.71 years as of October 2020 compared with 4.97 as of December 2019, the Treasury has already completed the funding programme for 2020 and has started to pre-finance 2021. Exchange rate and interest rate risks remain partially mitigated as 76.1% of State Treasury debt is denominated in local currency and 76.7% at fixed interest rates as of September 2020. While the relatively high share of foreign investors in State Treasury debt of 34.0% makes Poland vulnerable to bouts of volatility in risk-off environments, the well diversified investor base somewhat reduces that risk.

As the Economy Rebounds, Current Account Surplus Expected to Moderate

Poland’s external position has improved in 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 continued 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 centres along with an improvement in goods exports have contributed to Poland’s current account deficit shifting into a surplus of 0.5% of GDP last year, after an average deficit of around 1.0% since 2013.

In recent months, the fall in domestic demand has translated into a sharp reduction in imports of goods, greater than the decline in exports despite a weaker external demand from Poland’s major trading partners. Together with an improvement in the primary income balance because of a lower flow of income on direct investment, the current account surplus substantially increased to 3.0% of GDP in Q3 2020 as average over the last four quarters. This positive momentum is expected to be temporary. As the economy rebounds next year, the EC projects the surplus to gradually decline to more moderate levels of around 1.5% of GDP.

External debt is high at 58.2% of GDP as of Q2 2020 but has declined from a Q4 2016 peak of 76.3%. Risks are largely offset by the elevated level of foreign exchange reserves at USD 127.6 billion in October 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 Polish economy 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 NBP has implemented several accommodative monetary policy measures. The cut in its policy interest rate and in the reserve ratio was accompanied by repo operations to provide liquidity and a secondary market asset purchase programme. Although the scale of purchases has moderated recently as of September 2020, the NBP has bought around 5.0% of GDP of Polish Treasury securities and eligible assets guaranteed by the State Treasury, contributing to lower sovereign interest costs and boosting market liquidity. NBP also offered bill discount credit aimed at refinancing loans granted to enterprises by banks. 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, is now moderating. Preliminary estimate from the Central Statistical office (CSO) points to a consumer prince inflation drop to 3.0% in November from the peak of 4.7% registered in February and expectations are pointing to a further reduction.

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. Along with higher provisions for litigation risks, profitability is expected to be constrained. In DBRS Morningstar’s view, authorities’ support has been large, and this is expected to continue in order to preserve the sound position of the Polish financial sector. A slower than expected recovery, however, might intensify the risk of a reduction of credit should banking system’s perception of borrower riskiness increase as a result of a deterioration in credit quality. Moreover, the legal consequences of last year’s ruling by the European Court of Justice on the legacy exposure of mortgages indexed in Swiss francs still represents a source of uncertainty and banks have started to increase provisions. Loans subject to court cases are around 10% of total active portfolio but some ongoing litigations involve also loans that are already off banks’ balance sheets. This has brought banks to increase provisions to PNL 3 billion according to the NBP. Against this background, the Polish banking system’s Tier 1 capital ratio of 16.7% as of June 2020 is an important buffer to absorb losses.

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 low compared with the EU average at around $15,600 in 2019. According to World Bank Governance Indicators 2019, Poland ranks in the 66th percentile for Rule of Law and in the 71st percentile for Voice and Accountability. The respect of the Rule of Law remains a concern and could affect future EU funding. 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/370928.

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

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 principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020)

The sources of information used for this rating include Ministry of Finance, Ministry of Finance (Monthly bulletin on Treasury Securities supply and its background, November 2020, State Treasury Debt September 2020), National Bank of Poland, National Bank of Poland (Financial Stability June 2020, Inflation Report November 2020), CSO (GSU), Ministry of Development Funds and Regional Policy, Eurostat, European Commission (Economic Forecast Autumn 2020, AMECO), EBRD (Regional Economic Prospects September 2020), ECB, IMF, BIS, 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/370927

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: 11 December, 2015
Last Rating Date: 5 June, 2020

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