DBRS Morningstar Confirms Republic of Poland at “A”, Maintains 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 remains Stable.

KEY RATING CONSIDERATIONS

The trend confirmation reflects DBRS Morningstar’s view that risks to the ratings are balanced. Poland’s strong macroeconomic fundamentals should support fiscal account repair. Risks of a significant reduction in European Union (EU) funding over the medium term, although rising, remain contained in DBRS Morningstar’s view. Poland’s GDP exceeded pre-pandemic levels in the second quarter of this year and the economy is set to expand by more than 5.0% in 2021. Strong domestic demand will continue to support the 4.9% growth expected in 2022. A significant improvement in fiscal revenues, along with the withdrawal of pandemic support, will result in the deficit declining to 3.3% of GDP in 2021 and further to 1.8% in 2022 from 7.1% in 2020. This would facilitate a decline in the public debt-to-GDP ratio to below 50% in 2023 after the sizeable increase to 57.4% last year. However, COVID-19 new cases are increasing, likely prompting new restrictions which would weigh on growth. Moreover, Poland’s tight labour market could be conducive to higher inflation, possibly slowing growth in the medium term if real disposable income declines.

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, tensions with the European Commission (EC) have escalated again over recent months, in particular in relation to policies regarding judicial independence. This remains a concern in terms of respect for the rule of law in Poland and could ultimately result in lower EU funding for the country in the future. EU funds are an important driver of growth for Poland and the EC has not approved yet the Polish recovery and resilience plan. However, DBRS Morningstar anticipates that a compromise will be achieved.

RATING DRIVERS

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 further 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 economic growth hampering significantly the expected fiscal consolidation in the medium term; (2) an even more confrontational stance with EU authorities, leading to a significantly lower level of future EU funding.

RATING RATIONALE

Poland is Well Positioned for a Solid Growth Supported by Pent-Up Demand and EU Resources

Poland’s economic performance will continue to benefit from strong fundamentals and from the large flow of EU funds. In DBRS Morningstar’s view these funds will not be reduced significantly over the medium term despite the escalating tensions between the Polish government and the European authorities. After the mild GDP contraction of 2.5% in 2020, Poland will likely register a solid growth rate slightly above 5.0% in 2021 driven by sound private consumption growth and business investment. Compared to other countries, current supply side bottlenecks are not weighing materially on Polish manufacturing so far, as they are concentrated mainly in the automotive sector which weighs relatively little on the country’s industrial sector.

The easing of the restrictions since April 2021 as well as favorable labour market conditions have been supporting the unleashing of pent-up demand of private consumption. Poland’s real GDP exceeded the pre-Covid GDP level in June and Q3 GDP outturns point to an acceleration in economic activity. According to the National Bank of Poland (NBP), GDP should expand by 5.3% this year but COVID-19 infections have been rising in recent months and the risk of a reimposition of some restrictions is increasing for the remainder of the year. Nevertheless, in DBRS Morningstar’s view, these restrictions are likely to be more targeted geographically and their economic impact will likely be contained. The economy has showed a relatively greater resilience to the COVID-19 compared with the average of EU countries, reflecting a high capacity to adapt to restrictions.

Provided that the pandemic is under control both in Poland and its main trading partners, the country is expected to remain among the top economic performers in the EU in the next two years. GDP is projected to grow slightly below 5% both in 2022 and in 2023. Private consumption will be the main driver of growth in 2022, which will benefit from the measures included in the Polish Deal including lower taxation for low income earners and pensioners. DBRS Morningstar does not expect a cut in the EU cohesion funds while the Next Generation EU (NGEU) resources, which are still pending approval, could likely to start being spent from next year. Nevertheless, high inflation which stood at 6.8% in October, if more prolonged than anticipated might lead to an erosion of households’ purchasing power and in turn lower consumption. Poland is particularly exposed as the tight labour market is conducive to more intense second-round effects.

Looking at Poland’s long-term growth prospects, GDP potential growth might be negatively affected by regional disparities and adverse demographics, including the decline in the working-age population. This could make the labour market tighter, result in an elevated structural inflation, and put more pressure on public finances in the long term. Reforms included in the Polish Recovery and Resilience Plan are expected to mitigate this impact.

Tensions with the EC Escalated but A Compromise is the Likely Outcome

DBRS Morningstar assesses Poland’s membership of the EU positively, reflecting high integration in production value chains as well as the large amount of EU resources Poland receives. Since the country joined the union, EU resources have largely contributed to solid economic growth rates, with the annual real GDP growth rate averaging 3.7% during the 2004-20 period, one of the highest in the EU. This has supported GDP per capita convergence which in purchasing power standards (PPS) has increased from 50% to around 76% of the EU average in the same period. Poland is not only one of the largest beneficiaries of EU funds in terms of allocation but also has sound absorption rates compared with the EU average. Poland will benefit from the residual cohesion funds to be spent until 2023 from the past Multiannual Financial Framework (MFF) (2014-2020) as well as an additional EUR 75 billion from the current MFF. In addition, the Polish government also aims to use EUR 23.9 billion of grants and EUR 12.1 billion of loans from the Recovery and Resilience Facility (RRF) to increase public investment and make important reforms to foster the country’s competitiveness, improve digitalisation and the health sector, as well as for the green transition. Nevertheless, the EC has not yet approved the Polish recovery fund, but more progress could occur in 2022.

Since 2015, Poland’s Law and Justice (PIS) party and the EU authorities have clashed on many areas, most notably the government’s reform of the justice system, which according to the EC raises serious concerns over the respect for the rule of law, in particular judicial independence. This has led the EC to launch a series of infringement procedures against Poland including the procedure under Article 7(1) TEU which is still ongoing. Tensions have escalated in recent months following EC concerns regarding the activity of the Disciplinary Chamber of the Polish Supreme Court culminating with a financial penalty imposed by the European Court of Justice (CJEU). Meanwhile, the Polish Constitutional Tribunal has ruled that some EU treaty provisions are not compatible with the Polish constitution. This undermines the supremacy of EU law and in turn the CJEU competence of ruling over the Polish judicial system. In DBRS Morningstar’s view, this situation is contributing to delaying the approval of the Polish recovery plan and the risk of a broad suspension of EU funds is to some extent higher. DBRS Morningstar anticipates a compromise will be achieved (see “Poland: Tensions Are Rising But Funds Provide Motivation To Compromise with the European Commission” https://www.dbrsmorningstar.com/research/384466/poland-tensions-are-rising-but-funds-provide-motivation-to-compromise-with-the-european-commission), albeit both sides could test the limit of the negotiation. Nevertheless, the current policy making concerning the respect of the rule of law and state interventionism risk undermining Poland’s institutional independence and supports a negative assessment of the “Political Environment” building block.

Solid Nominal Growth Will Support the Improvement in the Headline Deficit

In response to the pandemic, the Polish government implemented a sizeable fiscal package which adversely affected the public accounts in 2020. However, as the economy returns to solid growth, the deficit is set to decline rapidly. The magnitude of the COVID-19 shock prompted the government to amend the stabilisation expenditure rule for 2020 in order to deliver a substantial package to support the economy. The combination of the increase in the state budget deficit, the COVID-19 Fund, and a non-returnable support from the Polish Development Fund, largely translated into the material rise in the general government deficit to 7.1% of GDP in 2020 from 0.7% in 2019. According to the EC, higher fiscal revenues and the gradual withdrawal of pandemic support on the back of the solid economic recovery, despite the one-off 14th pension payment amounting to 0.5% of GDP, will help deficit to decline this year to 3.3%.

With the Polish Deal entering into force in 2022 Poland’s government aims to provide an additional boost to the economy by rising healthcare expenditures, the personal income tax-free amount and the tax brackets, partially compensated by eliminating the possibility of deducting a part of the health insurance contribution from tax. As a result, personal income revenues will likely be negatively affected but strong economic growth and high inflation should continue to contribute to a decline in the deficit projected at 1.8% by the EC. At the end of November the government announced a series of measures included in an anti-inflation shield worth up PLN 10 billion (0.4% of GDP) to soften the impact of increasing electricity prices on households, which should translate into a slightly higher deficit than anticipated in 2022. On the other hand, macro developments should facilitate the improvement in the public accounts over the medium term but the structural deficit might end up being higher than expected. Moreover, despite the anti-inflation shield, the approved fiscal stimulus will likely contribute to a high inflation as the output gap in coming years is expected to be positive.

High Nominal Growth Rates Bode Well for the Decline in the Debt-to-GDP Ratio Over the Medium-Term

After a steady decline in the public debt-to-GDP ratio pre-pandemic, the economic recession brought about by the pandemic, along with the sharp rise in the primary deficit, translated into an increase of around 12 percentage points in the public debt ratio to 57.4% in 2020. Sound nominal growth along with moderate interest costs and an improving primary deficit will likely contribute to the decline in the public debt ratio below 50% in 2023.

Poland’s public debt affordability remains sound despite the large increase in the stock. The EC projects interest rate costs to remain very low, slightly above 1.0% of GDP in 2022 from 1.3% in 2020. Nevertheless, should inflation be higher than expected along with high global interest rates, interest costs will likely increase. The Treasury has already completed the funding of the State budget and the average time to maturity of the State debt has slightly increased to 4.88 years as of October 2021 from 4.63 years as of December 2020. The exchange rate and interest rate risks remain partially mitigated as 75.6% of State Treasury debt is denominated in local currency and 74.7% at fixed interest rates as of September 2021. The relatively high share of foreign investors in State Treasury debt at 33.5% makes Poland vulnerable to volatility which could increase should global inflation lead to higher global interest rates.

As Growth Normalises, the Current Account Surplus Is Expected to Moderate

Poland’s external position has improved in recent times 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. The sharp improvement in the current account surplus to 2.9% of GDP from 0.5% in 2019 is largely due to the significant fall in imports and low flow of income from foreign direct investments and will be followed by a gradual decline. The rise in commodity prices as well as the recovery in imports on the back of the recovery in demand will be conducive to a deterioration in Poland’s current account surplus, particularly in the balance of goods. The EC projects the surplus to decrease to 2.2% of GDP in 2022.

External debt is high but it has been on a declining trend since 2016. After a few quarters of growth last year it fell to 56.9% as of June 2021, its lowest level since Q4 2008. In light of the large flow of EU grants Poland is expected to receive, which should boost the capital account surplus, the declining trend in the external debt should continue. Despite the rising tensions with the EC capital outflows have remained contained but could intensify in case of a large increase in global interest rates. Poland benefits from an elevated level of foreign exchange reserves at USD 147.1 billion in October 2021, 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 capital outflows.

Uncertainty Over Legal Risk Remains Elevated While Provisions and Capital Mitigate Against Banking Sector Losses

The impact on Polish banks from costs stemming from the legal risk on foreign-exchange (FX) mortgages, albeit potentially material, will likely be gradual and mitigated by rising provisions and a high level of capitalisation. Following the CJEU’s decision on the legacy exposure of mortgages indexed to Swiss francs in Autumn 2019, litigations have risen, leading Polish banks to increase provisions for legal risks. The uncertainty is elevated and potential losses will depend on the number of litigations, the decision of local courts, and the guidance of the Supreme Polish Court. The Court has yet to take a final decision how to deal with the FX loans granted in the past that contain unfair terms, and its ruling has also been delayed due to disputes on the appointment of its judges. Nevertheless, the banking sector has begun to increase provisions, which account for around 19% of the total Swiss Francs mortgage portfolio as of June 2021. Total provisions now are almost the same value as are the total loans subject to litigation. Some banks have also started to offer out-of-court settlements that to some extent reduce uncertainty over time and appear to be less costly considering the current trend in the verdicts of local courts. The Polish Supreme Court is not expected to decide in the near term but an unfavourable decision could be challenging for the banking system, in particular for small and medium-size banks with large exposure to foreign exchange mortgages. This could translate into a lending standards tightening by those banks most affected. However, the overall impact on the system will likely be cushioned by provisions and a high level of capitalisation. DBRS Morningstar believes that the Polish banking system’s Tier 1 capital ratio of 18.29% as of June 2021 is an important buffer to absorb losses.

Polish banks are also well positioned to weather the impact of the consequences of the pandemic. This reflects the large increase in forward-looking provisions in 1H 2020 along with support provided by the government enabling the financial system to preserve its sound position. Moreover, non-financial corporations entered the pandemic with sound liquidity buffers and benefitted from the rapid support in the form of guaranteed loans, which were in part forgivable. So far, the nonperforming loan ratio has only marginally increased to 5.2% as of Q2 2021 from 4.8% pre-pandemic but once the government support measures are ultimately phased out, some worsening in credit quality is likely. Nevertheless, provisions for credit risks stemming from the pandemic have increased and in DBRS Morningstar’s view Polish banks are well positioned to absorb losses should the economy continue to register sound growth rates.

The spike in inflation over recent months is not expected to undermine the Polish monetary framework credibility, but risk of higher and prolonged inflation might require a faster than expected tightening. Following a first hike of 40 basis points from 0.1% in October, NBP again raised its reference rate to 1.25% in November to contain the substantial rise in inflation. Currently, the increase in consumer prices largely reflects temporary and external factors, including the rise in global energy and agricultural commodity prices, which are expected to moderate in coming months. Nevertheless, inflation might remain above the upper band (+/-1%) of the 2.5% target, requiring further and faster hikes, which could slower the recovery.

ESG CONSIDERATIONS

Human Capital and Human Rights (S) and Institutional Strength, Governance, and Transparency (G) were among the key drivers behind this rating action. Poland’s per capita GDP at around USD 17,300 in 2021 was low compared with the EU average. According to the latest World Bank Governance Indicators, Poland ranks in the 66.3 percentile for the Government effectiveness, in the 69.2 percentile for Rule of Law, in the 66.7 percentile for Voice and Accountability. The respect of the Rule of Law remains a concern and could affect future EU funding in the future. These factors have been taken into account within the following building blocks: Economic Structure and Performance, Fiscal Management and Policy, and Political Environment.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.

Notes:

All figures are in Polish zloty (PLN) 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 https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021) Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating Ministry of Finance, Ministry of Finance - The Public Finance Sector Debt Management Strategy in the years 2022-2025 (September 2021) - State Treasury Debt (September 2021) – Public debt Q2 2021 (September 2021) – Investor Presentation public finance Budget act 2022 (November 2021) – State budget borrowing requirements’ financing plan and its background (November 2021), National Bank of Poland, National Bank of Poland - Inflation Report (November 2021), CSO (GSU), Ministry of Development Funds and Regional Policy, Eurostat, European Commission – Economic Forecast Autumn 2021 – Breakdown of Cohesion Policy allocations per Member State – 2021 Rule of Law Report Country Chapter on the rule of law situation in Poland, European Central Bank (ECB), IMF, Polish Financial Supervision Authority, European Banking Authority (EBA), BIS, World Bank, Our World in Data, Ministry of Climate and Environment – Energy Policy of Poland until 2040 (February 2021), The Social Progress Imperative, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/388778.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
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: May 28, 2021

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