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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Poland’s (Poland) Long-Term Foreign and Local Currency – Issuer Ratings at “A”. At the same time, DBRS Morningstar confirmed 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 and historical underspending will likely soften the expected deterioration in the fiscal accounts, while the risk of a significant and prolonged reduction in European Union (EU) funding over the medium term remains contained, in DBRS Morningstar’s view. The impact of the Russian invasion of Ukraine on Poland’s economy has been contained so far reflecting modest trade links, a strong labour market and alternative sources of gas. Economic activity will slow down, but only moderately in the near term, dampened mainly by weaker external demand and squeezed real incomes. A gradual economic rebound supported by a strong labour market should soften the expected increase in the debt ratio to the still relatively low level of around 55.0% of GDP in 2024 from the projected 51.7% of GDP this year, according to the government. The banking system is expected to continue to increase reserves for the cost of legal risks on foreign-exchange mortgages to cushion future losses as litigations rise.

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 membership of 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) regarding the rule of law could ultimately result in significantly lower EU funding for the country in the future. EU funds are an important driver of growth for Poland, and despite the European Council’s endorsement of the Polish Recovery and Resilience Plan (PRRP), still further measures from the Polish government seem necessary to unlock the funds. Moreover, recent statements from the EC do not bode well for reimbursements from the new cohesion funds. However, DBRS Morningstar anticipates that a compromise solution 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; or (3) progress in implementing growth-enhancing reforms accompanied by improvements in the institutional framework.

One or a combination of the following factors could lead to a downgrade: (1) a weaker-than-expected economic growth together with a prolonged rise in expenditure causing the public debt-to-GDP ratio to increase materially in the medium term, or (2) an even more confrontational stance with EU authorities, leading to a significantly and prolonged lower level of future EU funding.

RATING RATIONALE

Modest Trade Links, Alternative Suppliers of Commodities, and Strong Domestic Demand Contain the Impact of the Russian Invasion

Over the past two decades, the Polish economy has demonstrated a remarkable resilience benefitting from a high degree of diversification, a large flow of EU funds, and a favourable labour market. This has translated into a relatively low volatility in economic performance and a steady improvement in the level of GDP per capita. Despite the tensions with the EC, DBRS Morningstar believes the risk of a significant and prolonged cut in EU funds remains limited; the funds are expected to amount to an average of 1.8% of GDP under the current Multiannual Financial Framework (MFF). The benefit Poland gains in terms of EU resources along with its role in providing assistance to a large flow of Ukrainian migrants estimated at 1.0-1.3 million, support the likelihood of a compromise.

Because of modest trade links, the direct economic impact of the conflict in Ukraine, despite its proximity, has been contained so far. Nevertheless, weaker external demand, high commodity price inflation and lower business confidence will be a drag on growth, particularly at the beginning of 2023. The latter would also reflect the tightening in financing conditions as a result of the aggressive monetary policy of the Polish central bank (Narodowy Bank Polski, NBP). According to the EC, after robust growth of 4.0% this year, Poland’s economic activity is set to weaken to 0.7% next year before rebounding by 2.6% in 2024. DBRS Morningstar views strong local public investment, continued fiscal support, and the tight labour market, including the impact of a sizeable amount of Ukrainian refugees working in the country, as supportive factors for growth. The recent missile hitting Poland is further contributing to increased tensions, but as long as this is an isolated event it is unlikely to risk crisis escalation.

Despite the uncertainty, the risk of a significant and prolonged cut in EU cohesion policy funds remains contained and PRRP resources are still likely to be disbursed boosting economic activity. Nevertheless, the Polish development fund is pre-financing the grants amount of the PRRP which will likely soften the impact of the economic slowdown in the near-term. On the other hand, longer-than-anticipated high inflation might lead to both a higher-than-expected erosion of households’ purchasing power and in turn lower consumption, as well as more tightening and lower business investment.

Poland appears well equipped to withstand the current energy shock benefitting from the diversified supply. Despite not receiving Russian gas since April, the country has been able to replace it using other sources, including higher imports through the LNG terminal of Swinoujscie. The risk of a gas shortage is mitigated by an almost full gas storage level and the new Baltic gas pipeline becoming operational at the end of September. After deciding to embargo Russian coal exports to Poland, the government aims to also stop imports of Russian oil starting in 2023 by replacing it with imports from other countries.

EC Requests Regarding the Rule of Law Require Additional Government Measures but a Compromise on the PRRP Remains the Most 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 3.8% during the 2004–21 period, one of the highest in the EU. This has supported GDP per capita convergence, which in purchasing power standards has increased to around 76% of the EU average from 50% in the same period. Poland is not only one of the largest beneficiaries of EU funds in terms of allocation, but it also has sound absorption rates compared with the EU average. The country will benefit from residual structural funds to be spent until 2023 from the past MFF (2014–2020) as well as an additional EUR 75,5 billion from the current MFF in the form of policy cohesion funds. In addition, the Polish government also aims to use EUR 22.5 billion of grants and EUR 11.5 billion of loans from the Recovery and Resilience Facility (RRF) to increase public investment and make important reforms to foster the country’s competitiveness, by improving digitalization, the health sector, and the green transition.

Poland’s governance indicators are weaker than EU peers on average, and the current policymaking concerning the respect of the rule of law and state interventionism risk is undermining Poland’s institutional independence. This does not bode well for the institutional environment in Poland and for the EC’s perception of the state of play, which is contributing to a delay in RRF disbursements as well as to a possible stoppage of reimbursements of new MFF cohesion funds. This supports a negative assessment of the Political Environment Building Block. In DBRS Morningstar’s view, despite the tensions between both sides, there is still appetite to find a compromise reflecting the strong importance of EU funds for Poland’s economic growth, as well as its role in supporting Ukrainian refugees. In DBRS Morningstar’s view, RRF could be postponed until after the next parliamentary elections expected in autumn next year.

Public Finances Will Deteriorate Requiring a More Conservative Fiscal Strategy in the Medium Term

Further energy-related support, higher spending for defense and refugees coupled with the impact of the tax reform will worsen the fiscal trajectory when sovereign interest costs are rising. The headline deficit is set to deteriorate significantly to 4.8% of GDP this year from 1.8% in 2021, and to further increase to 5.5% next year, according to the EC. On top of the impact of the Polish deal, which came into effect this year and envisages a reduction of the tax burden on lower incomes, the government has implemented an anti-inflation shield comprising a reduction in value-added tax for certain goods. Further subsidies, aids to refugees, a freeze on the electricity bills for households and some businesses up to a certain level of consumption, and the decision to increase military spending from 2.2% of GDP this year to 3.0% of GDP in 2023 will further contribute to the widening in the fiscal deficit next year, before it declines to 5.2% of GDP in 2024. This does not bode well for fiscal accounts and would require the government’s commitment to a more prudent fiscal strategy in the medium term.

Risks to a further increase in expenditures are related to possible pre-electoral spending and to a continuation in fiscal support to counteract the impact of high energy costs amid increasing sovereign funding costs. On the other hand, historical spending underperformance compared with planned expenditures and an improvement in fiscal revenues thanks also to strong nominal growth is expected to soften a persistent deterioration in the accounts. DBRS Morningstar will monitor the evolution in the fiscal accounts including the structural deficit, which is set to remain above 4.0% of GDP in the next two years, according to the EC.

A Relatively Low, Although Increasing, Level of Public Debt and Sound Affordability Bode Well for the Ratings

Poland’s ratings benefit from a relatively low public debt ratio, which is expected to remain below 60% of GDP in the medium term. Robust economic activity and the phasing out of COVID-19-related support will likely enable the debt ratio to decline to 51.7% of GDP this year compared with the peak of 57.1% during the pandemic in 2020, but this will be temporary. Lower nominal growth, a less conservative fiscal strategy, and higher interest costs will likely bring the debt ratio to around 55.0% of GDP in 2024, according to the government. Although, at this level, the country’s vulnerability to adverse shocks remains contained and Poland will continue to benefit from a sound fiscal space. A stabilisation in the debt ratio would require a more prudent fiscal policy in the years to come. Risk of a more significant upward trajectory remain elevated, particularly in the near term, should the government opt for additional fiscal support as elections are approaching.

The rapid increase in yields is not expected to significantly worsen debt affordability. Moreover, the Treasury enjoys a sizeable amount of liquid assets, which mitigate the risk from large borrowing needs. According to the government, interest costs on the State Treasury debt are likely to stabilise at around 2.0% of GDP compared with about 0.9% estimated on average in 2021 and 2022. Nevertheless, risks are increasing as inflation could be more persistent than expected, causing a further rise in yields. This is also because despite the sizeable share of debt at fixed rates, the relatively low maturity at around 4.8 years as of October 2022 only partially softens the rise in yields. The Treasury’s funding capacity, however, is solid. The State Treasury’s borrowing needs were already funded in August and its liquid assets of PLN 128 billion (4.2% of GDP) as of October are sound. The public debt profile has also improved as the share of the State Treasury debt denominated in foreign currencies has declined to 22.8% in August 2022, from 35.5% in 2014. This makes the debt less sensitive to a currency devaluation. Moreover, while non-resident investors hold a considerable share of public debt, these include mostly institutional investors, which tend to be less sensitive to volatility shifts.

EU Funds and Net Foreign Direct Investment (FDI) Will Continue to Fund the Deficit in the Current Account, While External Debt Is Set to Decline

Poland’s external position is good, and it is underpinned by a high level of competitiveness of its exports, improving its net international investment position, and a robust flow of EU funds and net foreign direct investments which will finance the current account deficits. Moreover, the economy benefits from a large amount of foreign-exchange reserves and a flexible exchange rate, important external shock absorbers.

The worsening in the terms of trade, along with large imports of commodities, are factors weighing on Poland’s trade balance, but this is expected to be temporary. The sharp decline in trade with Russia has been partially absorbed by the significant increase in exports to Ukraine. Nevertheless, the deficit in the current account will likely deteriorate to 4.0% of GDP this year from a deficit of 1.4% in 2021 and will only gradually narrow in the medium term to 2.5% in 2024, according to the EC. This also reflects the worsening in the primary income position because of high income of foreign direct investors in Poland. DBRS Morningstar projects the large flow of EU funds and net FDI to continue to finance Poland’s current account deficits. Over the medium term, DBRS Morningstar views positively Poland’s high degree of integration in EU value chains, which along with a flexible currency, should help cushion the impact of potential further disruptions in trade or a deterioration in foreign investors’ confidence.

External debt is high, but it has been declining and the large amount of foreign exchange reserves along with low reliance on portfolio investments mitigate the risks of an external shock. After peaking at 76.5% of GDP at the end of 2016, Poland’s external debt ratio has broadly persistently declined to around 55% of GDP as of June 2022, close to 2008 levels, reflecting strong nominal growth and a decline in the government external debt. In light of the large flow of EU grants Poland is expected to receive, which should boost the capital account surplus, the decline in external debt could continue. Moreover, Poland benefits from an elevated level of foreign-exchange reserves at around USD 133 billion in October 2022 (19% of GDP) and a high share of foreign direct investment, including inter-company debts. This makes the Polish economy more resilient to capital outflows. Nevertheless, the Russian invasion has intensified downward pressure on the zloty, and an escalation of tensions in Ukraine or with the EU might fuel capital outflows, putting further downward pressure on the currency.

Bank Provisions and Capital Are Important Shock Absorbers to Bank Losses Because of Foreign-Exchange Legal Risk

The aggregate impact on Polish banks from costs stemming from the legal risk on foreign-exchange mortgages, albeit potentially material, will likely be gradual and cushioned by bank reserves and a high level of capitalisation. Nevertheless, the uncertainty remains elevated, and potential losses will continue to depend on the number of litigations, the decision of local courts, as well as rulings from both the Court of Justice of the EU and the Polish Supreme Court. In the meantime, the banking sector continues to increase its reserves, which are estimated to account for around 40% of the remaining Swiss franc-denominated mortgage portfolio (net of provisions equivalent to 3% of total banking assets) compared with 19% in June last year. In parallel, the number of loans subject to litigation are estimated to amount to more than 100,000 compared with over 80.000 as end of 2021. 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. Legal rulings are expected to take time, and the overall impact on the system will likely be cushioned by provisions and a high level of capitalisation, albeit some medium-size banks that are more exposed to foreign-exchange mortgages might be more vulnerable.

DBRS Morningstar views risks to financial stability stemming from the housing market as contained. Households indebtedness is low, wages will likely grow robustly, and the borrower support fund—along with the mortgage holiday payment programme implemented by the government—should provide further help to shelter borrowers from elevated mortgage instalments because of high interest rates. This is particularly important as 90% of the stock of mortgages is at variable rates, meaning borrowers who received loans during a low-interest rate period are more vulnerable. The rise in yields has also affected banks’ capital position as around 23% of total assets are government or guaranteed government securities, with only 40% accounted at amortized costs. Nevertheless, the Polish banking system’s Tier 1 capital ratio of 16.9% as of June 2022 remains elevated and is an important buffer to absorb losses.

The spike in inflation since mid-2021 is prompting a significant tightening in monetary policy, which will weigh on business investment and lending demand. Between October 2021 and September 2022, the NBP has hiked the reference rate to 6.75% from 0.1%, but inflation continues to remain robust at 17.9% as of October, reflecting mostly higher commodity and food prices. The latest NBP’s decisions to hold the tightening cycle in the latest two months, does not change DBRS Morningstar’s views that the central bank is still determined to stave off overheating, although it will take more time. According to the latest central bank projections, inflation should peak this year at 14.5% before declining to 13.1% and 5.9% in 2023 and 2024, respectively.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The human capital and human rights factor affects the ratings. Despite progress with narrowing the EU income gap, the country’s GDP per capita at around USD 19,000 in 2022 remains well below the EU average, according to the International Monetary Fund (IMF). DBRS Morningstar considers this factor significant and has taken it into account within the Economic Structure and Performance Building Block.

Governance (G) Factors
The institutional strength, governance, and transparency factor affects the ratings. This factor reflects a weaker institutional profile including the respect of the rule of law, which could weigh significantly on the EU funding. According to World Bank’s latest Worldwide Governance Indicators, Poland ranks in the 63.5 percentile for Government Effectiveness, in the 65.4 percentile for Rule of Law, and in the 63.8 percentile for Voice and Accountability. DBRS Morningstar considers this factor significant and has taken it into account within the Fiscal Management and Policy and Political Environment Building Blocks. At the same time, DBRS Morningstar views the bribery, corruption, and political risks factor as relevant to the ratings, also reflecting a weaker score in the control of corruption compared with the EU average.

There were no environmental factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/405736.

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/401817/global-methodology-for-rating-sovereign-governments (29 August 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022) in its consideration of ESG factors.

The sources of information used for this rating include Ministry of Finance, Ministry of Finance – The Public Finance Sector Debt Management Strategy in the years 2023-2026 (September 2022) – State Treasury Debt August (October 2022) – Public debt Q2 2022 (September 2022) – State budget borrowing requirements’ financing plan and its background (November 2022), National Bank of Poland, National Bank of Poland – Inflation Report (November 2022), CSO (GSU), Eurostat, European Commission – Economic Forecast Autumn 2022 (November 2022) – 2022 Rule of Law Report Country Chapter on the rule of law situation in Poland (July 2022), European Central Bank (ECB), IMF, Polish Financial Supervision Authority, Bank for International Settlements, World Bank, 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: YES
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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/405737.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Carlo Capuano, Senior 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 27, 2022

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