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 will soften the likely deterioration in the fiscal accounts, while the risk of a significant 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 is clouding Poland’s economic outlook, but the modest trade links, and the alternatives in replacing Russian energy commodity imports should limit the impact on the country. Elevated inflation and robust real economic growth will facilitate a decline in the debt-to-GDP ratio below 50% of GDP in 2023 from a peak of 57.1% recorded in 2020. However, Poland’s tight labour market could be conducive to higher and more persistent inflation leading to a further tightening in monetary policy, possibly slowing economic growth in the medium term. The banking system is expected to continue to increase provisions for the cost of legal risks on foreign exchange mortgages to cushion future losses.

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) on respect for the rule of law could ultimately result in significant lower EU funding for the country in the future. EU funds are an important driver of growth for Poland and the EC has not yet approved the Polish Recovery and Resilience Plan (PRRP). 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; (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 causing the public debt-to-GDP ratio to increase materially 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

EU Resources, Modest Trade Links and Strong Private Consumption Limit the Impact of the Russian Invasion

Over the last 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 takes the view that risks are limited of a significant cut in EU funds, which are expected to amount to an average of around 2.0% of GDP under the current Multiannual Financial Framework (MFF). The benefit Poland gains in terms of EU resources is an important factor supporting the likelihood of a compromise.

The economy was performing robustly before the outbreak of the conflict. After experiencing a modest GDP contraction of 2.2% in 2020, one of the lowest in the EU, economic activity rebounded by a solid 5.9% in 2021 thanks to a moderate share of services exposed to social distancing requirements and robust government support. The lifting of the pandemic-related restrictive measures enabled pent-up demand to drive the recovery with GDP already surpassing pre-COVID-19 levels in the second quarter of last year. Preliminary data also indicate that activity remained robust at the beginning of this year but there is a high degree of uncertainty surrounding the economic performance for the reminder of the year in light of the impact of the Russian invasion of Ukraine.

The country’s strong fundamentals, modest trade links and alternative energy infrastructures will cushion the economic consequence of the Russian military aggression in Ukraine. According to the government, growth will slow to 3.8% in 2022 and to 3.0% in 2023 compared with the previous forecast of 4.3% and 3.7% in 2022 and 2023, respectively. Notwithstanding high uncertainty, DBRS Morningstar expects the conflict to have a limited impact on the country and for growth perspectives to remain sound. Trade links with Russia and Ukraine are relatively small reflecting their shares in Poland’s total exports of just 2.8% and 2.2%, respectively while import shares are 0.6% and 1.5%. Furthermore, the coal and the likely oil embargo along with the stoppage of Russian gas supplies are expected to have a contained impact on volumes of energy, although energy price increases could intensify. Poland previously imported around 45% (around 10 million of cubic meters) of its total imports of gas from Russia in 2020 but the government had already planned not to renew contracts by end-2022. Alternative infrastructures, including a LNG terminal and the upcoming Baltic gas pipeline from Norway, coupled with a very high level of gas storage, mitigate against the risks.

Private consumption will remain the main driver of growth both this year and in 2023, which will benefit from the measures included in the Polish Deal such as lower taxation for low income earners and pensioners. DBRS Morningstar does not expect a cut in the EU cohesion funds while the PRRP resources, which are still pending approval, could boost economic activity. Nevertheless, high inflation 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, however, could be in part cushioned by the possible effect of a high number of Ukrainian refugees remaining in the country when the conflict ends. So far, around 3.5 million refugees crossed the border with Ukraine to Poland but it is too early to project the number of migrants that will settle in Poland. The impact on Poland’s potential growth will likely depend on labour participation as well as the degree of integration.

Tensions With the EC Regarding the Rule of Law Are Easing and A Compromise on the PRRP 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 3.8% during the 2004-21 period, one of the highest in the EU. This has supported GDP per capita convergence, which in purchasing power standards (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. The country will benefit from residual cohesion funds to be spent until 2023 from the past MFF (2014-2020) as well as an additional EUR 75 billion from the current MFF in the form of cohesion funds. 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.

In DBRS Morningstar’s view, Poland’s leading role in offering protection to a large flow of Ukrainian refugees temporarily eases tensions with the EC and contributes to a possible compromise on the approval of PRRP. Since 2015, Poland’s Law and Justice (PiS) party and the EU authorities have clashed, most notably the government’s reform of the justice system, which according to the EC raises serious concerns over 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 escalated last year 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) of EUR 1.0 million a day which the EC may withhold from EU funding to Poland. This situation is contributing to a delay in the approval of the PRRP. Even including another fine of EUR 500 million related to a dispute over a coal mine with the Czech Republic, the overall financial impact on EU funding is expected to be contained. At the moment, tensions with the EC seem eased but future progress might also depend on Poland’s parliamentary majority which comprises different positions on Poland’s justice system. In the meantime, the EC is expected to provide funding to Poland for offering protection to refugees. All in all, governance indicators are pretty weak in Poland and the current policymaking concerning the respect of the rule of law and state interventionism risk undermining Poland’s institutional independence. This supports a negative assessment of the “Political Environment” building block.

Strong Nominal Growth and Progress with Tax Compliance Mitigate Against Higher Fiscal Spending

Higher spending for refugees and defense coupled with the impact of the tax reform and more social spending complicate the improvement in the fiscal accounts in coming years when interest costs are rising. On the other hand, higher nominal growth if accompanied by further progress with tax compliance and a more prudent fiscal stance should avoid a prolonged deterioration in Poland’s fiscal position.

In 2021, the phase-out of some of the COVID-19 support programmes as well as a strong economic rebound enabled the budget deficit to fall to 1.9% of GDP from 6.9% recorded in 2020. This was materially lower than projected by the government and reflected both a significant fall in public expenditures and windfall revenues. While the COVID-19 related measures will be fully withdrawn, the cost to shelter refugees, the likely extension of the anti-inflation programme and further social benefits including the change in the tax system will significantly weigh on fiscal accounts this year. However, the government projects only a temporary deterioration in public finances. The budget deficit should increase to 4.3% of GDP in 2022 before gradually improving to 3.7% in 2023 and to 3.1% in 2024 in spite of the planned increase in military spending from 2.2% of GDP to 3.0% from next year. In DBRS Morningstar’s view, risks to a prolonged deterioration in public accounts are increasing as growth could slow down more than expected due to the conflict in Ukraine. Moreover, inflation might require further government support along with more spending on refugees, should the conflict persist with limited EU funding support to compensate the cost for migrants (See the commentary Ukraine Refugees: More EU Funding May Be Needed To Alleviate Hosts’ Future Fiscal Pressure https://www.dbrsmorningstar.com/research/395412/ukraine-refugees-more-eu-funding-may-be-needed-to-alleviate-hosts-future-fiscal-pressure). On the other hand, macro developments coupled with further improvements in tax compliance should mitigate against this risk.

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

After a steady decline in the public debt-to-GDP ratio pre-pandemic, the recession along with the sharp rise in the primary deficit led the public debt to peak to 57.1% of GDP in 2020 up from 45.6% in 2019. A significant economic rebound accompanied by a better than expected primary deficit enabled public debt to start to decline to 53.8% of GDP last year. Poland‘s robust nominal growth is expected to more than compensate for the increase in interest costs and the primary deficit, enabling the debt to decline further this year. Nevertheless, future debt ratio improvements might be more challenging. A slower reduction in the primary deficit when interest cost are rising could weigh on the debt-to-GDP ratio trajectory. The IMF projects public debt to continue to fall below 50% of GDP in 2023.

Interest costs are rising but debt affordability is expected to remain sound. After several years of a declining trend, funding costs are expected to rise to 1.7% this year from 1.1% in 2021 before stabilising at 2.1% of GDP from 2023, according to the government. This level remains only slightly higher than the average of 1.8% registered from 2011 and 2021 but risks are on the upside as inflation could be more persistent than expected bringing a rapid increase in yields. Despite the sizable share of debt at fixed rates the relatively low maturity at around 4.8-years as of April 2022 only partially softens the rise in the yields. The treasury funding capacity, however, is solid. It has already financed 66% of the State Budget borrowing needs at the end of April and benefits from a sizeable cash buffer of PLN 88 billion. The public debt profile has slightly improved as the share of the State Treasury debt denominated in foreign currency has declined to 22.0% in March 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.

Return to Current Account Deficit Should Not Derail The Improvement in External Debt Thanks to Sizeable EU Transfers

Poland’s external position is sound and it is underpinned by a high level of competitiveness of its exports, improving the Net Internal Investment position (NIIP), and a robust flow of foreign direct investment. Moreover, the economy benefits from a large amount of foreign exchange reserves and a flexible exchange rate, important external shock absorbers.

The current account returned to a deficit of 0.6% of GDP last year, from a pandemic-induced surplus of 2.9% in 2020, largely driven by high imports in volume boosted by the recovery in the domestic demand and higher energy prices. In parallel, exports were under pressure due to prolonged supply side disruptions while the primary balance deteriorated as the profitability of domiciled foreign companies recovered. The conflict in Ukraine has clouded the outlook for Polish exports largely due to less favorable external demand as well as the direct impact on trade with Russia and Ukraine. The IMF projects a deficit of 2.9% of GDP this year. 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 further disruptions in trade or a deterioration in foreign investors’ confidence. Moreover, the large flow of EU resources should reduce Poland’s external financing needs.

External debt is high but it has been on a declining trend since 2016. After a few quarters of growth, it fell to 56.3% as of December 2021, its lowest level since Q3 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 could continue. Poland benefits from an elevated level of foreign exchange reserves at around USD 131 billion in April 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 the downward pressure on the Zloty, and an escalation of tensions in Ukraine or with the EU might fuel capital outflows putting downward pressure on the currency.

Banks Provisions and Capital Are Important Shock Absorbers to Banks Losses Due To FX Legal Risk

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 cushioned by rising provisions and a high level of capitalisation. Following the decision by the Court of Justice of the European Union (CJEU) on the legacy exposure of mortgages indexed to Swiss francs in Autumn 2019, litigations have risen, leading exposed 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, while the guidance of the Supreme Polish Court in full formation is not expected any time soon. The banking sector continues to increase provisions, which account for around 28% of the total Swiss Francs mortgage portfolio as of December 2021 compared with 19% in June last year. In parallel, total provisions now are the same value as are the total loans subject to litigation (around 80,000). 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. The Polish banking system’s Tier 1 capital ratio of 17.25% as of December 2021 is an important buffer to absorb losses.

The resilience of the Polish economy along with the moderate size of those sectors more vulnerable to COVID-19 restrictions has not yet translated into a rise in the trend of the non-performing loan ratio but the cost of risk will likely rise in response to the slowdown of economic growth. Moreover, interest rates are rising rapidly and almost all mortgages are at variable rates. This makes borrowers that were granted loans during a low-interest rate period more vulnerable. DBRS Morningstar views risks to financial stability as contained as household indebtedness is low, wages will likely grow robustly while the borrower support programme implemented by the government should provide further help to shelter households from elevated mortgage installments due to high interest rates.

The spike in inflation since mid-2021 is not expected to undermine the credibility of the Polish monetary framework, but the risk of a wage-inflation spiral is increasing. This is because consumer price growth has already exceeded double digits since March with core inflation also surpassing 7.0% in April amid a tight labour market and sustained wage growth. Nevertheless, the National Bank of Poland (NBP) appears determined to stave off overheating. Since October 2021 it has raised the policy rate cumulatively by 5.15%, now at 5.25% as of May, phased out the asset purchase programme and intervened in the foreign exchange market to sustain the currency. According to the latest NBS projections, inflation should peak this year at 10.8% before declining to 9.0% and to 4.2% in 2023 and 2024, respectively. DBRS Morningstar views the risk of higher and more prolonged inflation than expected increasing and this may require further monetary policy tightening weighing on the country’s economic performance.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
Human Capital and Human Rights is among the key drivers behind this rating action. This factor has been taken into account within the Economic Structure and Performance Building Block. Despite progress with narrowing the EU income gap, IMF projects the country’s GDP per capita at around USD 18,500 in 2022, which is low compared with its European Union peers.

Governance (G) Factors
Institutional Strength, Governance, and Transparency is among the key drivers behind this rating action. This factor has been taken into account within the Fiscal Management and Policy and Political Environment Building Blocks. 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.

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.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/397442.

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

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 2022-2025 (September 2021) - State Treasury Debt (March 2022) – Public debt Q4 2021 (March 2022) – Convergence Report (May 2022) – State budget borrowing requirements’ financing plan and its background (May 2022), National Bank of Poland, National Bank of Poland - Inflation Report (March 2022), CSO (GSU), Eurostat, European Commission – Economic Forecast Spring 2022 – 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, UN High Commissioner for Refugees, WeltRisikoBericht, 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.

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/397440.

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: November 26, 2021

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