DBRS Assigns A (low) Ratings to Republic of Latvia, Stable Trend

DBRS Ratings Limited has assigned long-term foreign and local currency issuer ratings of A (low) and short-term foreign and local currency issuer ratings of R-1 (low) to the Republic of Latvia. The trend on all ratings is Stable.

The A (low) ratings are underpinned by Latvia’s consensus around stable macroeconomic policy-making, its judicious fiscal management, and low level of public debt. The country emerged from the global financial crisis with a more prudent fiscal framework and a stronger banking sector. Latvia also benefits from membership in the European Union (EU) and Euro area. The crisis, nonetheless, was economically painful and aggravated existing structural challenges that constrain the ratings. These include a labor force still below pre-crisis levels and a high degree of economic informality. Both contribute to the slowing pace of EU income convergence.

Latvia’s near-term economic outlook is positive. After 2.7% expansion in 2015, the economy decelerated to 2.0% last year primarily due to weak investment dynamics. Investment has been weighed by disbursement delays from European Union investment funds. However, the upturn in the EU financings cycle and gradually improving credit conditions are expected to strengthen fixed capital formation. Further, tight labor markets and strong wage growth should maintain durable levels of domestic consumption. The European Commission (EC) forecasts economic expansion of 3.2% and 3.5% over the next two years.

Latvia’s prudent fiscal framework and its low levels of debt reflect the country’s consensus around stable macroeconomic policymaking. The government outperformed fiscal targets in recent years and the headline deficit was in balance last year. The deficit is set to deteriorate in general and structural terms over the forecast period due to tax cuts, higher social spending, and increased defense spending. Absent new measures, the EC views that Latvia could breach the provisions of the Stability and Growth pact by 2018. At 40% of GDP, government debt increased last year due to large prefunding of 2017 Eurobond redemptions. Funding costs are low and even with wider deficit projections, debt to GDP is expected to decline over the forecast period.

Membership of the European Union and the Euro area are significant benefits. Latvia is a net recipient of EU investment funds, and it is supported by the free movement of goods and services offered by the single market. Latvia has also benefited from the ECB’s government bond purchasing and its Quantitative Easing programs, which help reduce bond yields and the cost of servicing debt. Earlier this year, the Treasury issued its first 30-year bond, for which it had high demand and a low 2.330% yield.

However, income per capita in Latvia is roughly 60% of the average EU income level and the pace of income convergence has slowed from the pre-crisis trend. Slower convergence is a symptom of structural economic challenges that weigh on productivity growth. Adverse demographics from low birth rates and persistent emigration have kept the labor force below pre-crisis levels. Moreover, the informal economy is pervasive, measured around one-fifth of GDP. Informality narrows the tax base, obstructs efficient resource allocation, and exacerbates social inequities.

With its small and open economy, Latvia is structurally vulnerable to external shocks. The wide economic imbalances that built-up during the pre-crisis period have been repaired, as evident by Latvia’s 2016 current account surplus. Yet, the weak global environment and some strengthening of the effective exchange rate have slowed the pace of export growth. Furthermore, Latvia remains a net debtor nation, as illustrated by its -58% of GDP net international investment position. It is worth mentioning that export diversification is improving.

Sizable foreign deposits in domestic banks is a persistent, though well managed, external vulnerability. The Latvian financial system consists of two banking segments. The bulk of domestic lending is provided by Nordic bank subsidiaries in Latvia. Conversely, domestic banks rely on foreign deposits and focus on the wealth management of external clients. Though in decline, foreign deposits still amount to roughly 40% of the all bank deposits and a large share of the economy’s external debt. Moreover, certain foreign deposits of domestic banks are covered by a state deposit guarantee scheme and thus represent a contingent liability to the government. Authorities mitigate against risks associated with domestic banks with tighter capital and liquidity requirements.

RATING DRIVERS

The Stable trend reflects DBRS’s view that risks to the ratings are balanced. Measures that reduce some of the domestic economic vulnerabilities and strengthen income per capita convergence with European partners – without the recurrence of large macro-imbalances – could warrant upward rating action. Conversely, the ratings could face downward pressure if Latvia’s public debt dynamics significantly deteriorate, due to material underperformance of the economy, fiscal slippage, or deterioration of external finances.

Notes:
All figures are in EUR unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales. These can be found on www.dbrs.com at: http://www.dbrs.com/about/methodologies

The sources of information used for this rating include Republic of Latvia Ministry of Finance, Statistical Bureau Latvia, Bank of Latvia, European Commission, Statistical Office of the European Communities, International Monetary Fund, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is the first DBRS rating on this financial instrument.

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

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS 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 twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS 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.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Jason Graffam, Vice President
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer
Initial Rating Date: June 30, 2017
Last Rating Date: Not applicable as no last rating date.

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