DBRS Assigns AA (low) Ratings to Republic of Estonia, Stable Trend

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

The AA (low) ratings are underpinned by Estonia’s stable macroeconomic policy-making and its exceptionally strong sovereign balance sheet. Credit strength also derives from membership in the European Union and the currency area. These strengths are offset by Estonia’s small economy and its sensitivity to external shocks. Furthermore, the slower pace of Estonia’s income convergence with the EU average is symptomatic of structural challenges that have slowed productivity growth.

Estonia has formidable strengths. Years of extraordinary fiscal discipline provided policymakers with a buffer to manage the crisis shock, while maintaining an exceptionally low level of public sector debt. Excluding the crisis-induced 2008-2009 deficits, public finances have been in balance or in surplus since 2002. Gross debt was 9.5% of GDP in 2016, offset by 5.6% of GDP in liquid savings. Furthermore, membership in the European Union and the Euro area are significant benefits. Estonia is a net recipient of EU investment funds, and the economy is supported by the free movement of goods and services offered by the single market.

The new coalition government is pursuing a less rigid fiscal stance. It has proposed spending and investment packages for the coming years, offset only in part by new revenue measures. Recent legislation would also ease the country’s stringent fiscal rule, whereby a structural balance would not be required each year, but rather be maintained over the medium-term. DBRS recognizes that new budget measures align with the government’s intention to make fiscal policy more flexible to support medium-term growth, while maintaining fiscal prudence.

With its small and open economy, Estonia’s economic performance is highly sensitive to external developments. After reaching double digit growth in years prior to the global financial crisis, the economy demonstrated its vulnerability with a sharp economic contraction in 2008-2009. More recently, growth slowed over the last two years due to a weak external environment and investment delays. DBRS expects growth in the range of 2-3% in the next two years, as wage growth keeps consumption strong, EU fund transfers and business investment recover, and economic activity among key trading partners improves.

Estonia’s comparatively low income level and its slow pace of EU income convergence illustrates the country’s productivity challenges. Output per capita adjusted for purchasing power parity was 36% of the EU average in 1996. It increased at a rapid pace to 70% by 2007. Following the steep fall in output during the crisis, the indicator gradually increased to 74% by 2012, equal to the 2016 result. Slower EU income convergence since the crisis is a symptom of weak productivity growth, which weighs on the economy’s output potential.

In spite of weak labor productivity growth, the cost of labor has increased at a rapid pace. From 2010 to the first quarter of this year, labor productivity measured by output per employed person increased by 7%. However, as wage growth outstripped productivity growth, unit labor costs increased by 26% over the same period. Wage growth has been significant due to labor shortages and several years of increases to the minimum wage. This divergence could adversely affect corporate profits and challenge overseas competitiveness.

RATING DRIVERS

The Stable trend reflects DBRS’s view that risks to the ratings are balanced. Measures that advance income per capita convergence with European partners – without excessive macro-imbalances – could warrant upward rating action. The ratings could face downward pressure if an external shock causes material underperformance of the economy and results in a structural deterioration of fiscal performance.

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 Ministry of Finance, Bank of Estonia, European Commission, European Central Bank, 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: Thomas Torgerson, Senior Vice President
Initial Rating Date: July 14, 2017
Last Rating Date: Not applicable as no last rating date.

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