DBRS Confirms Republic of Latvia at A (low), Stable Trend

DBRS Ratings Limited has confirmed the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings at A (low) and its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trends on all ratings are Stable. The A (low) ratings are underpinned by Latvia’s consensus around stable macroeconomic policy-making, favourable economic conditions, judicious fiscal management, and low level of public debt.

The Stable trends reflect DBRS’s view that risks to the ratings are balanced. Latvia emerged from the global financial crisis with a more prudent fiscal framework and a stronger banking sector. Cyclical and structural improvements have helped narrow macroeconomic imbalances and strengthen the near-term economic outlook. The crisis, nonetheless, was economically painful and aggravated existing structural challenges that weigh on the ratings.

Latvia’s core credit strengths stem from a broad macroeconomic policy consensus and from membership of the EU and Euro area. The government has outperformed fiscal targets in recent years and the budget position was in balance last year. Authorities managed the severe demand shock from the global financial crisis with a comparatively moderate increase in public debt as a share of output. Moreover, 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. The country has also benefited from the ECB’s government bond purchasing and its Quantitative Easing programs.

The ratings are nevertheless constrained by structural credit challenges. These include its vulnerabilities to external shocks stemming from the country’s small and open economy, its still sizable foreign deposits in domestic banks, and its high degree of economic informality at roughly one-fifth of GDP. These challenges contribute to the slowing pace of EU income convergence. Income per capita in Latvia adjusted for purchasing power parity is still around two-thirds of the Euro area average.

Growth performance of the Latvian economy in 2017 has thus far been exceptional. After 2.1% growth in 2016, the economy expanded y/y by 4.0% and 5.8% in the second and third quarters, respectively. Robust external and domestic demand encourage the strong performance. Improving external conditions benefit exports, while the upturn in the EU financing cycle and a rebound from weak investment activity in 2016 are driving double-digit growth in investment. Furthermore, tightening labour markets and strong wage growth motivate the steady increase in household consumption. Inflation reached 2.7% in November 2017, and real wages increased by 3.9% y/y as of September 2017. Such robust wage performance is in part a catch-up following the large crisis-induced internal devaluation and is occurring in the context of a shrinking labour force from low birth rates and persistent emigration. DBRS expects the economy to grow each year by 3.5-4.0% through 2019.

Strong growth supports Latvia’s fiscal over-performance. Better than expected economic growth caused a more than 1 percentage point of GDP y/y increase in total revenues in the second quarter, resulting in a small fiscal surplus in the first half of 2017. Significant tax reform was passed in 2017 with the aim of improving tax administration and combating social challenges, including the informal economy and income inequality. The reform adjusts corporate income taxes – including a 0% corporate rate for reinvested profits until distribution when profits will be taxed at 20% – and makes the personal income tax more progressive. These measures are partially offset by the increases in excise duties and social contributions. The EC projects the reform to be moderately expansionary, with manageable deficits around 1.0% of GDP in 2018 and 2019. The commission’s 2018 structural deficit calculation of 1.8% of potential GDP, however, points to still unaddressed rises in medium-term public sector expenditures, most notably increases to social benefits, the public wage bill, and capital and defence spending.

Latvia’s public debt is on a declining trajectory and the Treasury has a favourable funding profile. General government gross debt increased to 40.6% of GDP last year, from 36.9% in 2015, largely due to a build-up in financial reserves and the pre-financing of a large 2017 debt redemption. The EC forecasts this ratio to decline below 36% by 2018. The IMF expects the ratio to decline to 27% by 2022. The favourable trajectory reflects strong fiscal discipline and low interest expenditure. The general government interest expenditure to GDP ratio is projected to decline from 1.3% in 2015 to below 1.0% this year. DBRS expects the government to continue to take advantage of high demand for its Eurobonds and low interest rates to prefund its redemptions in the coming years. Latvia issued its first 30-year bond in 2017 at low rates.

Despite broadly repaired stability indicators in Latvia’s segmented banking sector, credit growth has remained unusually slow. The banking sector is profitable and holds capital equal to more than one-fifth of risk-weighted assets. Non-performing loans as a share of total loans declined to 4.4% as of the second quarter 2017, down from the crisis peak that was near 20%. Years of private sector deleveraging has reduced household and corporate debt to pre-crisis levels. In spite of these favourable financial sector developments and a low interest rate environment, the cost of credit is comparatively high due to legacy risk aversion and market concentration. Consequently, credit growth is weak. Domestic lending, after emerging from negative growth in 2016, contracted by 3.7% y/y in the third quarter in large part due to structural changes in the banking sector. Excluding the one-off effects, loan growth would have been slightly positive.

With its small and open economy, Latvia is structurally vulnerable to external shocks via trade and financial channels. The pace of export growth by volume has slowed in the years between 2012 and 2016, due to weak European demand and some loss of competitiveness. Over this period, the effective exchange rate adjusted for rising unit labour costs strengthen by 16%. Moreover, foreign deposits in domestic banks still account for roughly two-fifths of total banking sector deposits, representing a persistent though well managed external vulnerability. Latvia remains a net debtor nation, illustrated by its -57% of GDP net international investment position.

However, recent external performance is encouraging. Export diversification has improved and demand from Europe has been strong. Exporters have been able to redirect products to new markets to substitute for the decline in trade with Russia. Export growth has been positive since mid-2016 and grew close to 10% in the first three quarters of 2017. The current account returned to surplus in 2016.

The political environment appears stable, despite frequent government turnover and lingering geopolitical tensions. Latvia has a long history since its 1991 independence of government reshuffling, but there is broad consensus around the European project and prudent fiscal management. The current three party coalition is expected to serve out its term prior to next year’s election. The opposition social democratic party, Harmony, which emerged as the largest party in the 2014 election, has led in opinion polls over the last year. Yet, it is likely they will remain in the opposition. Concerns in the Baltic region about Russian policy intensified following Russia’s annexation of Crimea in 2014. Roughly a third of the Latvian population are ethnic Russians. While geopolitical risks appear more tempered than in previous years, any escalation in tensions along the Russian border would adversely affect political stability and economic activity.

RATING DRIVERS

DBRS considers Latvia well-positioned in its current rating range. Measures that continue to reduce domestic economic vulnerabilities, strengthen the domestic banking sector, and improve income and productivity outcomes could place upward pressure on the ratings. Conversely, the ratings could face downward pressure if a severe external shock or failure to advance on key structural reforms causes material macroeconomic underperformance and deteriorates Latvia’s public debt dynamics.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the [A – BBB (high)] range. The main points discussed during the rating committee include Latvia’s economic performance, the labour market, tax reform, and the 2018 elections.

KEY INDICATORS

General Government Fiscal Balance (% GDP): 0.0% (2016); -0.9% (2017F); -1.0% (2018F)
General Government Gross Debt (% GDP): 40.6% (2016); 39.0% (2017F); 35.5% (2018F)
Nominal GDP (EUR billions): 24.9 (2016); 26.5 (2017F); 28.4 (2018F)
GDP per capita (EUR): 12,708 (2016); 13,657 (2017F); 14,656 (2018F)
Real GDP growth (%): 2.1% (2016); 4.2% (2017F); 3.5% (2018F)
Consumer Price Inflation (%): 0.1% (2016); 2.9% (2017F); 2.8% (2018F)
Domestic credit (% GDP): 88.6% (2016); 93.3% (Jun-2017)
Current Account (% GDP): 1.4% (2016); -1.4% (2017F); -1.6% (2018F)
International Investment Position (% GDP): -59.0% (2016); -56.7% (Jun-2017)
Gross External Debt (% GDP): 142.8% (2016); 138.1% (Sept-2017)
Governance Indicator (percentile rank): 78.8 (2016)
Human Development Index: 0.83 (2015)

Notes:

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development. Key indicator sources: Bank of Latvia, European Commission, Statistical office of the European Communities, International Monetary Fund, World Bank, United Nations Development Programme, Haver Analytics, DBRS.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

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, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

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 and US regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: June 30, 2017

DBRS Ratings Limited
20 Fenchurch Street
31st Floor
London
EC3M 3BY
United Kingdom
Registered in England and Wales: No. 7139960

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.