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

DBRS Ratings Limited confirmed the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings at A (low) and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trends on all ratings are Stable.

KEY RATING CONSIDERATIONS

The ratings are underpinned by Latvia’s consensus around stable macroeconomic policy-making, including judicious fiscal management and a low level of public debt, and institutional benefits from membership in the European Union (EU) and the Euro area. The ratings are nevertheless constrained by structural credit challenges. These include vulnerabilities to external shocks from the country’s small and open economy, the lower income level compared to Euro area partners, and the financial sector risks stemming from the non-resident deposit (NRD) banking sector.

Credit risk associated with the closure of ABLV Bank AS (ABLV) earlier this year appears limited. As Latvia’s largest NRD bank, ABLV announced liquidation in March 2018 following allegations of money laundering and corruption. The event does not appear to have adversely affected the strong performance of Latvia’s economy, nor did it result in a fiscal cost to the government. Notwithstanding some reputational damage to the Latvian financial system, the episode will likely accelerate the decline of the NRD banking sector – a positive development in DBRS’s view.

RATING DRIVERS

DBRS considers Latvia well-positioned in its current rating range. Improved income and productivity outcomes that further converge Latvia’s income level with its European partners, combined with ongoing fiscal discipline, could place upward pressure on the ratings. Continued efforts to strengthen Latvia’s financial system and reduce domestic economic vulnerabilities are also credit positive.

Conversely, the ratings could face downward pressure if Latvia’s public debt dynamics deteriorate in a marked manner. This could result from a severe external shock that causes material macroeconomic underperformance or a reversal of the Latvian authorities’ prudent fiscal management.

RATING RATIONALE

ABLV Liquidation Accelerates Decline in Non-Resident Deposits, Strengthening Financial and External Sectors

The fallout to the Latvian banking sector from the ABLV event was contained and appears to have accelerated the decline in bank deposits from non-resident serving banks. As of April 2018, NRDs shrank to €5.5 billion (31% of total deposits), down from €6.9 billion (36% of the total) in February 2018 and €12.4 billion (53% of the total) in 2015. DBRS foresees further downsizing of the NRD banking sector due to the authorities’ drive for rapid change to the NRD bank business model away from high-risk transactions. Aggressive unwinding of the NRD sector can occur rapidly and without systemic financial stress, as non-resident serving banks tend to have highly liquid balance sheets. ABLV depositors are planned to be compensated by the sale of ABLV assets, with no notable economic spillover or public draw-down from the deposit insurance fund.

Notwithstanding some reputational damage, the domestic financial market is disconnected from banks servicing foreign clients. NRD banks account for only 12% of total domestic lending. The bulk of domestic financial services are delivered by stable Scandinavian bank subsidiaries. The banking sector is profitable and holds capital equal to more than one-fifth of risk-weighted assets. Loans 90 days overdue as a share of total loans declined to 4.1% as of 2017, down from the crisis peak that was near 20%. Despite 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. Domestic lending contracted by 2.8% in 2017 in large part due to structural changes in the banking sector. Excluding one-off effects, loan growth would have been slightly positive.

The shrinking of NRDs can reduce external risks. Much of Latvia’s high external debt, at 141% of GDP in 2017, can be attributed to the still high level of NRDs in the system. Vulnerabilities to sudden out-flows associated with high external debt are in part offset by higher liquidity and capital requirements among NRD banks. However, external risks from Latvia’s small and open economy are more difficult to mitigate. Latvia’s export performance and its economy are inescapably linked to the economic performance of key eurozone trade partners. With a modest current account deficit and a manageable international investment position, DBRS sees no evidence of a build-up in external imbalances.

Strong 2017 Growth Momentum Expected to Moderately Slow Over the Next Few Years

Growth performance of the Latvian economy in 2017 was exceptional. After average 2.4% growth from 2014-2016, the economy expanded by 4.5% last year. Robust domestic and external demand encouraged the strong 2017 performance. Favourable external conditions increased export volumes by 4.8%, while the increase in private sector investment activity and absorption of EU structural funds drove double-digit investment growth. Furthermore, tightening labour markets and strong wage growth motivated the steady increase in household consumption. At 7.9%, gross nominal wage growth outpaced the 2.9% inflation rate in 2017. Such robust wage performance is in part a catch-up following the large crisis-induced internal devaluation. It is also occurring in the context of a shrinking labour force from low birth rates and emigration, and a higher minimum wage.

DBRS expects the economy to decelerate slightly in the coming years. EU-funded projects will continue to support investment, though at a less impressive rate than in 2017. Likewise, private consumption may likely moderate as employment growth slows and the household income effects from recent tax cuts wane. In its most recent release, the European Commission (EC) forecasts the Latvian economy to grow by 3.3% in 2018 and 2019.

Fiscal Policy Is Expected to Be Slightly Expansionary, While Debt Continues its Gradual Decline

After a 2016 fiscal balance, the deficit widened to 0.5% of GDP in 2017 as revenue growth from strong economic output only partially offset expenditure increases. 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 lowers corporate income taxes and makes the personal income tax more progressive. These measures are partially offset by the increases in excise duties and social contributions, yet the reform is expected to be moderately expansionary. The EC forecasts manageable deficits slightly above 1.0% of GDP in 2018 and 2019. Deficits could widen over the medium term due to still unaddressed increases in public expenditures, notably to social benefits, public wages and defence.

Latvia’s public debt is on a declining trajectory and the Treasury has a favourable funding profile. General government gross debt declined to 40.1% of GDP last year, and the EC forecasts this ratio to decline to 37.3% by 2018. The IMF expects the ratio to decline to 28.1% by 2022. The favourable trajectory reflects persistent primary surpluses and low interest expenditure. The general government interest expenditure to GDP ratio declined from 1.3% in 2015 to below 1.0% last year. DBRS expects the government to continue to take advantage of high demand for its Eurobonds and low interest rates to prefund its redemptions. Latvia issued its first 30-year bond in 2017 at low rates.

DBRS Expects Macroeconomic Policy Continuity Following the October 2018 General Elections

Latvia’s political environment appears stable and policy-making generally effective, despite frequent government turnover and lingering geopolitical tensions. Latvia has a long history since its independence of government reshuffling, including 15 Prime Ministers since 1991. The current three-party coalition is likely to serve out its term prior to the election in October 2018. 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. Irrespective of the election outcome, DBRS expects the next government will maintain broad consensus around the European project and prudent fiscal management.

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 evidence of Russian meddling in the election or escalation in tensions along the Russian border would adversely affect political stability and economic activity.

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

Fiscal Balance (% GDP): -0.5 (2017); -1.1 (2018F); -1.2 (2019F)
Gross Debt (% GDP): 40.1 (2017); 37.0 (2018F); 37.3 (2019F)
Nominal GDP (EUR billions): 26.8 (2017); 28.5 (2018F); 30.2 (2019F)
GDP per Capita (EUR): 13,855 (2017); 14,825 (2018F); 15,884 (2019F)
Real GDP growth (%): 4.5 (2017); 3.3 (2018F); 3.3 (2019F)
Consumer Price Inflation (%): 2.9 (2017); 3.0 (2018F); 2.5 (2019F)
Domestic Credit (% GDP): 148.1 (Sep 2017)
Current Account (% GDP): -0.8 (2017); -2.9 (2018F); -2.9 (2019F)
International Investment Position (% GDP): -56.5 (2017)
Gross External Debt (% GDP): 140.9 (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: Thomas R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: December 15, 2018

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