DBRS Morningstar Confirms Republic of Estonia at AA (low), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Estonia’s Long-Term Foreign and Local Currency – Issuer Ratings at AA (low). At the same time, DBRS Morningstar confirmed the Republic of Estonia’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trends on all ratings are Stable.

KEY RATING CONSIDERATIONS

The AA (low) ratings and Stable trends reflect DBRS Morningstar’s assessment of Estonia’s stable macroeconomic policy framework and its strong sovereign balance sheet, even when confronted with the current health and economic crisis. DBRS Morningstar expects the shock to the global economy brought on by the Coronavirus Disease (COVID-19) and the associated confinement measures to contract the Estonian economy this year and deteriorate its public finances. However, Estonia arrived to the crisis with years of near budgetary balance and the lowest public debt burden in the eurozone, allowing officials ample capacity for expansionary fiscal policy to support the economy during the shock.

The ratings are also underpinned by Estonia’s membership of the European Union (EU) and the Euro area. Estonia is a net recipient of EU structural funds, and the economy is supported by the free movement of goods and services offered by the single market. The ratings are, nevertheless, constrained by structural challenges that existed prior to the pandemic. This crisis illustrates the growth vulnerability to external shocks of Estonia’s small and open economy, and the global crisis will likely further slow the convergence of Estonian income levels with the EU. Income per capita in Estonia adjusted for purchasing power parity remains around three-quarters of the Euro area average.

RATING DRIVERS

DBRS Morningstar would consider upgrading the ratings if there is increased evidence of a persistent reduction in economic volatility inherent to Estonia’s small and open economy, or successful implementation of measures that improve income and productivity.

The ratings could be downgraded if the current external shock causes lasting material macroeconomic underperformance and permanent relaxing of fiscal discipline that significantly weaken Estonia’s public debt position. A return of excessive credit growth that leads to private sector over-indebtedness and financial sector instability would also be credit negative.

RATING RATIONALE

Health Related Outcomes Associated with COVID-19 have Been Better in Estonia Compared to Larger EU Peers

Due to lower population density, less cross-border transit, and an early and effective policy response, the number of confirmed COVID-19 cases and deaths – in both absolute terms and as a share of the population – are significantly lower in Estonia than in larger European countries. On March 12, 2020, the government declared a state of emergency that has since extended until mid-May. This included closure of businesses and schools, prohibited public gatherings, increased testing, and restricted movement. As of May 8, 2020, Estonia reported over 1,700 confirmed cases of COVID-19 and 56 people have died from the virus. These comparatively favourable outcomes reflect Estonia’s strong public institutions. Estonia is an exemplary performer, especially among its Baltic peers, on the World Bank Governance Indicators.

Despite the Strong Policy Response to the Crisis, the Estonian Economy will Contract in 2020

Confinement measures in Estonia, as elsewhere, are resulting in a serious economic shock. Though it is far too early to tabulate the exact economic cost of the crisis, economic activity indices have been in decline since February, 2020. Various service sectors, such as leisure activities and transport, have been affected the fastest and hardest, while information technology (IT) services have been less affected. The Ministry of Finance in its April 2020 Supplementary Budget expected a growth contraction of 8% in 2020 assuming confinement measures ease in May, similar to the IMF’s recent World Economic Outlook forecast of a 7.5% contraction of the Estonian economy this year.

External accounts are also expected to deteriorate as a result of the crisis. Exports account for roughly three quarters of Estonia’s GDP and service-sector exports have in recent years been resilient. The current account surpluses each year since 2009 has helped lower external debt and a narrow the net liability international investment position, which improved from -80.0% of GDP in 2009 to -20.0% in 2019. The IMF expects the decline in external demand to cause the current account to decline to a 2.7% deficit in 2020 and recover to 1.9% in 2021.

The government and the IMF both expect a strong recovery in 2021, when growth is expected to rebound to 7.9% according to the IMF. Whether the economy will manage such a strong V-shaped recovery will depend on the progress made in containing the spread of the virus, the speed economic sectors come back on line, the capacity of the labour market to reabsorbed side-lined employment, and the degree to which the shock imposes permanent economic damage. Policy measures have been designed to support employment and limit damage to companies and economic structures.

Economic Support Measures will Result in a Large Increase in the Fiscal Deficit and Public Debt

A state supplementary budget passed in mid-April was unprecedented in scale and designed to ensure the survival of solvent businesses and preserve the current level of household income. The majority of measures include direct spending for additional health funding, tax reductions for businesses and the self-employed, the reduction of excise duties on fuel and electricity, support to the unemployment insurance fund, a worker compensation programme, and a temporary suspension of second pillar pension payments. The support package also includes public loan guarantees that may over time have less impact on fiscal accounts. The general government nominal budget deficit in 2020, taking into account the economic contraction and headline support package, will be EUR 2.62 billion.

Following years of fiscal prudence, Estonia’s public finance accounts are well positioned to manage the shock. Estonia averaged a near budget position over the last 20 years, including the moderate 2.6% and 2.1% of GDP deficits recorded in 2008 and 2009. The country’s historically conservative fiscal policy reduces the need to finance deficits, and the public debt ratio was 8.4% of GDP in 2019. Net of the government’s two reserve funds worth 4.6% of GDP, Estonia’s public debt burden was even more trivial at the onset of the crisis.

The current crisis, however, will make its mark on public finances, which has weighed on DBRS Morningstar’s qualitative assessment of the “Fiscal Management and Policy” building block. The government calculates support measures combined with the economic shock will result in a nominal deficit of 10.1% of GDP in 2020, and expects debt to increase to 21.9% of GDP. Assuming the strong expected recovery next year, the government forecasts the deficit to narrow to 3.8% in 2021 and the debt to increase to 23.4%, still the lowest in Europe.

Financial Sector Risks from Nordic Parent Banks Appear Contained

Risks to financial stability associated with spill overs from Nordic economies and parent banks appear well managed. Ninety-percent of the Estonian banking sector is foreign owned, and the liquidity and funding position of the Estonian financial sector is directly and indirectly affected by the performance of Nordic economies. The global COVID-19 economic shock could reduce capital flows from the Nordic region into Estonia, and affect the income of Estonian exporters and their ability to service loans. However, DBRS Morningstar considers these risks to be mitigated by the strong asset quality, deposit funding, and capitalisation of banks operating in Estonia.

ESG CONSIDERATIONS

Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Estonia’s per capita GDP is relatively low at $24,000 in 2019 compared with its euro system peers. A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/360803/.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in Euros 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 (17, September 2019) : https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Ministry of Finance (Supplementary Budget April 1, 2020), Bank of Estonia, Statistical Office of Estonia, European Commission, Statistical office of the European Communities, International Monetary Fund (November 2019, April 2020), World Bank, United Nations Development Programme, Bank for International Settlements, Haver Analytics. DBRS Morningstar 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.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are 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:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/360802/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: November 22, 2019

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