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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings at A (low) and changed the trends to Stable from Positive. At the same time, DBRS Morningstar confirmed its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low) and changed the trends to Stable from Positive.

KEY RATING CONSIDERATIONS

The change in trend to Stable from Positive reflects the renewed challenges to Latvia’s macroeconomic performance posed by the current health and economic crisis. Specifically, DBRS Morningstar considers the deteriorating fiscal outlook in the “Fiscal Management and Policy” Building Block as rationale for the trend change. Consolidation of Latvia’s non-resident deposit banking sector and noteworthy tax reform have in recent years addressed some of Latvia’s structural challenges. However, DBRS Morningstar expects the shock to the global economy brought on by the Coronavirus Disease (COVID-19) and the associated confinement measures to cause the Latvian economy to contract this year and to cause its public finances to deteriorate well beyond previous assumptions.

The ratings are underpinned by Latvia’s consensus around stable macroeconomic policy-making and institutional benefits from membership in the European Union (EU) and the euro area. In contrast, the ratings are constrained by structural challenges. These include vulnerabilities to external shocks from the country’s small and open economy, lower income and productivity levels compared to EU peers, and remaining – albeit diminishing – financial sector risks stemming from banks that service foreign clients.

RATING DRIVERS

DBRS Morningstar could upgrade Latvia’s ratings if there is clear evidence of: (1) effective fiscal policy to deal with the current crisis, (2) enhanced economic resiliency to external developments, or (3) additional strengthening of the financial system, specifically by executing on the action plan to address Moneyval recommendations on reducing risks from the flow of cross-border funds for illicit activity.

Conversely, the ratings could be downgraded if: (1) a longer than expected economic shock causes lasting deterioration to Latvia’s medium-term economic outlook, its fiscal performance, and its public debt dynamics, (2) momentum to reduce financial sector vulnerabilities is reversed, or if additional cases of illicit activity in the banking sector cause reputational or operational damage to domestically focused banks.

RATING RATIONALE

Thanks to Comparatively Mild Lockdown Restrictions, the Economic Shock Should be Severe but Short-lived

The number of confirmed COVID-19 cases and deaths are significantly lower in Latvia than in larger European countries, as is the case in other Baltic states. As of May 22, 2020, Latvia recorded 22 deaths related to the outbreak of COVID-19. The more favourable result is primarily due to lower population density, less cross-border transit, and an early and effective policy response. On March 12, 2020, the government declared a state of emergency that has since extended until June 9, 2020, but with considerable easing of restrictions. Even if many non-essential retailers have voluntarily closed, most businesses are allowed to remain open. Subject to appropriate physical distancing, people are allowed to gather for events, and cultural, entertainment, and sports facilities are open. Baltic states have also agreed to open their mutual borders to resume air, sea, and rail transport.

The economic shock to Latvia this year will nonetheless be significant. The European Commission (EC) expects real GDP to contract by 7.0% in 2020. The shock to the economy will mostly stem from the decline in foreign demand, weaker domestic confidence, and the postponement of investment projects. Following the steep decline in the first few quarters of 2020, DBRS Morningstar expects a healthy recovery of the Latvian economy due to a more manageable health crisis, more mild lockdown restrictions, less severe employment loss from an effective employment furlough scheme, and reignition of domestic investment projects. The EC expects growth to rebound to 6.5% in 2021. DBRS Morningstar recognizes that these forecasts are subject to considerable downside revision depending on the evolution of the global health crisis.

DBRS Morningstar does not expect material deterioration in key external sector indicators, despite the shock to the economy from weaker external demand. Since the sharp fall in exports of goods and services will largely be offset by similarly large contractions in imports, Latvia’s current account position is unlikely to worsen from its near balance position recorded in 2019. As a result, Latvia’s net liability international investment position (NIIP) should continue its gradual improvement. The NIIP narrowed to -44.1% of GDP in 2019 from -82.4% a decade ago.

Government Support Measures will Result in Large Increases in the Fiscal Deficit and Public Debt

Following a near balanced budget position in 2019, the governments Stability Programme foresees the deficit widening in 2020 to 9.4% of GDP. The deterioration in the fiscal outlook weighs on DBRS Morningstar’s assessment of the “Fiscal Management and Policy” building block. The EUR 2 billion (6.5% GDP) aid package directs additional funding to healthcare costs and to support businesses and employees. Direct spending measures are a small share of the total spending bill, as the widening of the deficit is principally related to the decline in the revenue intake from tax deferral measures and the economic downturn. Furthermore, the development financial institution, ALTUM, provides companies with working capital loans, credit guarantees, and portfolio guarantees. Under a no-policy change assumption, where GDP picks up in 2021 and the expenditure increases are temporary, the government expects the deficit to decline to 5.0% of GDP in 2021.

The economic shock and the crisis response will cause Latvia’s public debt to increase by roughly six percentage points of GDP in 2020, but the country arrived to the crisis with modest level of debt. Debt declined to 36.9% of GDP in 2019, down from 40.9% in 2016. Due to the current health and economic crisis, the Stability Programme forecasts the ratio to rise to 51.7% in 2020. The support package has been backed with two issuances of Eurobonds in international financial markets in total amount of EUR 1.55 billion, regular government bond auctions in domestic financial market, and credit facilities available from multilateral financial institutions. The increase in the debt ratio is also contained by the partial reduction in accumulated large precautionary cash reserves.

Prior to COVID-19, Latvia Increased Regulatory Efforts to Reduce NRDs and High-Risk Transactions

The share of non-resident deposits (NRDs) in the Latvian banking sector has led to recent accusations of noncompliance with rules around the use of funds for illicit purposes. The publication in 2018 of the US Treasury FinCEN report resulted in the self-liquidation of NRD bank ABLV Bank AS in 2018. Another NRD bank, PNB Banka, closed in 2019 due to capital shortages. These incidences reflect risk associated with the NRD banking sector and weighs on DBRS Morningstar’s “Monetary Policy and Financial Stability” building block assessment.

However, Authorities have appropriately managed bank closures and the deposit guarantee scheme has operated effectively. Moreover, NRDs in the Latvian banking system have declined in recent years. As of 2019, foreign client deposits shrank to €3.2 billion (19.5% of total deposits), down from €8.1 billion (39.4% of the total) in January 2018 and €12.4 billion (53.4% of the total) in December 2015. There has also been a distributional change, where customer deposits from EU jurisdictions make up a majority of remaining foreign deposits. The decline in NRDs has reduced Latvia’s short-term external debt without undermining the confidence of domestic depositors, the financial system, the economy, or the country’s fiscal position.

Authorities passed reforms in recent years with the intention to change the business model of banks servicing foreign clients. In May 2018, the amendments to the Law on Prevention of Money Laundering and Terrorism Financing (ML/FT) went into force, and as of July 2018 banks can no longer perform any operations with high risk shell companies. This bans cooperation between banks and shell companies that have no real economic activity and are not required to file annual financial statements in their jurisdictions. In October 2018, the government approved the action plan measures necessary for the implementation of recommendations made by Moneyval, the Council of Europe’s anti money laundering body. In February, Moneyval announced Latvia is largely compliant with the recommendations and the Financial Action Task Force announced it will not place Latvia on the list of countries with strategic deficiencies, but the country remains under enhances monitoring.

Despite the complexities of the banking system, the domestic financial market is largely disconnected from banks servicing foreign clients. As the remaining NRD banks are in their search for new business models, their domestic exposure may grow. Banks servicing foreign clients account for only 6% of total domestic lending. The bulk of domestic financial services are delivered by the subsidiaries of large Nordic banks, whose financial performance and capitalization levels are strong.

DBRS Morningstar Expects Macroeconomic Policy Continuity from the 5-Party Coalition Government

The October 2018 parliamentary election resulted in another fragmented outcome. Arturs Krišjānis Kariņš of the New Unity party was eventually chosen as Prime Minister to lead a coalition of five disparate parties. Despite the fractured nature of Latvian politics, frequent government turnover, and lingering geopolitical tensions, Latvia’s political environment appears stable and policy-making generally effective. Latvia has a long history since its independence of government reshuffling, including 15 Prime Ministers since 1991. It nonetheless performs above the regional average on World Bank Governance rankings. The current coalition government has vowed to maintain macroeconomic stability, manage fiscal policy prudently, continue to pursue key reforms, and maintain broad consensus around EU membership.

ESG CONSIDERATIONS

Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Latvia’s per capita GDP is relatively low at $18,200 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/361350

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 Republic of Latvia Ministry of Finance (Stability Programme May 2020), Statistical Bureau Latvia, Bank of Latvia, European Commission (Spring Economic Forecast), Statistical Office of the European Communities, IMF (October 2019 WEO and April 2020 WEO), World Bank, UNDP, 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/361349

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: June 30, 2017
Last Rating Date: November 22, 2019

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