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

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

KEY RATING CONSIDERATIONS

The Stable trend on the A (low) ratings reflect DBRS Morningstar’s assessment that the challenges to Latvia’s macroeconomic performance posed by the current health and economic crisis are balanced by the country’s strengths. The shock to the global economy brought on by the Coronavirus Disease (COVID-19) and the associated restriction measures will cause the Latvian economy to contract this year. The extraordinary policy measures to mitigate the impact of the pandemic will also result in a significant deterioration in Latvia’s public finances. However, years of prudent fiscal policy allowed officials ample capacity for expansionary measures to support the economy.

Ratings are underpinned by stable macroeconomic policy-making, including judicious fiscal management and a low level of public debt, and institutional benefits from membership of the European Union (EU) and the euro area. The ratings are nevertheless constrained by structural challenges that existed prior to the pandemic, including vulnerabilities to external shocks from the country’s small and open economy, lower income and productivity levels compared to euro area partners, and remaining – albeit rapidly diminishing – financial sector risks stemming from banks that service foreign clients.

RATING DRIVERS

DBRS Morningstar could upgrade Latvia’s ratings if there is continued evidence of: (1) effective fiscal policy to deal with the current crisis, (2) enhanced economic resilience to external developments, and (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, DBRS Morningstar could downgrade the ratings 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, or (2) momentum to reduce financial sector vulnerabilities is reversed, possibly if additional cases of illicit activity in the banking sector cause reputational or operational damage to domestically focused banks.

RATING RATIONALE

Restrictions Return as COVID Cases Increase, but the Economic Shock Should be Less Severe than EU Peers

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 November 19, 2020, Latvia recorded 141 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. At the onset of Autumn and as cases once again started to rise in Latvia and across Europe, the government declared a State of Emergency between November 9 and December 6, 2020. Restrictions once again limit citizen mobility and the size of public gatherings.

The repeated bouts of social restrictions will cause a significant shock to Latvia’s economy this year, albeit more mild than its European peers. The European Commission (EC) expects real GDP to contract by 5.6% in 2020, compared with the expected 7.8% average euro area contraction. The shock to the Latvian economy will mostly stem from the decline in foreign demand, weaker domestic confidence, and the postponement of investment projects. While the recovery depends on the evolution of the global health crisis, certain conditions in Latvia – like the more manageable health crisis, more mild lockdown restrictions, less severe employment loss from an effective employment furlough scheme, and reignition of domestic investment projects – will likely support economic activity next year. The EC expects growth to rebound to 4.9% in 2021 and be supported over the forecast period by EU stimulus grants.

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 -41.6% of GDP in 2019 from -82.4% a decade ago.

The Economic Shock and Government Support Measures will Result a Deterioration in Public Finances

Following a near balanced budget position in 2019, the government foresees the deficit widening in 2020 to 7.6% of GDP. Due to less economic contraction in the first half of the year, this recent projection is roughly two percentage points better than previously forecast. The total amount of direct and indirect support measure this year to offset the COVID-19 crisis are worth EUR 3.3 billion (11.9% of GDP). These include tax holidays, support to households, employment protection, loans and credit guarantees to businesses, and an increase in public and EU spending on human and physical capital. Under a no-policy change assumption, where GDP picks up in 2021 and the expenditure increases are temporary, the government expects the fiscal deficit to decline to 3.9% of GDP in 2021.

The economic shock and the crisis response will cause Latvia’s general government debt to increase by roughly ten percentage points of GDP in 2020, but the country arrived to the crisis with a modest level of debt. General government debt declined to 36.9% of GDP in 2019, down from 40.4% in 2016. The government forecasts the ratio to rise to 47% in 2020 and decline gradually thereafter. The crisis-related public spending has been funded with two issuances of Eurobonds in international financial markets at historically low interest rates, regular government bond auctions in domestic financial markets in 2020, 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

Despite the complexities of the banking system, the bulk of domestic financial services are delivered by the subsidiaries of large Nordic banks, whose financial performance and capitalization levels are strong. As in most countries, the banking sector will be challenged by the pandemic. However, the negative short-term effects of the COVID-19 outbreak on financial stability are mitigated by government support packages for businesses and households, ultra-accommodative monetary policy, and strong regulation. Major lenders also allowed bank clients who were experiencing temporary financial difficulty due to the crisis to defer their principal payments.

The part of the Latvian banking sector servicing foreign clients has received attention in recent years. The share of non-resident deposits (NRDs) in the Latvian banking sector led to 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 shortfalls. These events reflect risk associated with the NRD banking sector and weighs negatively on DBRS Morningstar’s “Monetary Policy and Financial Stability” building block assessment.

However, Latvian authorities appropriately managed bank closures and the deposit guarantee scheme has operated effectively. Moreover, NRDs in the Latvian banking system have rapidly declined. As of the second quarter of 2020, foreign client deposits shrank to €3.5 billion (20.0% 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 2020, Moneyval announced Latvia is largely compliant with the recommendations and the Financial Action Task Force announced it would not place Latvia on the list of countries with strategic deficiencies, but the country remains under enhanced monitoring.

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 regaining its independence of government reshuffling. 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/370337.

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 (July 27, 2020) https://www.dbrsmorningstar.com/research/364527/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 (Investor Presentation October 2020), Statistical Bureau Latvia, Bank of Latvia, European Commission (Autumn Economic Forecast), Statistical Office of the European Communities, IMF (October 2020 WEO), World Bank, ECB, UNDP, Bank for International Settlements, Johns Hopkins University Coronavirus Resource Center, 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/370338.

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

Lead Analyst: Jason Graffam, Vice President, Credit Ratings
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: May 22, 2020

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