DBRS Morningstar Upgrades Republic of Latvia to A, Trend Changed to Stable

DBRS Ratings GmbH (DBRS Morningstar) upgraded the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings to A. 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 ratings upgrade reflects DBRS Morningstar’s assessment that Latvia’s credit improvements offset the challenges posed by the ongoing health and economic crisis. The country’s comparatively mild economic contraction during the shock and its strong expected recovery illustrates Latvia’s improved economic resiliency. Also supporting the upgrade, Latvia has made noteworthy progress reducing financial sector risk stemming from the banks that service foreign clients. The Economic Structure and Performance, and the Monetary Policy and Financial Stability building blocks are the key factors for the upgrade.

Ratings are underpinned by stable macroeconomic policy-making. Years of counter-cyclical fiscal policy and low levels of public debt prior to the Covid-19 crisis allowed officials ample capacity for offsetting support measures. Latvia also 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. These include economic and geopolitical external vulnerabilities, deteriorating demographic trends, and lower income and productivity levels compared to euro area partners.

RATING DRIVERS

DBRS Morningstar could upgrade Latvia’s ratings if there is evidence once crisis conditions have passed that policy-makers successfully: (1) rebalance the structural fiscal position; and (2) improve the economy’s resiliency by rising income and productivity levels.

DBRS Morningstar could downgrade Latvia’s ratings if: (1) there is a weakening of fiscal discipline; or (2) momentum to reduce financial sector vulnerabilities is reversed.

RATING RATIONALE

The Economic Shock Has Been Less Severe In Latvia Compared To EU Peers, Despite Recent Rise In Infection

Adverse health and economic outcomes were significantly lower in Latvia in 2020 when compared with larger European countries. This was principally due to lower population density, less cross-border transit, and an early and effective policy response. As such, the economy contracted by 3.6% in 2020, a result much better than the 6.6% contraction of the entire euro area. The stronger than expected performance was in part the result of robust exports. The increase in the exports of goods and the large contraction of imports meant the goods trade deficit improved in 2020 from a year earlier. The current account advanced from near balance in 2019 to a 2.9% of GDP surplus in 2020. It will likely weaken again as imports linked to investments increase. Higher external savings has led to a narrowing of Latvia’s net international investment position (NIIP) to -36.6% of GDP in 2020, from -41.7% in 2019 and -83.5% in 2010.

Strong performance of exports, investments, and government support measures will buttress the recovery in the coming years. The EC expects the economy to grow by 4.7% in 2021, despite the recent rise in infections and the reimposition in October 2021 of mobility restrictions. Measures increased the COVID-19 Stringency Index in November 2021 to 70, an all-time high. Even after some easing, the public health complications will temporarily weigh on growth in the final months of 2021 and into early next year. However, the eventual absorption of EU funds and a healthy rebound in private consumption as the labour market repairs should keep growth performance strong over the forecast period. The EC expects GDP to expand by 5.0% in 2022, and 4.0% in 2023. Such healthy growth is contingent on increasing Latvia’s vaccinated population. As of mid-November 2021 roughly 60% of the Latvian population were fully vaccinated, among the European country’s with the lowest rate.

The COVID-Related Shock To Public Finances Will Be Significant; Rapid Fiscal Repair Is Likely

Following a near balanced budget position in 2019, the general government budget deficit widened in 2020 to 4.5% of GDP, a much better result than initially expected. A second round of support measures was adopted in October 2021 in response to the re-introduction of pandemic restrictions. These additional measures include income support to households and business, and spending towards public health and investment. Most recent estimates are for the deficit to widen to 9.5% of GDP this year. Current assumptions are for solid recoveries of tax revenues and expiry of the temporary support measures next year, assuming the health situation improves as expected. The EC expects deficits of 4.2% in 2022 and 2.0% in 2023. Given Latvia’s historical record with balance sheet repair, DBRS Morningstar takes the view that the budget may well approach balance faster than currently envisaged.

The economic shock and the crisis response underpin Latvia’s general government debt increase. The 2022 Draft Budget expects the ratio to rise to 51.7% of GDP by 2022, from 36.7% in 2019. Despite the crisis-related rapid rise in the debt ratio, funding conditions are strong. The country arrived to the crisis with a modest level of debt after reducing the ratio from its previous 47.7% of GDP peak in 2010. Allowing for additional fiscal space, the cost of servicing Latvia’s debt declined to 0.7% of GDP in 2020, down from 1.2% of GDP in 2015.

Well Capitalized And Liquid Banking Sector; Increased Regulatory Efforts To Reduce High-Risk Transactions

In Latvia’s complex 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. Yet, 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, prudent lending practices since the Global Financial Crisis, and strong regulation.

The part of the Latvian banking sector servicing foreign clients 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. However, the Latvian authorities have managed the challenges without disruption to the domestic economy and the deposit guarantee scheme has operated effectively. Combating Money Laundering and Terrorism Financing (ML/TF) has been very high on the political agenda in Latvia, which has led to financial sector reforms designed to change the business model of banks servicing foreign clients and de-risking the financial sector. NRDs in the Latvian banking system rapidly declined, and there has also been a distributional change to NRDs. Customer deposits from EU jurisdictions, rather than from outside the EU, make up a majority of foreign deposits.

The 2022 Election Will Likely Produce Another Fractured Government; Latvia Is Strong On Governance Indicators

The October 2018 parliamentary election resulted in a fragmented outcome. Arturs Krišjānis Kariņš of the New Unity party was eventually chosen as Prime Minister to lead a coalition of five disparate parties. The result of the October 2022 election will likely be just as fractured. Most recent polling from Politico shows no party with support above 15%. 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.

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 USD17,500 in 2020 compared with its euro system peers. This factor has been taken into account within the “Economic Structure and Performance” building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/388359.

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in EUR 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 9, 2021) https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments. Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021) https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

The sources of information used for this rating include Republic of Latvia Ministry of Finance (Investor Presentation October 2021, Draft Budget 2022), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Development Report September 2021), European Commission (Autumn Economic Forecast), Statistical Office of the European Communities, IMF (October 2021 WEO), World Bank, ECB, UNDP, Bank for International Settlements, Johns Hopkins University Coronavirus Resource Center, Oxford Coronavirus Government Response Tracker Stringency Index, European Centre for Disease Prevention and Control, Social Progress Imperative, Global Carbon Project, Politico Poll of Polls, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/388358.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: May 21, 2021

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