DBRS Morningstar Confirms Republic of Latvia at A, Trend Stable

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

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS Morningstar’s assessment that previous credit improvements help offset the challenges to Latvia posed by the pandemic and Russia’s invasion of Ukraine. Shortages of materials and labour, rising costs of energy, commodities, and other inputs, have dampened Latvia’s growth prospects. The Russian invasion comes at a time when Latvia’s public sector balance sheet was already strained by the ongoing health and economic crises. However, the country’s comparatively mild economic contraction during the worst of the pandemic and its strong recovery last year illustrate Latvia’s improved economic resiliency. The country’s effective de-linking of trade and of its banking system away from Russia limit systemic consequences from sanctions and counter-sanctions. Strong domestic conditions and EU-transfers will also support the economic recovery.

The ratings are underpinned by Latvia’s membership of the European Union (EU) and the euro area, and stable macroeconomic policy-making. Years of counter-cyclical fiscal policy and low levels of public debt prior to the Covid-19 crisis provided ample capacity for offsetting support measures. It also allowed the government to increase spending to help safeguard households and corporates from security risks and rising energy prices. The ratings are nonetheless constrained by structural challenges. 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 that policy-makers successfully: (1) rebalance the structural fiscal position; and (2) improve the economy’s resilience by rising income and productivity levels.

DBRS Morningstar could downgrade Latvia’s ratings if: (1) the economic consequences to Latvia from Russia’s invasion into Ukraine are severe and protracted; (2) there is a weakening of fiscal discipline; or (3) momentum to reduce financial sector vulnerabilities is reversed.

RATING RATIONALE

Following A Healthy Recovery, Latvia’s Growth Is Decelerating Due To Yet Another Shock

The pandemic forced Latvia’s economy to contract by 3.8% in 2020, a result less severe than the 6.4% euro area contraction. Despite a fourth quarter slowdown from renewed Covid-19 restrictions, the economy expanded last year by 4.8%. Strong consumer spending and healthy export performance drove the 2021 recovery. Russia’s invasion of Ukraine has increased near-term risks. The invasion exacerbated the global rise in energy and food prices from pandemic-induced supply chain disruptions. In its winter forecast, the EC expected eventual absorption of EU funds and a healthy rebound in the labour market to drive a 4.5% and 3.8% expansion of the Latvian economy in 2022 and 2023. These GDP forecasts may now appear high. War uncertainty and inflation (8.6% in February 2022) are likely to weaken consumer spending and delay investment.

The external balance deteriorated in 2021 as imports recovered, notwithstanding robust export performance. Exports of wood products, and electrical and machinery goods have performed particularly well. From the 2.9% of GDP surplus in 2020, the current account weakened to a 2.9% deficit last year. External uncertainty around trade and the rise in imports linked to investments could cause the external balance to remain negative. The IMF expects the current account to average -1.6% over its five year forecast period. While a moderate external deficit is reasonable and reflects Latvia’s large investment needs, returning to a healthy surplus is key to further narrowing the country’s net international investment position. NIIP was -28.1% of GDP in 2021, a steady improvement from -83.5% in 2010.

Shocks To Public Finances Have Been Significant; Eventual Fiscal Repair Is Likely To Remain A Priority

Following years of prudent general government budgeting, the pandemic caused the deficit to deteriorate to 4.5% of GDP in 2020 and then widen further to 7.3% in 2021. Measures to mitigate the health and economic crisis included income support to households and business, and spending towards public health and investment. A second round of support was necessary in October 2021 in response to the re-introduction of pandemic restrictions. The 2022 Budget, assuming solid recoveries of tax revenues and the expiry of temporary support measures, expected a 4.8% deficit this year and for the deficit to improve to 2.1% in 2023. Russia’s invasion of Ukraine likely delays the expected budget consolidation. Latvia recently increased public spending to shield households and firms from rising energy prices and to buttress security. Defence spending will rise from 2.2% of GDP this year to 2.5% by 2025.

The economic shock and the crisis response underpin the large increase in Latvia’s general government debt. The 2022 Budget expected the ratio to peak in 2022 at 51.7% of GDP, up from 36.7% in 2019. Despite the pandemic-related rapid rise in the debt ratio, funding conditions are strong and interest payments are low. The cost of servicing Latvia’s debt declined to 0.7% of GDP in 2020, down from 1.2% of GDP in 2015. It is worth noting that recent reforms to the pension system protect Latvia’s public finances from the adverse effects of an aging population. At under 16% of GDP in 2019, Latvia’s age-related spending is among the lowest in the EU.

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 consequences of the pandemic and of Russia’s invasion of Ukraine. The negative short-term effects on financial stability from the pandemic were mitigated by government support packages for businesses and households, ultra-accommodative monetary policy, prudent lending practices since the Global Financial Crisis, and prudent regulation. Furthermore, the largest banking groups have low direct financial sector exposure to Russia, Belarus and Ukraine.

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; Build-up of NATO Forces In Baltics

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 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 16%. 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. Russia’s invasion of Ukraine has heightened alarm in Europe and triggered additional build-up of NATO forces in the Baltics. DBRS Morningstar is of the view that a more muscular European security apparatus reduces downside risks to the Baltic States and their respective economies from notional or actual Russian aggression.

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 USD19,500 in 2021 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 at: https://www.dbrsmorningstar.com/research/393851.

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 February 2022, Draft Budget 2022), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Development Report September 2021, Quarterly Bulletin 4Q 2021), European Commission (Winter Economic Forecast), Statistical Office of the European Communities, IMF (October 2021 WEO), World Bank, ECB, Bank for International Settlements, 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/393850.

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: November 19, 2021

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