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

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

KEY RATING CONSIDERATIONS
The Stable trends reflect DBRS Morningstar’s assessment that Estonia’s credit strengths, including strong public finances and a dynamic economy, mitigate the risks stemming from Russia’s invasion of Ukraine. Estonia’s economy weathered the Coronavirus Disease (COVID-19) pandemic-related shock comparatively well with real GDP exceeding pre-pandemic levels by 8.3% by the end of 2021. The energy and confidence shocks as well as trade disruptions caused by Russia’s invasion pushed the Estonian economy into a technical recession in Q3 2022. While growth will most likely remain subdued in 2023, DBRS Morningstar expects Estonia to return to higher growth rates after this year provided that inflationary pressures abate and external competitiveness is preserved. Public finances have deteriorated as a result of the pandemic and the energy crisis in Europe; however, Estonia entered the crises with a sound fiscal position and the lowest public debt burden in the euro area. This position has allowed for ample public support to the economy when necessary. The strong growth in tax collection has helped finance the measures to support the economy in 2022, however, the fiscal deficit will likely deteriorate in 2023 due to the introduction of unfunded measures and weaker economy. DBRS Morningstar expects fiscal repair to ensue over time.

Estonia’s membership in the European Union (EU) and the euro area as well as its strong institutions underpin the ratings. The free movement of goods and services offered by its single market supports the country’s economy, which will also benefit from EU funding programmes in the coming years. Conversely, Estonia’s comparatively small and volatile economy constrain its ratings. Income per capita adjusted for purchasing power parity, which has steadily converged over time, stood at around four-fifths that of the euro area in 2021.

RATING DRIVERS
DBRS Morningstar could upgrade Estonia’s ratings if one or a combination of the following occur: (1) evidence of increased resilience to economic volatility inherent to Estonia’s small and open economy; or (2) successful implementation of measures that improve income and productivity.

DBRS Morningstar could downgrade Estonia’s ratings if one or a combination of the following occur: (1) external shocks cause lasting economic underperformance and permanent relaxing of fiscal discipline that significantly weakens Estonia’s public debt position over time; or (2) renewed excessive credit growth leads to over-indebtedness in the private sector and instability in the financial sector.

RATING RATIONALE
Strong Inflationary Headwinds Take a Toll on Estonia’s Economic Performance

Estonia’s small and open economy has expanded rapidly in the last few years as real GDP growth averaged 3.7% and GDP per capita in euros jumped 113.4% between 2010 and 2021. After a comparatively mild pandemic-induced contraction of 0.6% in 2020, output expanded strongly by 8.0% in 2021 on the back of healthy domestic demand components and solid growth in exports, including high value-added sectors such as information and communications technology (ICT). The fallout from Russia’s invasion of Ukraine, mainly higher inflation and lower consumer and business confidence, disrupted this positive momentum. Annual consumer price index (CPI) inflation reached 19.4% in 2022 after peaking at 24.8% year over year in August 2022. While inflation appears to have peaked, it is expected to come down slowly as the extremely high energy commodity prices, albeit declining in recent months, have not been fully passed on to end consumers, according to Eesti Pank (Bank of Estonia or the central bank).

The erosion of purchasing power, tighter monetary policy in the euro area, and weaker demand conditions have increasingly hampered growth in Estonia. The Estonian economy entered into technical recession in Q3 2022 after two quarters of contraction. Private consumption showed signs of deterioration in Q3 2022. Strong labour market and nominal wage gains remain supportive, while the boost from household’s pandemic-related savings and second-pillar pensions drawdowns is waning. The higher energy prices, and trade disruptions affecting certain sectors (e.g., wood processing), have increasingly impacted industrial production in recent months. Most forecasting institutions revised their growth projections for Estonia downward in 2022 and 2023 since the Russian’s invasion. In its December 2022 forecasts, the central bank forecast GDP to contract by 0.5% in 2022 and grow tepidly at 0.4% in 2023, which are slightly more pessimistic than the European Commission’s (EC) forecasts. While the economic outlook will remain cloudy in the near term, DBRS Morningstar expects growth to gather pace in coming quarters, provided that inflation and the energy crisis effects ease over time. The EU’s Multiannual Financial Framework 2021‑2027 (16.9% of 2021 GDP) and the NextGenerationEU plan (3.6% of GDP) together amount to a large transfer into the Estonian economy and should continue to uplift growth.

Strong Tax Collection Helps Finance Support Measures But Fiscal Deficit To Widen in 2023

In the decade before the coronavirus pandemic, Estonia’s average budget was broadly balanced, guided by the country’s prudent fiscal approach. After the pandemic drove the general government budget deficit to 5.6% of GDP in 2020, the deficit narrowed to 2.4% of GDP in 2021 due to Estonia’s strong economic recovery and the lower take-up of coronavirus support measures. This improving trend was disrupted by the energy shock on economic activity and the new measures to shelter households and companies from the impact of extremely elevated inflation and energy prices. The stronger than expected revenue growth (e.g., VAT tax collection) could lead Estonia to outperform the government’s fiscal deficit projection of 2.7% of GDP in 2022, despite the higher spending related to deal with the energy crisis (around 0.9% if GDP), defence, and refugee accommodation. For this year, the EC projects that the deficit ratio will reach 3.7% of GDP in part due to the unfunded measures included in the draft budgetary plan for 2023, an important portion of which is of permanent nature. The plan includes higher permanent expenditures on public wages, child benefits, defence, and education amounting to 2.8% of GDP starting in 2023, which some revenue-enhancing measures amounting to 0.9% of GDP may partially offset, according to EC’s calculations. After 2023, DBRS Morningstar expects the fiscal accounts to improve as the immediate pressures from the Russia’s invasion ease and macroeconomic conditions are more conducive for fiscal repair.

Estonia’s Public Debt Ratio is Increasing, but Remains the Lowest in the EU

Estonia’s traditionally conservative fiscal policy is reflected in its very low public debt ratio, which remains the lowest in the EU. The economic contraction and the fiscal measures to manage the pandemic resulted in a 10-percentage point increase in the public debt-to-GDP ratio to 18.5% of GDP in 2020 from 8.5% at the end of 2019. After a marginal decline in 2021, the public debt ratio is once again on the rise, albeit at a slower pace than previously anticipated. The EC expects this ratio to have reached 18.7% of GDP in 2022 and gradually rise toward 22.0% of GDP in 2024. Similar to other issuers, Estonian 10-year bond yields have increased rapidly in recent months, mainly reflecting the materialised and anticipated monetary policy tightening and to a lesser extent spread widening. Nevertheless, Estonia’s interest debt burden remains small (0.1% of GDP in 2022) and its debt profile remains favourable. In addition, the two reserve funds worth 8.2% of GDP as at end-2022 serve as a liquidity cushion.

Banking Sector Well Placed To Face A More Challenging Backdrop

Estonia’s economic recovery, together with its strong banking-sector metrics, have helped to contain the pandemic’s effects on financial stability. While Estonia’s financial sector has limited direct links to Russia, the repercussions of Russia’s invasion of Ukraine—including weaker macroeconomic conditions, higher costs of living, and increased loan servicing costs—will test households’ and companies’ ability to pay off their debts. Thus far, overdue loans as a share of the loan portfolio have remained very low and Eesti Pank estimates that this share will rise marginally from 0.2% in Q3 2022 to 1.0% in 2023, well below the levels seen in the 2008-2010 crisis. Accumulated savings, companies’ healthy buffers, and the expectation of only a small increase in unemployment supports this view.

The majority of the banking system is foreign owned (e.g., by Nordic banks) and, as such, risks are linked to spillovers from Nordic economies and to the economic performance of the Baltic neighbours. Estonia’s strong profitability, which should benefit from higher interest rates in the context of limited asset-quality deterioration, and the banking system’s good capital position, with a CET1 ratio of 25.6% at Q2 2022, mitigate risks from stressed borrowers. Also, Eesti Pank plans to tighten its macroprudential measures by increasing the countercyclical buffer requirement for the banks to 1.5% from 1.0% in December 2023 to reduce the risks associated with strong credit growth.

External Accounts Remain Sound Despite Energy Shock

On average, Estonia recorded an annual current account surplus of 0.8% of GDP during the 2009–21 period, reversing the external imbalances that built up leading into the global financial crisis. The country’s strong savings position helped to lower external debt and narrow its net liability international investment position, which improved to -19.2% in Q3 2022 from -78.6% of GDP in Q4 2009. Direct trade links to Russia or Ukraine are limited while exports of services elsewhere, particularly in ICT and in transport and logistics, remain strong. Likewise, the terms-of-trade shock has been comparatively mild in Estonia since its shale exports benefit from higher energy prices. Following small current account deficits in 2020 and 2021, the EC forecasts surpluses during the 2022–24 period.

Estonia’s Political Environment Benefits from Strong Institutions and EU and NATO Membership

Following the break-up its first cabinet in June 2022, Prime Minister Kaja Kallas formed a new three-party coalition led by the Reform Party with a slim 52-seat majority in the 101-seat parliament. Political turbulence has not hampered the government’s ability to respond to the consequences of Russia’s invasion of Ukraine, although the execution of the Estonian Recovery and Resilience Plan has faced execution challenges thus far. The next parliamentary elections will be held on March 5, 2022. The Reform Party is leading the polls, although the current coalition would still fall short of a majority. EU and NATO membership provide Estonia a broadly stable political environment, and DBRS Morningstar expects policy continuity. Estonia benefits from a sound political and institutional framework, reflected in its strong performance on the World Bank Governance indicators.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The Human Capital and Human Rights factor affects the ratings. DBRS Morningstar considers this factor significant and has taken it into account within the Economic Structure and Performance building block. Estonia’s GDP per capita of USD 27,962 in 2021 according to the International Monetary Fund (IMF) is relatively low compared with its euro system peers.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/408634.

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, https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-andgovernance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.

The sources of information used for this rating include Ministry of Finance (2023 Draft Budgetary Plan of 2023, Investor Presentation October 2023, Debt Management Presentation January 2023), Bank of Estonia (Estonian Economy and Monetary Policy 2022/4, Financial Stability Review 2022/2), Statistical Office of Estonia, EC (European Economic Forecast Autumn 2022, Commission Opinion on the Draft Budgetary Plan of Estonia November 2022, Analysis of the recovery and resilience plan of Estonia October 2021, The EU’s 2021-2027 long-term Budget and NextGeneration Facts and Figures April 2021), Estonia’s Fiscal Council, European Central Bank, Statistical Office of the European Communities, International Monetary Fund (WEO and IFS), World Bank, Bank for International Settlements, Politico Poll of Polls, Social Progress Imperative (2022 Social Progress Index), and 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: YES
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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/408633.

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

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head Global Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: July 29, 2022

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