DBRS Morningstar Confirms Republic of Latvia at “A”, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Latvia’s (Latvia) 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 Latvia’s previous credit improvements help offset the challenges posed by Russia’s invasion of Ukraine. After a comparatively mild economic setback from the pandemic, Latvia now faces stubbornly elevated inflation, higher interest rates, and a subdued global backdrop, which are weighing on economic activity and risk triggering a short-lived recession in 2023. The country’s effective de-linking of trade and its banking system from Russia limits systemic consequences to Latvia from the invasion. Provided inflation pressures recede and competitiveness is preserved, DBRS Morningstar expects growth rates in Latvia will rise as strong domestic fundamentals and European Union (EU) funds will remain supportive in the medium term. While the strains from the pandemic on public finances have been receding and are expected to remain limited in 2023, the economic downturn and the measures taken to cushion the impact of high energy prices, accommodate people fleeing Ukraine, and enhance national security are expected to keep the fiscal deficit high in 2023. However, the government remains committed to return to smaller deficits over time and Latvia’s low levels of debt still provide significant room to respond to potential challenges.

The ratings are underpinned by Latvia’s membership in the European Union and the euro area as well as its strong political institutions and effective policymaking. Several years of contained fiscal deficits and low levels of public debt prior to the pandemic provided authorities with ample capacity to respond. It also allowed the government 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 with euro area partners.

RATING DRIVERS
DBRS Morningstar could upgrade Latvia’s ratings if there were evidence that policymakers successfully rebalanced the structural fiscal position and improved the economy’s resilience by raising income and productivity levels.

DBRS Morningstar could downgrade Latvia’s ratings if the economic consequences to Latvia from Russia’s invasion of Ukraine were severe and protracted, there were a weakening of fiscal discipline, or the momentum to reduce financial sector vulnerabilities were reversed.

RATING RATIONALE
The Energy Shock Takes A Toll On Latvia’s Growth In 2023 But Medium-Term Prospects Remain Supportive

After output plummeted during the global financial crisis, Latvia's small and open economy quickly recovered and then expanded at a solid pace for over a decade. Between 2010 and 2021, real GDP growth averaged 2.9%, and GDP per capita (in euros) increased by 107.0%. This period of steady increases in the standard of living was interrupted by the pandemic, which in 2020 triggered a contraction in output of 2.2% in Latvia, albeit less severe than the 6.1% seen in the euro area. The improving public health situation and accumulated savings during the pandemic underpinned a strong recovery in private consumption, driving GDP growth to 4.1% in 2021 and 2.0% in 2022. Output exceeded its pre-pandemic levels by 2021. In contrast, the repercussions from Russia’s invasion of Ukraine in the shape of elevated inflation, higher interest rates, and weakening foreign markets already dampened aggregate demand in H2 2022. Annual consumer price inflation in Latvia reached 20.1% YoY in February 2023, which was the highest in the euro area.

In this context, the government projects a contraction of 0.6% in GDP in 2023, with the recovery starting in H2 2023. The European Commission expects a slightly more benign slowdown, with GDP growth at 0.1% in 2023, in part reflecting the more recent plunge in the price of energy commodities. In any case, both institutions expect higher growth rates afterwards, as inflation pressures recede and private consumption and investment recover. Over the medium term, EU funds will continue to support investment and structural growth prospects. The funds allocated to Latvia by the EU’s Multiannual Financial Framework 2021-2027 and the NextGenerationEU plan amount respectively to 23.4% and 6.4% of 2021 GDP. The main downside risks are linked to the evolution of the war in Ukraine, energy prices, and stubbornly high inflation affecting cost competitiveness in Latvia.

The Pandemic And Energy Shock Triggered A Significant Deterioration In Public Finances But Gradual Fiscal Repair Expected Over Time

Latvia’s prudent fiscal policy resulted in moderate fiscal deficits between 2012 and 2019, with the exception of a balanced position in 2016. The pandemic shock caused the deficit to deteriorate to 4.3% of GDP in 2020 and to widen further to 7.0% in 2021, as the impact of the coronavirus economic support measures stood at an estimated 3.2% of GDP in 2020 and 6.2% in 2021. While pandemic-related support is projected to drop to 2.0% of GDP in 2022 and 0.2% in 2023, Russia’s invasion of Ukraine and the ensuing energy crisis in Europe has triggered additional temporary measures. According to the new administration’s budget, the measures taken to cushion the effect of elevated energy prices and to accommodate people fleeing Ukraine are estimated to have an impact of 1.5% of GDP both in 2022 and 2023. However, these measures are mostly temporary and expire after the first half of 2023. The government projects the fiscal deficit to shrink to 4.7% of GDP in 2022 and 4.2% in 2023 before narrowing towards 2.0% of GDP in 2025. While the rapid decline in energy prices in recent months might lead to lower support spending, the still-high uncertainty over the evolution of the economy and energy prices will remain a source of risk to public finances.

The Government Debt Ratio Expected To Have Peaked In 2021 And Decline Over Time

The pandemic shock largely explains the increase in Latvia’s general government debt ratio to 43.6% of GDP at year-end 2021 from 36.5% at year-end 2019, according to Eurostat. Nonetheless, Latvia recorded the fourth-lowest public debt ratio in the eurozone at 39.9% of GDP in Q3 2022. The low levels of debt continue to provide flexibility to finance higher funding requirements if needed in the future. The Treasury projects in its December 2022 forecast the debt ratio to have dropped to 40.9% by year-end 2022 as the substantial expansion of nominal GDP should more than offset for the still-high fiscal deficit in 2022. Afterwards, the debt ratio is projected to increase to 41.9% at year-end 2023 before dropping below 39.0% by year-end 2025, albeit subject to high uncertainty. The latest projections from the Treasury include lower levels of indebtedness, especially when compared with the 2022 Stability Programme.

The elevated inflation rate and rapid monetary policy tightening at the euro area level, coupled with the uncertainty brought by the invasion, have led to a swift increase in Latvia’s marginal funding costs, similar to other sovereigns. Nevertheless, Latvia’s interest burden remains moderate (0.5% of GDP in 2022), its debt profile favourable, and it still benefits from a cash buffer estimated at 3.9% of GDP in 2022. Also, 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 less than 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 liquidity, capitalisation, and financial performances remain strong. Latvia’s significant financial institutions’ Common Equity Tier 1 Ratio at 23.1% and liquidity coverage ratio at 304.9% as of Q3 2022, both well above their regulatory minimums, provide ample room to absorb shocks. Prudent lending standards and sound regulation have underpinned credit quality, with the nonperforming loans ratio at 0.83% as of Q3 2022. House prices have been steadily increasing at high rates for several years, but Latvian household indebtedness is among the lowest in the euro area. After weathering the pandemic shock well, Latvian banks’ asset quality could deteriorate as higher costs of living and higher interest rates reduce households’ ability to repay their debts. Provided asset quality does not deteriorate markedly, banks should benefit from the re-pricing of their lending portfolios, given the predominance of variable rate mortgages. On a positive note, 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 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. However, the Latvian authorities have managed the challenges without disruption to the domestic economy. Combating Money Laundering and Terrorism Financing 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 change in the origin of NRDs. Customer deposits from EU jurisdictions, rather than from outside the EU, now make up the majority of foreign deposits.

The 2022 Election Resulted in Political Continuity; Build-Up Of NATO Forces In Baltic States

Latvia’s political environment appears stable and its policymaking generally effective. It ranks above the regional average on the Worldwide Governance Indicators. After his party won the October 2022 parliamentary elections with 19.0% of the votes, Arturs Krišjānis Kariņš (New Unity, JV) was confirmed as Prime Minister for a second consecutive term with the support of 54 members in the 100-seat parliament and leads a three-party coalition government. The administration identifies national security, education, energy, climate and environment, competitiveness, and improving quality of life as key policy priorities. Noteworthy, the Social Democratic Party (Harmony), which has historically drawn support from Latvia’s Russian-speaking minority and was the most-voted party in the previous three general elections, failed by a narrow margin to pass the 5% threshold to have representation in parliament during this legislature.

Russia’s invasion of Ukraine has brought geopolitical risks to the forefront. Russia’s actions have triggered an additional build-up of NATO forces in the Baltic countries. 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.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. DBRS Morningstar considers this factor significant and has taken it into account within the Economic Structure and Performance building block. Latvia’s GDP per capita, estimated at USD 21,482 in 2022, according to the International Monetary Fund, is relatively low compared with its European 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/410947.

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 Republic of Latvia Ministry of Finance (Investor Presentation February 2023; Draft Budgetary Plan 2023 February 2023; Press Release: The government approves the bill on the State budget for 2023 and the budget framework for 2023, 2024 and 2025, February 2023), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Forecasts December 2022; Macroeconomic Developments Report September 2022; Financial Stability Report 2022), Latvia’s Central Election Commission, European Commission (Commission Opinion on the Draft Budgetary Plan of Latvia February 2023; Fiscal Statistical Tables providing relevant background data for the assessment of the 2023 Draft Budgetary Plan February 2023; The EU’s 2021-2027 long-term Budget and NextGeneration Facts and Figures April 2021; Assessment of the final national energy and climate plan of Latvia October 2020), Statistical Office of the European Communities, International Monetary Fund (WEO October 2022 and IFS), World Bank, European Central Bank, Bank for International Settlements, Social Progress Imperative (2022 Social Progress Index), 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.

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/410946.

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: Michael Heydt, Senior Vice President, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: September 16, 2022

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