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 CREDIT RATING CONSIDERATIONS
The Stable trends reflect DBRS Morningstar’s assessment that Estonia’s low public debt ratio and strong post-pandemic recovery have helped absorb the economic and fiscal impacts as well as the lingering risks created by Russia’s invasion of Ukraine. After a strong recovery, Estonia’s real GDP is expected to contract for a second consecutive year in 2023 dragged down by the energy shock, trade disruptions, and weaker performance of key export markets. DBRS Morningstar expects economic activity to recover as energy and inflation pressures abate; however, geopolitical and external competitiveness developments as well as higher interest rates continue to pose risks. The effects from the war in Ukraine have also hit public finances. DBRS Morningstar expects the introduction of a significant increase in expenditures to deal with the cost-of-living pressures and additional defence and refugee integration requirements to widen the fiscal deficit in 2023. In this context, Estonia’s public debt ratio is expected to increase gradually, although it is still expected to remain the lowest in the euro area. The new government, which came into office in April 2023, has approved measures to increase tax revenues starting in 2023 to deal with the higher expenditure needs and to help rebalance fiscal accounts, although a rapid return to its pre-pandemic fiscal performance is not expected unless additional measures are introduced.

The ratings reflect Estonia’s very low public debt ratio and its strong fiscal track record. Also, 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 constrains its ratings. Income per capita adjusted for purchasing power parity, which has steadily converged in the recent years, stood at around four-fifths that of the euro area in 2022.

CREDIT 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.

CREDIT RATING RATIONALE
The Economy is Undergoing a Downturn but Expected to Recover Over Time as the Energy Crisis Recedes

The worsening of economic conditions exacerbated by Russia’s invasion of Ukraine—including higher energy and food prices, higher interest rates, and supply disruptions—as well as weaker external demand are taking a toll on Estonia’s small and open economy. For the full year, real GDP contracted 1.3% in 2022 driven by a fall in intellectual property investment and the drag from net foreign trade. Estonia recorded the highest annual inflation among EU member states in 2022, reaching 19.4%, mostly driven by the energy and food components. The strength of the labour market and the push from households’ pandemic-related savings and second-pillar pensions have helped absorb the erosion of purchasing power although private consumption contracted in the second half of 2022. From the supply side, the higher energy prices and challenges with raw materials previously sourced from Russia affected the industrial sector’s performance, especially in the case of wooden and metal products. That said, Estonia’s economic slowdown takes place after a strong post-pandemic recovery, with real GDP surpassing its pre-pandemic level by 7.9% by the end of 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).

Real GDP contracted for the fifth consecutive quarter in Q1 2023. Going forward, DBRS Morningstar expects economic activity to pick up starting in the second half of the year as households’ purchasing power improves, key trading partners recover, and investment benefits from the execution of EU funds. Estonia’s central bank projects real GDP to contract by 1.0% in 2023 before picking up to 2.4% and 3.5% in 2025. The central bank expects households’ purchasing power to recover to pre-downturn levels by the end of 2024 as strong wage growth is projected to exceed falling inflation. While DBRS Morningstar expects Estonia’s main markets to recover in coming years, preventing a permanent loss of competitiveness due to the price and wage pressures in Estonia will remain vital to Estonia’s export performance. The EU’s Multiannual Financial Framework 2021‑2027 (16.9% of 2021 GDP) and the NextGenerationEU plan (3.6% of 2021 GDP) together amount to a large transfer into the Estonian economy and should continue to uplift growth. The main risks to the growth outlook remain linked to the evolution of geopolitical tensions, inflationary and competitiveness pressures, and the effects associated with the monetary policy tightening cycle.

External Accounts Remain Sound but Softness in Key Export Market and Competitiveness Pressures Pose Headwinds

Estonia’s external position has improved markedly since the global financial crisis. On average, Estonia recorded an annual current account surplus of 0.5% of GDP during the 2009–22 period, reversing the external imbalances accumulated previously. This helped to lower external debt and to narrow its net liability international investment position, which improved to -21.3% in Q1 2023 from -78.6% of GDP in 2009. On the other hand, the current account deficit reached 2.9% of GDP in 2022 driven by the deterioration in the trade balance in a context of weakening demand from key trading partners, competitiveness pressures, and some sector-specific effects. The wood and metal processing industries, which relied on Russia for raw materials, have been affected by disruptions and had to readapt their supply chains. Similarly, transportation and storage have been hit. These negative developments were mitigated by the good performance of ICT, the recovery of tourism exports, and the fact that Estonia’s oil shale exports benefitted from higher energy prices. Going forward, the performance of the export sector will depend on the evolution of demand in its key trading partners as well as cost-competitiveness dynamics. If wage and inflation pressures remain elevated in Estonia, and redirecting supply chains lead to permanently higher costs, this could impair the country’s cost-competitiveness. However, DBRS Morningstar sees these risks as contained at the moment given the good starting point and Estonia’s firm-based and fully flexible wage setting, which limits the risk of unsustainable wage growth over a prolonged period of time.

Fiscal Deficit Expected to Widen in 2023 but Corrective Measures Should Help Gradually Reduce It

Estonia’s fiscal performance pre-pandemic was very strong with the general government budgetary balance recording an average surplus of 0.4% of GDP for the period of 2000–19. Since then, the pandemic and the side effects from Russia’s invasion of Ukraine have weakened Estonia’s fiscal position. The fiscal deficit reached 5.6% of GDP in 2020 and then narrowed to 2.4% of GDP in 2021 helped by Estonia’s strong recovery and lower take-up of coronavirus support measures. Despite the higher spending needs related to the energy crisis, defence, and refugee accommodation in 2022, the fiscal deficit narrowed more than anticipated to 0.9% of GDP due to strong revenue growth and some under-execution on the expenditure side. High inflation and employment growth drove revenue growth over 13% in 2022, in spite of the economic contraction.

The Stability Programme 2023 (SP) projects the deficit to reach 4.5% of GDP in part driven by structurally higher expenditures on public wages, child benefits, defence, and education amounting to 2.8% of GDP starting in 2023, only partially compensated by revenue-enhancing measures amounting to 0.9% of GDP. Furthermore, the SP includes a protracted deterioration in public finances with the fiscal deficit remaining above 4.0% for the 2024–27 period as government expenditures are increasing faster than revenues. However, DBRS Morningstar takes the view that the government will most likely outperform these projections in light of the tax measures recently approved by the parliament as well as potentially stronger than assumed nominal growth. The tax measures, which include increasing the VAT tax rate and corporate income tax to 22% from 20%, could boost revenues by 0.4% of GDP per annum on average between 2024 and 2027. In addition, the government intends to pass further tax measures and tighten control of expenditures in coming years. This tighter fiscal policy, in conjunction with an easing energy crisis and stronger macroeconomic conditions, should help gradually narrow Estonia’s fiscal deficit in coming years. On the other hand, a prolonged slowdown and more persistent expenditure pressures could challenge the intended fiscal consolidation.

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

The Estonian government's debt-to-GDP ratio, at 18.4% of GDP in 2022, remains the lowest in the EU, even after increasing from 8.5% of GDP in 2019, reflecting the exceptional financing needs related to the pandemic and the conflict in Ukraine. The government debt ratio is projected to increase over the next years; however, DBRS Morningstar takes the view that it will remain at low levels. The SP projects the public debt ratio to increase to 33.0% by 2027, more pessimistic compared with the International Monetary Fund’s (IMF) 24.7% for the same year. DBRS Morningstar considers that the MoF’s projections could be revised downward in coming months as the revenue-enhancing measures planned by the new government are incorporated or nominal GDP grows more than assumed. Estonia’s favourable debt profile, small debt burden, and financial reserves further strengthen the country’s debt and liquidity profile. The MoF’s two reserve funds worth 5.0% of GDP as of 30 April 2023 serve as a liquidity cushion. While the cost of funding has been increasing rapidly over the last year, Estonia’s interest debt burden remains small (0.1% of GDP in 2022) and its relatively long average maturity at 7.3 years will help smooth out its effects. Furthermore, Estonia started issuing euro-commercial paper in June 2023, further diversifying its short-term instruments and complementing its existing domestic short-term bonds (T-bills).

Banking Sector Well Placed to Face a More Challenging Backdrop

Estonia’s strong banking-sector metrics limit financial stability risks. According to the European Banking Authority, Estonian banks are among the best capitalised in the EU, with a CET1 fully phased-in ratio of 21.9% at Q4 2022, and compare positively on profitability metrics. In general, Estonian banks comfortably exceed regulatory liquidity requirements and benefit from a stable and strong domestic deposit base. From the asset side, banks in Estonia have limited exposure to sovereign bonds, with most of the exposures linked to the property market through mortgages and corporate financing to the real estate and construction sector. 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. As deposit growth slowed in 2022, banks have resorted to other sources of financing such as bonds and loans from parent banks. Nevertheless, DBRS Morningstar notes that Estonian banks are principally funded by local deposits, which helps reduce their exposure to global financial stress and their reliance on cross-border parent banking group financing.

Estonia’s financial sector has limited direct links to Russia. Nevertheless, the repercussions of Russia’s invasion of Ukraine—including weaker macroeconomic conditions, higher costs of living, and increased loan servicing costs—are testing households’ and companies’ ability to pay off their debts. Thus far, nonperforming loans as a share of the loan portfolio have remained very low at 0.6% in Q4 2022, among the lowest in the EU, supported by its resilient labour market and the private sector’s financial buffers. Provided asset quality deterioration remains limited, banks should benefit from higher interest rates given the predominance of variable-rate loans. After years of strong increases, credit growth is slowing down and housing prices have stabilised in recent months in response to the rapid tightening of monetary policy in the euro area. This might ease the estimated overvaluation in the housing market estimated at 10% to 15% in 2022. 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.

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

Estonia benefits from a sound political and institutional framework, reflected in its strong performance on the World Bank Governance indicators. A new coalition government led by Prime Minister Kaja Kallas and composed of the centre-right Reform Party, the liberal Estonia 200, and the centre-left Social Democrats was formed after the parliamentary elections on March 5, 2023. The coalition, which has a 60-seat majority in the 101-seat parliament, plans to invest in the areas of defence, energy, and competitiveness while remaining committed to rebalancing public finances. The taxation increases recently approved point in this direction.

Russia’s invasion of Ukraine has heightened geopolitical risks in the Baltic region. Conversely, Estonia’s EU and NATO membership provide a stable macroeconomic and institutional framework and a strong security agreement that mitigate the risks from a potential Russian aggression. If anything, NATO has increased its military presence in eastern Europe, including Estonia, as a direct result of Russia’s invasion. In addition, Estonia has stepped up its multiyear military spending plans.

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, estimated at USD 28,631 in 2022 according to the 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 (July 4, 2023) at https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/417474.

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 (29 August 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. 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/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings, in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for these credit ratings include the Ministry of Finance (Stability Programme 2023, Investor Presentation June 2023, Debt Management Presentation June 2023), Bank of Estonia (The Estonian Economy and Monetary Policy 2023/2, Financial Stability Review 2023/1), Statistical Office of Estonia, EC (European Economic Forecast Autumn 2022, 2023 Country Report – Estonia, The EU’s 2021-2027 long-term Budget and NextGeneration Facts and Figures April 2021), The North Atlantic Treaty Organization (NATO), European Banking Authority, European Central Bank, Statistical Office of the European Communities, International Monetary Fund (WEO and IFS), World Bank, Bank for International Settlements, Social Progress Imperative (2022 Social Progress Index), and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were 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 credit 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 credit 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://registers.esma.europa.eu/cerep-publication/. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/417475.

These credit ratings are 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: January 20, 2023

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