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 CREDIT RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s assessment that the risks to the ratings are balanced. After a comparatively mild contraction in 2020, Latvia experienced a strong post-pandemic recovery, benefitting from healthy fundamentals and state support. More recently, the rapid surge in energy prices, and more broadly in consumer inflation, following Russia’s invasion of Ukraine, has taken a toll on economic activity. Nevertheless, the growth slowdown has been less intense than anticipated, and DBRS Morningstar expects growth rates to accelerate as household purchasing power recovers and European Union (EU) funded investment picks up. Latvia’s prudent fiscal management pre-pandemic provided the country with enough fiscal space to alleviate the effects of the pandemic and Russia’s invasion of Ukraine without putting excessive stress on the public sector balance sheet. The deterioration in public finances is gradually reversing and the fiscal deficit ratio is expected to decline faster than previously anticipated, in part thanks to a milder economic slowdown and the removal of support measures. DBRS Morningstar expects the next government will remain committed fiscal consolidation, and Latvia’s low levels of debt will continue to 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 the 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.

CREDIT RATING DRIVERS
DBRS Morningstar could upgrade Latvia’s ratings if there is evidence that policymakers successfully rebalance the structural fiscal position and improve 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 are severe and protracted, there is a weakening of fiscal discipline, or the momentum to reduce financial sector vulnerabilities is reversed.

CREDIT RATING RATIONALE

High Inflation and Higher Rates Are Slowing Down Growth But Medium-Term Prospects Remain Supportive

Latvia's small and open economy makes the country vulnerable to external shocks and this, coupled with its relatively lower income level compared to its euro area partners, could exacerbate economic volatility. That said, Latvia’s economic performance since the global financial crisis has been strong and its economy fairly resilient to the pandemic, energy, and interest rate shocks. Real GDP growth averaged 2.9% between 2010 and 2022 and GDP per capita (in euros) went from representing 30.0% of the euro area’s GDP per capita to 53.5% by 2022. More recently, the Latvian economy experienced a comparatively mild contraction of 2.3% in 2020 followed by strong post-pandemic recovery growth of 4.3% in 2021 and of 2.8% in 2022, so that output is well above its pre-pandemic levels. Latvia’s healthy economic and fiscal position pre-pandemic helped absorb the shock.

The effects of Russia’s invasion of Ukraine, including high inflation, higher interest rates, and supply disruptions, have negatively affected Latvia’s economic growth, especially starting in the second half of 2022. Latvia suffered one of the highest consumer inflation rates in the euro area in 2022 at 17.3%, similar to other Baltic countries, mainly driven by the energy component. Despite the erosion of household purchasing power, private consumption remained strong last year on the back of a resilient labour market, state support and accumulated savings. Exports also contributed, helped by the post-pandemic recovery in tourism. On the other hand, surging construction costs and delays in implementing EU-funds led to a contraction in construction investment. The Ministry of Finance, among other institutions, have revised upwards Latvia’s growth outlook for 2023 on the back of a milder than anticipated economic impact from the energy crisis and high inflation. This is despite Latvia’s historical links with Russia in energy and other trade, which have dropped significantly since 2014. The share of total goods and services exports to Russia shrank to around 5.0% in 2022 from close to 12.0% in 2014. On the import side, Latvia diversified away from fossil fuels imported from Russia and companies dealt with supply disruptions of intermediate goods from Russia and Belarus (e.g., wood, fertilizers, and steel).

Latvia's economic resilience to successive shocks in recent years, together with healthy growth prospects, support DBRS Morningstar’s positive qualitative factor for the “Economic Structure and Performance” building block assessment. In its latest projections, the Ministry of Finance expects economic growth to slow to 1.0% in 2023 and to then accelerate to 2.5% in 2024 and to 2.9% in 2025 and 2026, as receding inflation improves purchasing power and EU-funded investment picks up. The main uncertainties are linked to the evolution of geopolitical tensions, energy prices, and the ultimate impact from the rapid monetary policy tightening on activity in the euro area including Latvia. The preservation of competitiveness in an environment of rising prices and wages will remain key, especially if the labour market remains tight.

Successive Shocks Have Weakened Latvia’s External Position But Conditions Are Expected to Improve

The current account balance deteriorated significantly as a result of rapidly rising energy prices and higher general government borrowing needs. The current account went from an average surplus of 1.0% of GDP between 2016 and 2020 to deficits of 4.2% of GDP in 2021 and 6.4% of GDP in 2022. While the deterioration is significant, it’s only a fraction of the imbalance pre-global financial crisis and its key drivers are expected to gradually reverse. Assuming that the impact of the energy shock diminishes and that the fiscal deficit narrows, Latvia’s current account should rebalance over time. Given the still high price and wage pressures in Latvia, avoiding sizable and permanent losses in competitiveness will remain key in this respect. While a moderate external deficit is reasonable and reflects Latvia’s large investment needs, a healthy surplus over the longer term is key to further narrowing the country’s net international investment position (NIIP). NIIP was -27.2% of GDP in 2022, a steady improvement from -81.7% in 2010.

The Pandemic And Energy Shocks Triggered A Significant Deterioration In Public Finances But A Gradual Rebalancing Already Started

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 4.4% of GDP in 2020 and to widen further to 7.1% in 2021.The government estimates that the impact of the coronavirus economic support measures was 3.2% of GDP in 2020 and 6.3% in 2021. The government deficit declined to 4.4% of GDP in 2022 as strong revenue growth and a sharp decline in pandemic-related support more than compensated for the temporary measures undertaken to deal with the consequences of Russia’s invasion of Ukraine.

The Ministry of Finance improved its fiscal deficit projection for 2023 to 2.7% of GDP, from the 4.0% of GDP anticipated in its 2023–2026 Stability Programme. This is due to better-than-expected tax collection and social security contributions benefitting from a more benign macroeconomic environment and high wage growth during the first half of 2023. The impact from the measures taken to cushion the effect of elevated energy prices and to accommodate migrants from Ukraine is estimated to decline to 1.1% of GDP in 2023 from 1.5% of GDP in 2022, assuming no further extensions. Over the medium term, assuming no policy changes, the Ministry of Finance forecasts smaller deficits of 2.2% of GDP in 2024 and 1.3% of GDP in 2025, followed by a surplus of 0.1% of GDP in 2026. The discontinuation of pandemic and energy support measures, coupled with cyclical improvements, is projected to more than compensate for the budgeted expenditure measures, including public wage increases, defence investments, higher social benefits, and interest payments. However, DBRS Morningstar notes that achieving this projected rebalancing could be challenging if geopolitical tensions escalate or external conditions weaken materially, most likely leading to addition government support.

Latvia’s Low Public Debt Ratio And Improving Medium Term Trajectory Provide Valuable Fiscal Space If Needed

Latvia’s low public debt-to-GDP ratio continues to provide flexibility to finance higher funding requirements if needed in the future, despite the rise in the debt ratio since the pandemic. The debt-to-GDP ratio stood at 40.8% of GDP in 2022, up from 36.5% of GDP in 2019, driven by additional financing related to the pandemic and the energy crisis. Still, Latvia’s debt ratio remains one of the lowest in the euro area. The debt ratio declined in 2022, as the debt-increasing fiscal deficit was more than offset by the strong nominal GDP growth. In its latest no-policy-change scenario, the Ministry of Finance projects the public debt ratio to decline to 39.7% in 2023, then increase to 40.5% in 2024 before staying below 40% at the end of the medium term. The Ministry of Finance projects the interest burden, which stood at 0.5% of GDP in 2022, to gradually increase over the medium term, reflecting the higher costs of funding faced by Latvia in an environment of higher monetary policy rates as well as some widening of spreads. Nonetheless, debt affordability remains comfortable, and Latvia benefits from a favourable debt profile and a cash buffer estimated at 3.9% of GDP in 2022.

Latvia’s Banking Sector Is Well Placed Against The Risk of Asset Quality Deterioration

In Latvia, the bulk of domestic financial services is delivered by the subsidiaries of large Nordic banks whose liquidity, capitalisation, and financial performances remain strong. According to European Banking Authority data, Latvian banks’ Common Equity Tier 1 Ratio at 23.3% and liquidity coverage ratio at 177.4% as of Q1 2023, both well above their regulatory minimums, provide ample room to absorb shocks. The resiliency of the banks is reinforced by a strong rise in their profitability as their lending book reprices more rapidly than their deposit base in an environment of rising interest rates. Prudent lending standards and sound regulation have underpinned credit quality, with the ratio of nonperforming exposures at 0.83% as of Q1 2023. Latvia’s central bank deems that the financial resilience of Latvian borrowers has remained good overall, underpinned by its accumulated savings and state support. Private sector indebtedness remains low and the debt payment burden remains small. Nevertheless, higher costs of living, higher interest rates, and tighter financial conditions increase the risks of deteriorating asset quality and may contribute to weaken the economic recovery.

Latvia has made significant progress in strengthening its Money Laundering and Terrorism Financing framework and effectively de-risking the financial sector in recent years. This led banks servicing foreign clients to substantially downsize their operations and change their business model. In this direction, the share of non-resident deposits (NRDs) of total deposits shrank to 9.2% from more than 50% in 2015. Also, there has also been a change in the origin of NRDs as customer deposits from EU jurisdictions, rather than from outside the EU, now make up the majority of foreign deposits. Furthermore, the largest banking groups have low direct financial sector exposure to Russia, Belarus, and Ukraine. However, the Latvian central bank highlights that, given the geopolitical context, the risks of cyberattacks and other large-scale unexpected disruptions in the financial infrastructure remain high.

DBRS Expects Broad Policy Continuity Despite Recent Political Instability; Build-Up Of NATO Forces In Baltic States

The coalition government formed after the October 2022 parliamentary elections, led by Arturs Krišjānis Kariņš from New Unity (JV), collapsed around mid-August 2023. Ongoing government formation talks suggest that prime ministerial candidate Evika Siliņa (JV) will likely head the next coalition government composed of JV, the Union of Greens and Farmers (ZZS) and the Progressive Party (PRO) that would hold a slim majority in parliament. DBRS Morningstar expects the next government will remain committed to return to smaller deficits over time. Despite the fractured nature of Latvian politics, frequent government turnover, and lingering geopolitical tensions, Latvia’s political environment appears stable and policy-making is generally effective. As of 2021, Latvia ranked broadly in line with the EU27 average for most of the Worldwide Governance Indicators.

Russia’s invasion of Ukraine brought geopolitical risks to the forefront, especially for the Baltic states, given their geographical proximity and historical links to Russia. Nevertheless, Latvia's membership in the EU and NATO provides a stable macroeconomic and institutional framework and a strong security arrangement that mitigates the risks of possible Russian aggression. Since Russia’s invasion of Ukraine, NATO has increased its military presence in Eastern Europe, including Latvia, and the country has stepped up its multi-year military spending plans.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The Human Rights and Human Capital (S) factor is a significant consideration for Latvia’s ratings. DBRS Morningstar considered this
factor in the Economic Structure and Performance building block. Latvia’s GDP per capita, estimated at USD 22,348 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 (July 4, 2023) 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/420663.

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 (August 29, 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 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 Republic of Latvia Ministry of Finance (Investor Presentation, July 2023; Stability Programme of Latvia 2023–2026, April 2023; Informative Report: On Macroeconomic Indicators, Revenues and General Government Budget Balance Forecasts for 2024, 2025 and 2026, August 2023), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Forecasts June 2023; Financial Stability Report 2023), European Commission (Spring Forecast, May 2023; 2023 European Semester: Country Report – Latvia), Statistical Office of the European Communities, International Monetary Fund (WEO and IFS), World Bank, European Central Bank, Bank for International Settlements, Social Progress Imperative (2022 Social Progress Index), 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: NO
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/420665.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Javier Rouillet, Vice President, Credit Ratings
Rating Committee Chair: Michael Heydt, Senior Vice President, Credit Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: March 17, 2023

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