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

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Latvia’s (Latvia) Long-Term Foreign and Local Currency – Issuer Ratings at “A”. At the same time, Morningstar DBRS 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 Morningstar DBRS’ assessment that the risks to the credit ratings are balanced. After a strong post-pandemic recovery, the side effects from Russia’s invasion of Ukraine and a weaker external backdrop have increasingly taken a toll on Latvia’s economic performance, affecting private consumption and exports. In 2023, Latvia’s real GDP contracted by 0.6% related to the cumulative impact of higher inflation, higher interest rates, and weaker external demand. While the near-term growth outlook is expected to remain challenging, Morningstar DBRS expects growth to accelerate as household purchasing power recovers, external conditions improve, 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 strain on the public-sector balance sheet. The fiscal deficit was smaller than anticipated at 2.3% of GDP in 2023 and well below the 7.2% of GDP recorded in 2021, driven by the removal of emergency support and strong revenue growth. Morningstar DBRS expects the fiscal rebalancing to continue over the medium term, although the new spending measures introduced by the incoming administration and Latvia’s defence commitments will likely slow the adjustment pace. Latvia’s low levels of debt continue to provide significant room to respond to potential challenges.

The credit ratings are underpinned by Latvia’s membership in the EU 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 deal with the pandemic, energy, and security risks. The credit 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
Morningstar DBRS could upgrade Latvia’s credit 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.

Morningstar DBRS could downgrade Latvia’s credit ratings if external shocks result in a prolonged period of weak economic performance and a material worsening of fiscal performance leading to a sustained deterioration in the public debt trajectory, or the momentum to reduce financial sector vulnerabilities is reversed.

CREDIT RATING RATIONALE

The Economy Contracted in 2023 and the Near-Term Outlook Appears Challenging, but Medium-Term Prospects Remain Supportive

The effects of Russia’s invasion of Ukraine, including high inflation, higher interest rates, and supply disruptions, coupled with the weak environment in Europe have negatively affected Latvia’s economic growth. Against this background, activity lost significant momentum during H2 2022 and H1 2023. In annual terms, real GDP contracted 0.6% in 2023 after expanding 3.4% in 2022. Although the breakdown is still not available, Latvia’s central bank estimates private consumption and exports to have contracted by 1.8% and 6.8%, respectively, in 2023. Annual headline inflation reached 17.3% in 2022 and 9.0% in 2023. Encouragingly, headline inflation has declined sharply throughout 2023 and fell to 1.0% YoY in January 2024. While feeble economic activity might continue during the first half of 2024, growth is expected to accelerate in the second half. The central bank projects real GDP growth at 2.0% in 2024, 3.6% in 2025, and 3.8% in 2026, as receding inflation improves purchasing power, external demand strengthens, and both EU-funded and nationally funded projects spur public investment.

Despite the recent deceleration in growth, the unemployment rate remained low at 6.5% in Q3 2023 and the MoF projects wage growth of 11% in 2023, 7.5% in 2024, before slowing down to 5% over the medium term. The preservation of competitiveness in an environment of strong wage growth will remain key, especially if the labour market remains tight and productivity dynamics are not commensurate. In the near term, the main uncertainties are linked to the evolution of geopolitical tensions, the speed of the recovery of its key European trading partners, and the interest rate outlook. Over the medium term, demographic pressures and labour shortages could restrict potential growth, if unaddressed.

Latvia's small and open economy makes the country vulnerable to external shocks and this, coupled with its relatively lower income level than 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 2.6% between 2010 and 2023, and real GDP finished 2023 6.5% above pre-pandemic levels. Latvia has significantly narrowed the income gap, with its GDP per capita (in euros) estimated at 54.0% of the euro area’s GDP per capita in 2023 compared with 30.0% in 2010, although its convergence is behind that of both Estonia and Lithuania. Latvia's economic resilience to successive shocks in recent years, together with healthy growth prospects, support Morningstar DBRS’ positive qualitative adjustment of the “Economic Structure and Performance” building block assessment.

External Accounts Weakened Due to Shocks and Weak Foreign External Demand, Maintaining Competitiveness Will Remain Key

The current account balance deteriorated significantly during 2021 and 2022, reflecting the rapid surge in energy prices, accumulation of inventories, 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 3.9% of GDP in 2021 and 4.7% of GDP in 2022. Latvian exports contracted during the first three quarters of 2023 compared to the same period of 2022, reflecting the weakness in external demand, especially affecting Latvia’s main trading partners such as the Nordics, Baltics, and Germany. The decline has been more acute for goods exports affected by the downturn in manufacturing in Europe and affecting Latvia’s important wood industry. The current account is expected to remain in negative territory but should gradually rebalance once the energy shock dissipates and external demand strengthens. The International Monetary Fund projects a current account deficit of 3.0% of GDP in 2023 and 2.2% of GDP on average between 2024 and 2028. Given the still high wage pressures in Latvia, avoiding sizeable and permanent losses in competitiveness will remain key in this respect. Even if external accounts have weakened in recent years, the country’s net international investment position remains relatively stable at -26.8% of GDP in Q3 2023 after a material improvement from -81.7% in 2010.

Fiscal Rebalancing Is Progressing, but Consolidation Path Is Expected to Remain Gradual and Additional Shocks Could Cause Delays

Latvia’s prudent fiscal policy resulted in moderate fiscal deficits between 2012 and 2019, with the exception of a balanced position in 2016. Since then, the pandemic as well as Russia’s invasion of Ukraine and the government’s measures to deal with its consequences have led to significant deterioration in Latvia’s fiscal position. The government estimates that the accumulated budgetary impact stemming from COVID-19, energy, and Ukraine-related support reached 3.2% of GDP in 2020, 6.3% in 2021, 3.8% in 2022, and 1.5% in 2023. During this period, the fiscal deficit averaged 3.5% of GDP. On a positive note, provisional estimates indicate that the fiscal deficit declined to 2.3% of GDP in 2023 from 4.6% in 2022, both outperforming the Ministry of Finance’s (MoF) projections in April (4.0%) and October (2.7%) 2023. This improvement reflects the withdrawal of the bulk of pandemic support, lower energy support, and continued strong and fairly broad-based revenue growth underpinned by a strong labour market and rising nominal income.

The new government, formed in September 2023, approved an expansionary budget for 2024 that includes additional expenditure measures partially compensated by revenue measures, with an aggregate deficit-increasing impact of 0.8% of GDP, according to the European Commission. These measures include higher public wages, supplementary payments to pensioners, increased healthcare and education spending, and investments in defence and internal security. On the other hand, Latvia’s energy support measures had concluded by the end of 2023, although further measures could be introduced in the future if needed.

The government’s fiscal strategy projects a fiscal deficit ratio of 2.8% of GDP in 2024, to be followed by a no-policy change path of 2.3% of GDP in 2025 and 0.9% of GDP in 2026. This represents a slower fiscal consolidation path than anticipated previously, although it does not materially alter Latvia’s trajectory over time. Latvia’s commitment to raise its defense budget from 2.4% of GDP in 2024 to 3.0% in 2027 will narrow the fiscal space available for other priorities. Morningstar DBRS notes that achieving this projected rebalancing could be challenging if geopolitical tensions escalate or external conditions weaken materially, most likely leading to additional government support. Latvia’s low levels of public debt provide space to deal with such eventualities without materially undermining its credit profile, unless this leads to a permanent and material weakening of its fiscal position. Over the medium to long term, dealing with an ageing and shrinking population that is expected to put increasing pressure on the country’s pension system will remain a challenge, although the government’s previous and planned reforms should help balance the sustainability and adequacy of the pension system.

Latvia’s Low Public Debt Ratio Provides 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. According to preliminary estimates, debt-to-GDP increased to 43.1% of GDP in 2023 from 40.8% in 2022 and was higher than the MoF’s October 2023 forecast of 39.7% of GDP. Despite the smaller-than-anticipated fiscal deficit ratio in 2023, a lower nominal GDP than anticipated for 2023, explained by lower inflation and real GDP growth, was the main driver for this. Latvia’s debt ratio is above its pre-pandemic levels at 36.5% of GDP in 2019 but remains one of the lowest in the euro area. The MoF’s October projection of 41.0% of GDP in 2026 now appears more challenging, given the first estimate of 2023. However, in the absence of other economic shocks, Morningstar DBRS expects the public debt ratio to increase only marginally in 2024 and to remain relatively stable over the medium term. Weaker economic performance or a failure to correct the deficits could put upside pressure on the debt ratio. The interest burden, which stood at 0.5% of GDP in 2022, is expected to gradually increase over the medium term, reflecting the higher costs of funding faced by Latvia. Nonetheless, debt affordability remains comfortable, and Latvia benefits from a favourable debt profile and a cash buffer estimated at 3.5% of GDP in 2023. Planned gross borrowing needs are estimated at a manageable 7.1% of GDP in 2024.

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

Financial stability risks are contained. On aggregate, Latvian banks exhibit strong solvency, liquidity, and profitability. According to European Banking Authority data, Latvian banks’ Common Equity Tier 1 ratio at 21.6% and liquidity coverage ratio at 196.3% as of Q3 2023, both well above their regulatory minimums, provide ample room to absorb shocks. Higher interest rates have spurred banks’ profitability while asset quality remains strong, with the ratio of nonperforming exposures at 0.5% as of Q3 2023, underpinned by prudent lending standards and sound regulation. Going forward, a manageable deterioration in asset quality is expected in light of the weak economic environment, higher interest rates, and costs. However, the low private-sector indebtedness, small debt payment burden, and strong labour markets act as mitigants. In Latvia, the housing market activity and price growth have decreased in 2023 after several years of strong house price growth. The risks of a sharp correction is limited given slow housing construction and higher construction costs.

Given that the bulk of domestic financial services is delivered by the subsidiaries of large Nordic banks, Latvia’s financial sector is exposed to the developments and strategic decisions of its parent banks and their home countries. This raises contagion risks in case of a deep real estate crisis in the Nordics affecting the banking system. In addition, given the geopolitical context, the risks of cyberattacks and other large-scale unexpected disruptions in the financial infrastructure remain high, according to the Latvian central bank. The authorities remain committed to strengthening the Money Laundering and Terrorism Financing framework. The significant progress on this front in recent years resulted in a significant drop in the share of non-resident deposits to 9.2% from more than 50% in 2015.

Morningstar DBRS Expects Broad Policy Continuity Despite Recent Political Instability, NATO Increased Presence in the Baltics States

Despite the fractured nature of Latvian politics, frequent government turnover, and lingering geopolitical tensions, Latvia’s political environment appears stable and policymaking is generally effective. Latvia ranked broadly in line with the EU27 average for most of the Worldwide Governance Indicators in 2022. A new coalition government led by Prime Minister Evika Siliņa (New Unity, JV) was formed in September 2023, following Arturs Krišjānis Kariņš’ resignation, also from JV, less than a year after being re-elected as prime minister. The new coalition formed by JV, the Union of Greens and Farmers (ZZS), and the Progressive Party (PRO) holds a slim majority in parliament. Morningstar DBRS expects the new government to remain committed to prudent fiscal management even if the spillovers from Russia’s invasion of Ukraine are putting additional strain on public finances. In its 2024 budget, the government is prioritizing spending in the areas of security, education, and health.

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 multiyear military spending plans.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG considerations had a significant effect on the credit analysis.

Social (S) Factors
The Human Rights and Human Capital factor is a significant consideration for Latvia’s credit ratings. Morningstar DBRS considered this factor in the Economic Structure and Performance building block. Latvia’s GDP per capita, estimated at USD 24,929 in 2023, 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/research/428750.

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 (October 6, 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/about/methodologies.

The sources of information used for this credit rating include Latvia’s Ministry of Finance (Investor Presentation, January 2024; Draft Budgetary Plan 2024), Latvia’s Ministry of Climate and Energy (Latvia’s draft updated National Energy and Climate Plan), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Forecasts December 2023; Financial Stability Report 2023), European Commission (2023 Country Report – Latvia; Opinion on Draft Budgetary Plan 2024), 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. Morningstar DBRS considers the information available to it for the purposes of providing this credit 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

Morningstar DBRS 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. Morningstar DBRS’ outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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://dbrs.morningstar.com/research/428751/.

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

Lead Analyst: Javier Rouillet, Senior Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: September 15, 2023

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