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's assessment that Latvia's low public debt ratio and prudent fiscal policy record mitigate the risks of higher fiscal deficits in a challenging economic and geopolitical environment. The fiscal deficit improved to 2.2% of GDP in 2023, driven by the reduction of emergency support and strong revenue growth. Still, rising spending on public wages and domestic and external security is expected to widen the deficit to 2.6% of GDP in 2024, before a gradual fiscal consolidation over the medium term. Latvia's low public debt levels, while expected to increase in the coming years, still offer significant capacity to respond to potential challenges. After a strong post-pandemic recovery, real GDP growth contracted by 0.3% in 2023 dragged down by a weaker external environment, the effects of high inflation and restrictive monetary policy. While uncertainty and external risks remain high, Latvia's economic growth is expected to accelerate as household purchasing power recovers, external conditions improve, and European Union (EU)-funded investment picks up.

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. Latvia's strong fiscal track record and low levels of public sector debt support the credit ratings. Despite the expected increase in the coming years, Latvia's debt-to-GDP ratio should remain one of the lowest in the EU-27 and provide flexibility to respond to further shocks in the future. The credit ratings are nonetheless constrained by structural challenges. Latvia's small economy, which is highly dependent on exports and has relatively lower levels of income and productivity compared to its euro area partners, could make the economy more vulnerable to economic or geopolitical shocks. Adverse demographic trends, as well as the risk of eroding competitiveness, could limit long-term growth, if sustained.

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 a prolonged period of weak economic and fiscal performance leads to a sustained deterioration in the public debt trajectory, or the momentum to reduce financial sector vulnerabilities is reversed.

CREDIT RATING RATIONALE

Fiscal Rebalancing 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, public finances have remained under pressure due to measures to deal with successive shocks, including the pandemic and Russia's invasion of Ukraine. The fiscal deficit averaged 4.6% of GDP during 2020-2023. Despite last year's economic weakness, the fiscal deficit narrowed to 2.2% of GDP in 2023 from 4.6% of GDP in 2022. The improvement was driven by the removal of most pandemic-related support (0.2% from 2.1% of GDP), the lower fiscal cost of measures to address the energy crisis (1.0% from 2.6% of GDP), and still strong revenue growth supported by a strong labour market and rising nominal incomes. This more than offset higher spending on public salaries, health and education, as well as investments in defence and internal security.

The government's latest forecasts, published in August 2024, envisage the fiscal deficit increasing to 2.6% of GDP in 2024, driven by further increases in spending on internal and external security, as well as by the rise in public sector salaries. The impact of the full phase-out of COVID-19 and energy support measures in 2024, discretionary tax measures and additional dividend payments from state-owned enterprises will help offset the higher spending, albeit only partially. In a no-policy change scenario, the government now projects that the fiscal deficit to increase further to 2.9% in 2025 and then gradually decline to 2.2% of GDP in 2028. This represents a slower path of fiscal consolidation than previously anticipated, although it does not substantially alter Latvia's trajectory over time. Morningstar DBRS notes that achieving this projected rebalancing could be challenging if geopolitical tensions rise or external conditions materially weaken, likely leading to additional government support. The government plans to raise the maximum structural deficit allowed under the national fiscal framework (Fiscal Discipline Law) to 1.0% of GDP from the current 0.5%. In this way, the national framework would be aligned with the EU's reformed fiscal rules that came into force in May 2024, less restrictive, and according to its estimates would be consistent with maintaining the long-term average debt at 40.0% of GDP as set out in the in the current government's declaration.

Latvia's Public Debt Ratio is Expected to Rise, But to Remain Low in the Medium Term

The public debt-to-GDP ratio increased to 43.6% of GDP in 2023 from 41.8% in 2022 and 36.7% in 2019. The government expects the public debt ratio to remain on a gradual upward trend over its forecast horizon, due to higher-than-expected budget deficits and downward revisions to nominal GDP projections. The government projects the public debt ratio to increase to 45.8% of GDP in 2024 and reach 48.9% of GDP in 2028, under the no-policy change scenario. While public debt projections have worsened, Latvia's public debt-to-GDP ratio is expected to remain among the lowest in the EU-27 and should provide flexibility to respond to additional shocks in the future. Still, a more protracted economic weakness or persistently wider fiscal deficits could put additional pressure on the public debt ratio. Government debt service costs, which stood at 0.6% of GDP in 2023, are expected to gradually increase over the medium term, reflecting the higher financing costs faced by Latvia. However, debt affordability remains comfortable, with Latvia benefiting from a favourable debt profile and a cash buffer of 3.7% of GDP at the end of 2023. Projected gross borrowing needs are estimated at 7.1% of GDP in 2024.

Economic Performance Weakened Amid External Turbulences, But Medium-Term Prospects Remain Supportive

Latvia's small and open economy, coupled with a relatively low income level compared to its euro area partners, makes the country more vulnerable to external shocks and could lead to greater economic volatility. That said, Latvia's economic performance since the global financial crisis has proven fairly resilient to the pandemic, energy, and interest rate shocks. Real GDP growth averaged 2.6% between 2010 and 2023. Latvia has significantly narrowed the income gap, with its GDP per capita (in euros) estimated at 52.0% 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.

Latvia's real GDP contracted by 0.3% in 2023, driven mainly by the slowdown in the foreign sector and lower private consumption, while construction investment and public consumption grew strongly. The negative contribution of foreign trade to real GDP growth was 2.0 percentage points last year. Real exports contracted by 5.9% in 2023, particularly the manufacturing and the transport and storage exports, reflecting a decline in foreign trade globally and the economic downturn in Latvia's key trading partners. Real GDP growth in the other Baltic economies, Germany, Finland and Sweden, also came in negative territory last year. In addition, after two years of above 7% growth, private consumption declined by 1.3% in 2023 dampened by the effects of high inflation and tighter monetary policy. On the other hand, investment grew 8.2% driven by strong construction leading to an increase in the investment to GDP ratio to 24.1% in 2023. The labour market remains strong and average gross monthly earnings growth at 11.9% in 2023 despite the recent increase in unemployment to 7.2% in Q1 2024. Encouragingly, inflation has fallen sharply, averaging below 1.0% in H1 2024, after recording annual headline inflation of 17.3% in 2022 and 9.0% in 2023. This eases concerns over the unsustainable increases in prices and costs impacting the competitiveness in Latvia.

The government expects real GDP growth of 1.4% in 2024, which is lower than previously anticipated, to accelerate to 2.9% in 2025 and average of 2.5% between 2026-2028. This reflects the expectation that the recovery of household purchasing power, the strengthening of external demand and projects financed by both the EU and the country, including Rail Baltica, will boost growth. The EU's MFF 2021-2027 and the Recovery and Resiliency Facility taken together represent around EUR 7.0 billion (17.3% of 2023 GDP). Maintaining competitiveness in an environment of strong wage growth will remain key, especially if the labour market remains tight and productivity dynamics are not proportionate. In the short term, the main uncertainties are related to the evolution of geopolitical tensions, the speed of recovery of Latvia's main European trading partners and the outlook for interest rates. In the medium term, demographic pressures and labour shortages could restrict potential growth, if not addressed.

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

The current account balance has deteriorated significantly in recent years due to the effects of the pandemic, the energy crisis, and lower external demand from Latvia's main trading partners. The current account balance on average went from a surplus of 1.0% of GDP between 2016 and 2020 to a deficit of 4.2% of GDP between 2021 and 2023. Still, FDI flows and EU-related capital transfers largely offset these current account deficits. In addition, the country's net international investment position continued to decline steadily to -23.8% of GDP in the first quarter of 2024, compared to -83.4% in 2010. Latvian exports suffered from weak external demand in 2023, with sharper declines in goods exports reflecting the slowdown in manufacturing and construction activity in its main trading partners, such as Germany, the Nordics and the other Baltic economies. Freight transport experienced some difficulties due to lower trade levels, while air transport was more favourable due to passenger transport. Looking ahead, external demand from its major trading partners is expected to pick up as the effects of monetary policy tightening and geopolitical tensions ease over time. Given the still high wage pressures in Latvia, it will remain essential to avoid significant and permanent losses of competitiveness in this regard. The International Monetary Fund projects average current account deficits of 3.4% of GDP between 2024 and 2028.

Latvia's Banking Sector Well Placed to Face 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 23.6% and liquidity coverage ratio at 172.6% as of Q1 2024, are both well above their regulatory minimums, providing ample room to absorb shocks. Moreover, Latvia's central bank decided to raise the countercyclical capital buffer requirement to 1.0% from 0.0% with the aim of strengthening the resiliency of banks. Higher interest rates have spurred banks' profitability while asset quality remains strong, with the ratio of nonperforming exposures at 0.4% as of Q1 2024, underpinned by prudent lending standards. The main systemic risk is linked to a protracted period of economic weakness and tight lending conditions that could impair debt repayment, particularly for businesses. The predominance of variable-rate lending means that tight monetary policy is transmitted quickly. However, low private-sector indebtedness, among the lowest in the eurozone, a small debt payment burden, and fairly resilient labour markets mitigate the associated risks. The housing market is experiencing a moderate downturn, with activity declining and price growth decelerating until recently. The expected continuation of a gradual easing cycle by the ECB in coming quarters, could facilitate a gradual recovery in the market.

Since most of domestic financial services are provided by the subsidiaries of large Nordic banks, the financial sector in Latvia is exposed to the developments and strategic decisions of its parent banks and their home countries. This increases the risks of contagion in the event of a deep real estate crisis in the Nordics affecting Latvia's banking system. Moreover, given the geopolitical context, the risks of cyberattacks and other large-scale unexpected disruptions to financial infrastructure remain high, according to the Latvian central bank. The Latvian authorities remain committed to strengthening their fight against money laundering and terrorist financing (AML/CFT), and the IMF has commended their progress. The significant progress made in this area in recent years has resulted in a significant drop in the proportion of non-resident deposits, to 9.3%, from more than 50% in 2015.

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

Despite the fractured nature of Latvian politics, frequent government turnover, and geopolitical tensions, Latvia's political environment appears stable and policymaking is generally effective. Latvia is in line with the EU27 average in most of the Worldwide Governance Indicators. A new coalition government led by Prime Minister Evika Sili¿a (New Unity, JV) was formed in September 2023, following the resignation of Arturs Kri¿j¿nis Kari¿¿, also of 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) has a slim parliamentary majority. 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 an additional strain on public finances. Latvia's commitment to increase its defence budget from 2.9% of GDP in 2024-2025 to 3.7% of GDP in 2027-2028 will reduce the fiscal space available for other priorities.

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.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights. Latvia's GDP per capita, estimated at USD 23,153 in 2023, according to the International Monetary Fund, is relatively low compared with its euro system peers. Morningstar DBRS has taken these considerations into account within the "Economic Structure and Performance" building block.

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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/438765.

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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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, May 2024; Stability Programme of Latvia 2024-2028; Updated Macroeconomic and Public Finance Forecasts for 2025-2028, August 2024), Latvia's Cabinet of Ministers (Declaration on the intended activities of the Cabinet headed by Evika Sili¿a, 15 September 2023), Latvia's Ministry of Climate and Energy (Latvia's draft updated National Energy and Climate Plan), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Forecasts June 2024; Financial Stability Report 2024), European Commission (2024 Country Report - Latvia; Spring 2024 Economic Forecast), Statistical Office of the European Communities, International Monetary Fund (WEO and IFS; Staff Concluding Statement of the 2024 Article IV Mission, June 2024), World Bank, European Central Bank, Bank for International Settlements, Social Progress Imperative (2024 Social Progress Index), Haver Analytics. Morningstar DBRS 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

Morningstar DBRS 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. Morningstar DBRS' outlooks and 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://www.dbrsmorningstar.com/research/438766.

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

Lead Analyst: Javier Rouillet, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: March 01, 2024

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