Morningstar DBRS Confirms Republic of Estonia at AA (low), Stable Trend

DBRS Ratings GmbH (Morningstar DBRS) 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 remain Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS' view that the government's fiscal consolidation plan and expected economic recovery mitigate the risks from the current economic and fiscal challenges. Gradually restoring purchasing power, declining Euro Area interest rates, EU-financed investments and a generally improving economic outlook should support private demand and investments next year. The adverse spillovers from the Russia-Ukraine war--foremost a protracted economic recession, a stark inflationary shock and elevated geopolitical risks--have intensified the fiscal challenges for Estonia. Public expenditure on salaries, social support and military defence has increased structurally. In our view, the proposed fiscal consolidation plan--including broad tax increases--that is anticipated to be implemented over the next two years will limit Estonia's fiscal deficits to moderate levels of about 3% of GDP. While the public debt burden is on an upward trajectory, it is anticipated to remain at levels of below 30% of GDP over the medium-term. Morningstar DBRS expects Estonia's external position to remain strong, although competitiveness pressures could lead to weaker current account balances than in the decade before the pandemic.

Estonia's credit ratings are underpinned by its strong institutions, anchored by membership in the European Union, the Euro Area and NATO. The free movement of goods and services facilitated by the EU's single market and Estonia's business-friendly framework support its export-oriented economy. The low public debt ratio resulting from a strong fiscal track record and national fiscal framework further support the credit ratings. Conversely, Estonia's small, open economy is prone to adverse external developments, making the economy susceptible to more volatile performance, such as that experienced in recent crises, compared to peers with similar rating levels. Moreover, per-capita income at about USD 30,138 in 2023 remains below the levels of peers, although strongly converging in the past decade.

CREDIT RATING DRIVERS
Morningstar DBRS could upgrade Estonia's credit ratings if the following occurs: (1) evidence of increased economic resiliency with improvements in per-capita income and productivity; and (2) a significantly stronger fiscal position than currently expected.

Morningstar DBRS could downgrade Estonia's credit ratings if one or a combination of the following occur: (1) persistent economic and fiscal weakness that leads to materially higher public debt over time; or (2) the emergence of significant financial and/or macroeconomic imbalances.

CREDIT RATING RATIONALE

Consolidation Measures will Stabilise Fiscal Performance Over the Medium-Term Amid High Expenditure Pressures

Estonia's fiscal deficit will slightly widen in 2024 to 2.9% of GDP after 2.8% in 2023, according to government estimates. Estonia's fiscal position has structurally weakened in recent years, in our view, as fiscal challenges have increased. The economic fallout and fiscal support measures stemming from the pandemic and Russia's invasion of Ukraine pressured tax revenues and induced structurally higher expenditures for public salaries, social benefits and defence. Defence expenditure, estimated at 3.7% of GDP in 2024, is high in relation to a European comparison, and will remain at elevated levels given the increased security risks in Eastern Europe. A multi-year fiscal consolidation plan by the current government mainly envisages strengthening the revenue side from 2025 with tax increases for households and businesses that could amount to 1.5-2.0% of GDP of additional revenue each year, including "security" tax surcharges that are promised to remain in place only temporarily until 2028, according to government estimates. In addition, operating cost savings and the stabilisation of social expenditure are foreseen to contribute to fiscal consolidation over the medium-term. In our view, the implementation of the consolidation measures over the next years is realistic and anchored by Estonia's commitment to comply with EU fiscal rules, although implementation details might be adjusted along the way. The fiscal deficit is projected to stabilise at around 3% in 2025 and gradually narrow to 2.5% by 2027 according to government estimates.

Morningstar DBRS notes that Estonia's pre-pandemic fiscal track record is strong in our view, with fiscal surpluses averaging around 0.3% of GDP during 2000-19. Morningstar DBRS takes the view that fiscal risks for Estonia will remain tilted to the downside over the medium-term. Fiscal deficits could materially widen compared to the current government projections should implementation progress fall short in timeline and scope. Also, the materialisation of fiscal contingencies in a security crisis and a generally weaker economic trajectory are key downside risks.

The Economic Recession Is Proving More Protracted, But Conditions Are Set for a Recovery in the Coming Years

The Estonian economy is likely to remain in recession this year due to the continued drag from net exports and investment and still sluggish private consumption. The government projects real GDP to decline by 1.0% in 2024 after a contraction of 3.0% in 2023 and negligible growth in 2022. The adverse spillovers from the Russia-Ukraine war--including a stark inflationary shock, higher interest rates, and supply disruptions--as well as cyclically weaker external demand, have taken a significant toll on Estonia's small and open economy. Investment remains weak due to still high interest rates, low-capacity utilization, and weak activity in the manufacturing and construction sectors. Still, Estonian exports have started to recover in the second half of 2024 as demand from the country's main trading partners recovers from cyclical weaknesses. The gradual restoration of households' purchasing power will benefit private consumption over the next years following an inflationary shock of a combined 30% in 2022 and 2023. At the same time, the government's fiscal consolidation package, that includes increases of the VAT, excise duties and income taxes, will dampen the recovery in private consumption in 2025 and 2026. Still, EU-funded investment grants, worth around EUR 6 billion (or 15% of GDP in 2024) available in the coming years, will support investments in the medium term. Real economic growth is expected to recover to 2.1% in 2025 and to accelerate to 2.7% in 2026, according to government projections.

Morningstar DBRS notes that Estonia's economy grew strongly in the decade prior to the pandemic, with real GDP growth averaging 3.7% between 2011 and 2019, and showed resilient performance during the pandemic in 2020/2021. Estonia's per-capita income, standing at about USD 30,138 in 2023, strongly converged towards euro area levels. Supply side bottlenecks that emerged in 2022 with regards to energy, transportation and storage have abated since then. Energy import reliance is low in a European comparison given and the connection to European electricity grids has strengthened. The unemployment rate at 7.4% at the end of the third quarter in 2024 is moderate despite the prolonged economic weakness. The main risks to the growth outlook remain linked to the evolution of geopolitical tensions, inflationary and competitiveness pressures, and the economic developments of Estonia's main export partners.

Estonia's External Position Remains Sound, but Adverse Trade and Competitiveness Pressures Persist

Estonian goods exports have started to slowly recover in 2024 as cyclical demand weaknesses from major trading partners in the EU have faded. Goods exports had declined significantly over the past two years, particularly driven by the downturn in the manufacturing, real estate and construction sectors in the Nordic countries and Germany. Moreover, the sanctions regime against Russia has affected sectors that relied on cheap inputs from Russia and Belarus (e.g., the wood processing industry) and curtailed economic activity in the transport sector (e.g., transport of petroleum products). By contrast, exports of services have performed better, underpinned by the strong performance of ICT and the recovery in tourism. Estonia is set to post a current account deficit of about 1.5% of GDP in 2024, according to the European Commission. The country's external balance turned negative since 2020 due to a more challenging trade environment and the indirect impact of the Russia-Ukraine war. Also, elevated imports of defence equipment will continue to weigh on the balance of payments. We anticipate moderate current account deficits to persist although gradually narrowing over the medium term, driven by a further cyclical recovery of demand from EU trading partners--which account for about three quarters of Estonian goods exports.

Estonia's current account balances will most likely remain weaker going forward compared to the decade prior to the pandemic. Prolonged higher growth in price levels and labour costs in Estonia compared to the Euro area peers in conjunction with declining global export shares indicate that the country's export competitiveness has structurally declined in recent years. Still, the country's favourable tax and business environment, a low energy import dependence and skilled workforce continue to support the economy's competitiveness. With Estonia being a small open economy, we expect that the elevated exposure to adverse external pressures will persist. Morningstar DBRS anticipates that the continued heightened geopolitical risks in Europe and more challenging international trade relations from next year on will limit Estonia's external performance going forward. Morningstar DBRS notes that Estonia's overall external position remains sound with net IIP standing at -12.7% as of Q2 2024. The country had reduced external imbalances after joining the Euro area in 2011, improving the net IIP markedly after the great financial crisis.

Estonia's Public Debt Ratio Remains Among the Lowest in the EU but is set to Increase Amid Higher Public Funding Needs

Estonia's debt-to-GDP ratio remains the lowest in the EU, despite the projected increase by the government to 23.3% of GDP at the end of 2024 from 8.5% of GDP in 2019, reflecting the exceptional financing needs related to the pandemic and the conflict in Ukraine. The trajectory of the public debt ratio over the medium-term hinges on the ability of the government to implement the announced fiscal consolidation plan starting in 2025 and the pace of the anticipated economic recovery. The government's budget strategy projects that the debt ratio could peak at around 27% in 2027 and then gradually decline thereafter, compared with a steeper increase to 33.0% by 2028 if no adjustment measures are implemented. The country's interest bill is set to increase slightly to 0.5% of GDP next year and could reach about 0.8% of GDP by 2028 given the higher interest rate environment and additional borrowings. The country's debt profile benefits from a relatively long average maturity at 6.5 years, and a predominantly EUR-denominated and fixed rate debt portfolio. Estonia's material financial reserves (amounting to about 8% of GDP in 2024) further strengthen the country's liquidity profile.

Estonia's Healthy Banking Sector Limits Financial Stability Risks

Estonian banks are among the most strongly capitalised in the EU, with a CET1 ratio of 20.7% in Q2 2024, and compare positively on profitability metrics. Estonian banks' profits have started to moderate in 2024 after reaching record levels in 2023 benefitting from the repricing of their predominantly variable-rate loan portfolios as the ECB's policy rates increased. Asset quality remains very strong supported by the resiliency of the labour market, households and firms' moderate financial buffers, and the relatively good performance of the real estate sector in Estonia. Non-performing loans as a percentage of the loan portfolio at 0.75% in Q2 2024, among the lowest in the EU. Nevertheless, the protracted recession over the past two years and higher interest rates have weakened households' and companies' debt-servicing ability to some extent.

The Estonian banking sector has a large exposure to the real estate market. Loans to construction and real estate companies account for about 40% of the corporate loan portfolio, one of the highest in the EU, and mortgages account for close to 80% of outstanding loans to households. While risks stemming from the commercial real estate sector remain high, the payment behaviour of companies in the sector has remained good and banks' lending to the sector has been conservative. After years of strong price growth, the residential real estate market has cooled down in response to tighter monetary policy, with the number of transactions falling significantly. The Estonian banking system is at large foreign owned (e.g., by Nordic banks) and, as such there is elevated exposure to spillovers from economic performances of Nordic and Baltic neighbours. Morningstar DBRS notes that Estonian banks are principally funded by local deposits, which helps reduce their susceptibility to external financial stress and their reliance on cross-border parent group financing.

Estonia Benefits from Strong Institutions anchored by EU and NATO Membership

Estonia benefits from a strong institutional framework and an overall stable political environment, as indicated by its persistently strong comparative assessments in the World Bank's Governance indicators. Prime Minister Kristen Michal (Reform Party) has been leading a three-party coalition government since July 2024 - with the liberal Estonia 200 and the Social Democrats. The new cabinet follows the same government constellation formed after the 2023 elections by Michal's predecessor Kallas, who left national politics to take the role of EU Commissioner. Morningstar DBRS expects the government to remain committed to an ambitious fiscal consolidation package in 2025, that will remain crucial to address medium-term fiscal pressures. In our view, also Estonia's strong fiscal track record and commitment to the fiscal rules at the European level mitigate more pronounced fiscal risks.

Geopolitical risks in Europe remain heightened after the start of Russia's invasion of Ukraine in 2022, particularly in the Baltic region as direct neighbours of Russia. In our view, Estonia's EU and NATO membership is a crucial mitigant of security and economic risks that could stem from any future escalation of the conflict. The EU provides a stable institutional and macroeconomic framework with economic and fiscal support mechanisms. The military alliance NATO has increased its military presence in eastern Europe, including Estonia and the country has additionally stepped up its own military defence capabilities.

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. Estonia's GDP per capita, estimated at USD 30,138 in 2023 according to the International Monetary Fund (IMF), remains relatively low compared with its euro area peers. Morningstar DBRS has taken this consideration 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/444232.

EURO AREA RISK CATEGORY: LOW

Morningstar DBRS notes that this Press Release was amended on 6 February, 2025 to update the title of the ESG methodology.

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 Risk 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 these credit ratings include the Ministry of Finance (Autumn 2024 Economic Forecast, 2025 Draft Budgetary Plan, Estonia's National Medium-Term Fiscal-Structural Plan 2025-2028, State Budget Strategy for 2025-2028, Investor Presentation August 2024, MoF's Economic, Debt Management and Fiscal Presentations November 2024), Bank of Estonia (The Estonian Economy and Monetary Policy 2024/3, Financial Stability Review 2024/2), Statistical Office of Estonia, EC (Autumn 2024 Economic Forecast; 2024 Country Report - Estonia), 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 (2024 Social Progress Index), Haver Analytics and Macrobond. 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: YES
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/444231.

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: July 14, 2017
Last Rating Date: 7 June, 2024

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