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' view that Latvia's low public debt ratio and prudent fiscal policy record in the past mitigate the risks of a higher fiscal deficit in the near term amid a challenging economic and geopolitical environment. The fiscal deficit is projected to widen to just below 3% of GDP this year, having decreased to an estimated 2.1% in 2024. The temporary deterioration is expected to be driven by lower revenues from income tax decreases and rising spending on internal security and defence, while a gradual fiscal consolidation is expected over the medium term. Latvia's low public debt levels, although expected to increase slightly in the coming years, still provide significant room to respond to potential shocks. After displaying a remarkable degree of economic resilience to a succession of shocks in recent years, real GDP growth contracted in 2024 dragged down by lower investment and a weak external environment. While uncertainty and external risks remain high, Latvia's economic growth is expected to rebound as private consumption recovers and European Union (EU)-funded investment picks up.

The credit ratings are underpinned by Latvia's membership in the EU and the euro area, its strong political institutions and effective policymaking, and its strong fiscal track record and low levels of public sector debt. Despite the expected increase in the coming years, Latvia's debt-to-GDP ratio should remain one of the lowest in the EU 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, or the crystalisation of significant contingent liabilities, leads to a sustained deterioration in the public debt trajectory.

CREDIT RATING RATIONALE

Fiscal Rebalancing Path Is Expected to Remain Gradual, but Could Be Complicated by a Slower Economic Recovery

The government narrowed the general government fiscal deficit from 7.2% of GDP at the height of the pandemic in 2021 to 2.1% in 2024, as estimated by the Ministry of Finance (MoF). Revenue growth of 9.7% in 2024 outpaced expenditure increases thanks to a strong tax revenue intake. Higher expenditure of 5.4% was driven by increases on public wages as well as social benefits. However, the improving fiscal results likely will come to an end this year. Deficit-enhancing measures adopted by the government in the 2025 budget are expected to push the deficit to 2.9%, with the MoF projecting a gradual reduction of deficits thereafter that could bring the deficit down to 2.1% by 2028. A tax reform reducing the tax burden on labour is expected to have a negative fiscal impact on the revenue side that would be mitigated by revenues from a one percentage point transfer from the funded pension scheme (2nd pillar) to the 1st pension pillar and other measures such as higher excise taxes. On the expenditure side the government is limiting public sector wage growth but faces spending pressure on internal security and defence. The Ministry of Defence projects defence expenditure to rise to 3.7% of GDP already next year, up from 2.9% in 2023. EU Recovery and Resilience Facility grants of around 1.5% of GDP per year will partially help funding investments in 2025 and 2026.

The projected deficit trajectory until 2028 marks a slower path of fiscal consolidation than previously anticipated, without substantially altering Latvia's medium-term projections. Morningstar DBRS notes that achieving the projected rebalancing could be challenging if the economic recovery is further delayed, potentially lowering tax revenues. In addition to defence, the country faces rising spending pressures in the medium-term from ageing and climate change. Nevertheless, Latvia has a track record of prudent fiscal policy, which resulted in either moderate fiscal deficits or virtually balanced positions between 2012 and 2019. Budget targets have been largely outperformed in recent years despite heightened uncertainty, reflecting the authorities' prudent planning. In its fiscal structural plan 2025-28 submitted to the European Commission (EC), the Latvian authorities are committed to maintaining deficits below the 3% of GDP reference. The International Monetary Fund (IMF) notes that Latvia has some fiscal space that could be further enhanced by structural fiscal measures including broadening the tax base and reducing subsidies as well as the shadow economy.

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

Ater falling to 44.4% of GDP in 2022, the public debt-to-GDP ratio increased in 2024 to almost 48%, exceeding its 2021 pandemic peak level. Latvia's debt burden is almost 10 percentage points (pps) higher than in 2019. The government expects the public debt ratio to remain on a gradual upward trend driven by higher-than-previously planned budget deficits. The government projects the public debt ratio to increase to 50% by 2027, before decreasing again in 2028. A more protracted economic weakness or persistently wider fiscal deficits however could put additional pressure on the outlook for public debt. Government debt service costs, which stood at 0.7% of GDP in 2023, are expected to gradually increase and to surpass the 2010-19 average of 1.3% of GDP in 2027, reflecting the larger debt stock and Latvia's higher financing costs. Moreover, the Fiscal Discipline Council, the country's fiscal watchdog, warns that Latvia faces fiscal risks related to the operations of state-owned enterprises including AirBaltic as well as the implementation of the Rail Baltica project. Non-consolidated liabilities of government controlled non-financial entities outside of general government amounted to 15.7% of GDP in 2023. The estimated costs of the rail transport infrastructure Rail Baltica project have increased significantly, with Latvia potentially facing additional funding needs to complete the first project phase by 2030. While public debt projections have worsened and contingent liability risks have increased, Latvia's public debt-to-GDP ratio is expected to remain among the lowest in the EU and should still provide flexibility to respond to additional shocks. Debt affordability also remains comfortable, with Latvia benefiting from a favourable debt profile and a cash buffer of 5.0% of GDP at the end of 2024.

Economic Growth To Rebound and Medium-Term Prospects Remain Healthy Despite Weaker Competitiveness

After displaying a remarkable degree of economic resilience to successive shocks in recent years, Latvia's real GDP contracted in 2024. Following data revisions, Latvia's GDP showed solid growth of 1.7% in 2023 (instead of a previously reported 0.3% contraction), while growth in the first three quarters of 2024 was -0.5% year-on-year, dragged down by declines in external trade and investment and subdued private and public consumption increases. Private consumption disappointed despite strong real disposable income driven by inflation decreasing to 1.3% from 9.1% a year prior. Tight financing conditions also weighed on business investment and sluggish external demand was a drag for trade. The unemployment rate stabilized at 6.8% over the past reported months, after surpassing the euro area average in 2023.

Growth is projected to gradually rebound. The EC projects real GDP growth of 1.0% in 2025 and 2.1% in 2026. The Bank of Latvia is more optimistic, projecting growth of 2.1% in 2025 accelerating to 3.0% and 3.3% in 2026 and 2027, respectively. The projected recovery will be supported by all expenditure components, though net exports are only expected to contribute to growth from next year. The labour market is expected to remain tight and to continue supporting moderate wage growth that should translate into increasing private consumption. Easing financing conditions and project execution financed by both the government and the EU (with projected budget expenditure of funds of more than 3% of GDP in both 2025 and 2026) are expected to continue supporting investment. Average annual inflation is projected to rise again, but to remain close to or below 2%. This should ease concerns over the unsustainable increases in prices and costs impacting Latvia's competitiveness. Wage growth has outpaced productivity growth over the past years and coupled with higher energy costs, the IMF expects these to have some economic scarring effects. But it still projects healthy medium-term growth of around 2.5%. Downside risks to the growth outlook emanate from geopolitical tensions, an under-execution of EU funded projects and a further weakening of competitiveness. A broader trade war as result of higher US tariffs, would weigh on Latvia's open economy. Demographic pressures and labour shortages could also restrict potential growth in the longer term, if not addressed.

Latvia's small and open economy, together with a relatively low income per capita compared to its euro area partners, makes the country vulnerable to external shocks and could lead to greater economic volatility. That said, Latvia's flexible and dynamic economy has proven resilient to the pandemic, energy, and interest rate shocks. Real GDP growth averaged 2.8% over 2011-23. Latvia has significantly narrowed the income gap, with its real GDP per capita (in purchasing power terms) estimated at 70% of the EU's average in 2023, up by more than 10 pps over the past ten years, although it still trails 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 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. Latvia's external position also weakened as result of losses in price competitiveness. The current account balance on average went from a surplus of 1.1% of GDP over 2016-20 to a deficit of 5.5% of GDP in 2022, narrowing to 3.9% in 2023, as a large goods trade deficit was still only partly balanced by a surplus in services. FDI flows and EU-related capital transfers largely funded these current account deficits. In addition, the country's negative net international investment position has continued to improve. Looking ahead, Latvian exports are projected to pick up gradually as the effects of monetary policy tightening and geopolitical tensions ease over time. Moreover, the IMF anticipates moderating inflation and wage growth to help the country to recover some price competitiveness. The EC projects the current account deficit to narrow down from 3.2% in 2024 to 2.3% in 2026. The purchase of defence equipment in line with higher military expenditure and the implementation of EU funded projects will likely complicate a return to a more balanced position.

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 22.8% and liquidity coverage ratio at 167.0% as of Q3 2024, are both well above their regulatory minimums, providing ample room to absorb shocks. Moreover, the countercyclical capital buffer requirement is gradually being raised to 1.0% in June 2025 from currently 0.5% with the aim of strengthening the resiliency of banks. Higher interest rates have spurred banks' profitability while asset quality continues to remain strong, with the ratio of nonperforming exposures still at 0.4% as of Q3 2024, underpinned by prudent lending standards. The main risks stem from a protracted period of economic weakness, still tight lending conditions and the prevalence of variable-rate loans that could impair debt repayment. 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 experienced a moderate downturn, but now seems to be turning a corner. Market activity is picking up as housing affordability is improving on the back of wage growth and the ECB's monetary policy easing.

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, although risks are limited by the strong credit profile of the relevant banks. 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% as of December 2024, 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 policymaking is generally effective. Latvia is broadly in line with the EU 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) holds only 50 seats (out of 100) in the Saeima (parliament) but is supported by some independent members of parliament. Divisions among the coalition partners surfaced regarding the candidate's selection for the post of governor of the Bank of Latvia. Morningstar DBRS expects the Latvian 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 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. Ethnic Russians account for 23% of Latvia's population, although a wave of integration measures including the phase out of Russian as language of instruction in schools did not provoke any strong reaction from Latvia's Russian-speakers. 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. In January 2025, NATO announced the launch of a new military activity ("Baltic Sentry") enhancing its presence in the Baltic Sea to bolster the protection of critical infrastructure, after the sabotage of undersea cables connecting Estonia and Finland in December 2024. Similar suspected hybrid attacks have been on the rise in the region in recent years. Most recently an underwater data cable between Sweden and Latvia has been damaged in January. Geopolitical risk could increase further if NATO is weakened, but this is not Morningstar DBRS' baseline expectation.

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 24,223 in 2024, according to the IMF, 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/448042.

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 these credit ratings include Latvia's Ministry of Finance (Investor Presentation, January 2025; Macroboard December 2024; Fiscal Structural Plan of Latvia 2025-2028; Draft Budgetary Plan 2025; Stability Programme of Latvia 2024-2028), Latvia's Ministry of Economy (Latvia's Economic Development Report, December 2024), State Audit Office (Review of the Rail Baltica project, June 2024), Fiscal Discipline Council (Surveillance Report on the 2025-2027 Medium-Term Budgetary Framework, the 2025 Budget, and the 2025-2028 Fiscal Structural Plan, October 2024), Latvia's Ministry of Defence (2025 Defence Budget, December 2024), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Forecasts December 2024; Financial Stability Report 2024), European Commission (Autumn 2024 Economic Forecast; Assessment of Latvia's medium-term fiscal-structural plan; Commission opinion on the 2025 Draft Budgetary Plan of Latvia, November 2024), Statistical Office of the European Communities, European Parliament (Latvia's climate action strategy, December 2024), International Monetary Fund (WEO and IFS; 2024 Article IV Consultation - Press Release, Staff Report; Latvia Selected Issues, September 2024), OECD (Economic Outlook, December 2024), World Bank, European Central Bank, Bank for International Settlements, Stockholm School of Economics (Shadow Economy Index for the Baltic Countries), Social Progress Imperative (2024 Social Progress Index), NATO, 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: 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://www.dbrsmorningstar.com/research/448044.

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

Lead Analyst: Max Dietz, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: 30 June 2017
Last Rating Date: 30 August 2024

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