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

DBRS Ratings Limited has confirmed the Republic of Estonia’s 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 are Stable.

The Stable trends reflect DBRS’s view that risks to the ratings are balanced. Despite remaining structural challenges to the economy and the government’s recent shift towards more public spending flexibility, Estonia’s economic and fiscal performance has been strong.

The AA (low) ratings are underpinned by Estonia’s stable macroeconomic policy framework and its exceptional sovereign balance sheet. Excluding the crisis-related deficits, public finances have been near balance or in surplus since 2002. The European Commission (EC) expects general government gross debt of only 9.2% of GDP in 2017. Debt appears even more negligible once offset by the Treasury’s 5.6% of GDP in liquid savings. Membership in the European Union (EU) and the Euro area are also significant benefits. Estonia is a net recipient of EU structural funds, and the economy is supported by the free movement of goods and services offered by the single market.

The ratings are nevertheless constrained by structural credit challenges. Estonia is vulnerable to external shocks stemming from the country’s small and open economy. The rising labour costs that have outpaced productivity growth could weaken export price competitiveness. Moreover, convergence of Estonian income levels with the EU has slowed over the last decade. Income per capita in Estonia adjusted for purchasing power parity, while high when compared against regional peers, remains around three-quarters of the Euro area average.

The Estonian economy gained momentum in 2017. After 2.1% growth in 2016, the Estonian economy expanded by 4.4% y-o-y as of the third quarter on a four-quarter rolling basis. The economy is currently operating above trend and the output gap is positive. Despite favourable credit conditions, there is little evidence of excessive private sector leverage, housing market imbalances, or saving-investment misalignments. Strong economic outcomes stem in part from positive external conditions, but principally from robust domestic demand. The investment surge linked to the EU funding cycle has supported capital formation, and domestic consumption is fuelled by strong wage growth.

Inflation is higher than the EU average, reaching 3.4% y-o-y in December 2017, and average monthly wages expanded by 7.3% in the third quarter of 2017. DBRS expects inflationary pressures to ease as base effects from tax measures and higher food and energy prices fade. However, strong wage growth appears persistent and reflects tight and structurally constrained labour markets. Even as aging demographics shrink the working age population, the strong growth environment and policy changes (most recently the Work Ability Reform) have boosted labour participation. Thus, the expected rise in the unemployment rate, from 6.9% in 2017 to 8.5% in 2019, reflects increased labour supply in a context of skills and regional labour mismatches. The EC expects GDP growth of 4.4% in 2017 and 3.2% in 2018.

The strong growth performance is accompanied by an improved external position. The current account has been mostly in surplus since 2009 and reached 2.5% of GDP in the second quarter of 2017. Sustained current account surpluses have improved Estonia’s external position, evident by lower external debt and a narrower net liability international investment position (IIP). IIP improved from -80% of GDP in 2009 to -34% as of 2Q17. Much of the external debt is owed to parent corporates that have been the source of substantial inward direct investment over the last decade. The improvement mitigates risks of sudden capital withdrawals and reduce vulnerabilities associated with external shocks.

Some erosion of external competitiveness is evident by Estonia’s trade performance. Labour costs have risen sharply. This can contribute to tightening profit margins of export oriented corporates and weaken external competitiveness. The real effective exchange rate adjusted for unit labour costs strengthened by 11% from 2012 to 2016. Over the same period, the growth of goods exports has been flat and the index for total trade volume has gradually declined. It is worth noting that exports still account for roughly four-fifths of Estonia’s GDP and service sector export performance remains resilient.

The budget position, which has roughly remained in headline and structural balance since 2010, is expected to run modest deficits over the forecast period. The general government recorded a 0.3% of GDP deficit last year and officials expect a similar outcome in 2017. Several new tax measures will take effect in 2018, notably a lowering of personal income taxes offset by excise tax increases and corporate income tax reform. On spending, a social investment program worth nearly half a percent of GDP from 2018-2020 is set to begin this year. Likewise, the delivery of EU funding also affects Estonia’s fiscal outcomes, as the co-financing of projects is at times required to provision certain EU structural funds. Consequently, the EC forecasts headline deficits of 0.4% of GDP and 0.5% in 2018 and 2019.

The government modified the State Budget Act in 2017. The change allows the government to run structural deficits up to 0.5% of GDP, so long as they were proceeded by accumulated structural surpluses. This contrasts with the structural balance requirement under previous legislation. While the Estonian Fiscal Council has been critical of what it considers a loosening of fiscal discipline, DBRS is of the view that the change allows for greater public spending flexibility around key objectives while still maintaining fiscal prudence. Under the 2018 budget proposal, the government aims for a 0.25% of GDP structural deficit in 2018 and 2019, a balance position in 2020, and 0.5% surplus in 2021.

Estonia’s low gross government debt is an outlier among its EU partners. The country’s conservative fiscal policy reduces the need to finance deficits, and authorities expect debt to remain below 10% of GDP over the forecast period. Yet, given its small and open nature, the Estonian economy is particularly vulnerable to adverse external scenarios. The government provisions against shocks by maintaining a high level of liquid savings. As of the third quarter 2017, the Liquidity Reserve, a financial buffer for daily cash-flow management, was €876 million and the crisis-related provisioning Stabilization Reserve Fund reached €413 million. Both make up 5.6% of GDP and well exceed the State Treasury’s debt portfolio.

Risks to financial stability associated with spillovers from Nordic economies and parent banks appear well managed. The liquidity and funding position of the Estonian financial sector is directly and indirectly affected by the performance of the Nordic country economies. Banks in Estonia rely on roughly one-fifth of their funding from parent banks. An economic slowdown in the Nordic region could cause capital outflow from Estonia, and affect the income of Estonian exporters and their ability to service loans. These risks are mitigated by the improved economic conditions of Nordic countries, and strong asset quality, deposit funding, and capitalisation of banks operating in Estonia.

Credit growth and the domestic real estate sector are expanding at a strong pace. Lending to households and the non-financial sector increased 15.5% in the three years between the second quarter 2014 and the second quarter 2017. Real estate prices advanced by 17.9% over the same period. Notwithstanding, debt to income ratios remain well below crisis-level peaks and private sector savings rates are still at historical highs. Estonia has a series of macro-prudential measures intended to increase capital buffers if the lending environment turns excessive. Given strict loan-to-value and debt-to-income limits for obtaining mortgages, there is no evidence that banks have eased lending standards.

After its first year in office, the three-party coalition government led by the Estonian Centre Party has pursued a host of fiscal measures. Most notable is the change to Estonia’s structural fiscal rules which eases some of the public-sector spending constraints to increase investment in key areas. DBRS expects Estonian public institutions to remain strong and predictable. Estonia is an exemplar performer, especially among its Baltic peers, on the World Bank Governance Indicators. Regulatory quality ranks in the 93rd percentile.

RATING DRIVERS

DBRS considers Estonia well-positioned at its current rating level. Nonetheless, one or a combination of these factors could lead to upward pressure on the ratings: (1) Increased evidence of a persistent reduction in economic volatility inherent to Estonia’s small and open economy; (2) Successful implementation of measures that improve income and productivity.

One or a combination of these factors could lead to downward pressure on the ratings: (1) An external shock, possibly from financial instability among key Nordic partners, that causes sudden capital outflow from Estonia and material macroeconomic underperformance. (2) A return of excessive credit growth, particularly in the housing market, that leads to private sector overleverage and financial sector instability. (3) An unexpected relaxing of fiscal discipline, beyond recent changes to the State Budget Act, that significantly weakens Estonia’s public debt dynamics.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AA – A (high) range. The main points discussed during the rating committee include the economy’s size and volatility, changes to fiscal policy, wage growth dynamics, and risks stemming from Russia.

KEY INDICATORS

Fiscal Balance (% GDP): -0.3 (2016); -0.2 (2017F); -0.4 (2018F)
Gross Debt (% GDP): 9.4 (2016); 9.2 (2017F); 9.1 (2018F)
Nominal GDP (EUR billions): 21.1 (2016); 23.0 (2017F); 24.6 (2018F)
GDP per capita (EUR thousands): 16.0 (2016); 17.4 (2017F); 18.6 (2018F)
Real GDP growth (%): 2.1 (2016); 4.4 (2017F); 3.2 (2018F)
Consumer Price Inflation (%, eop): 0.8 (2016); 3.7 (2017F); 3.0 (2018F)
Domestic credit (% GDP): 94.3 (2016); 88.0 (Nov-2017)
Current Account (% GDP): 1.9 (2016); 1.8 (2017F); 1.4 (2018F)
International Investment Position (% GDP): -37.1 (2016); -32.7 (Q3-2017)
Gross External Debt (% GDP): 90.4 (2016); 83.1 (Q3-2017)
Governance Indicator (percentile rank): 82.7 (2016)
Human Development Index: 0.87 (2016)

Notes:

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development. Key indicator sources: Ministry of Finance, Bank of Estonia, Statistical Office of Estonia, European Commission, Statistical office of the European Communities, International Monetary Fund, World Bank, United Nations Development Programme, Haver Analytics, DBRS.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.
The sources of information used for this rating include Ministry of Finance, Bank of Estonia, Statistical Office of Estonia, European Commission, European Central Bank, Statistical Office of the European Communities, International Monetary Fund, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve-month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
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Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: July 14, 2017

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