DBRS Confirms Republic of Latvia at A (low), Stable Trend

DBRS Ratings Limited confirmed the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings at A (low) and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trends on all ratings are Stable.

KEY RATING CONSIDERATIONS

The ratings are underpinned by Latvia’s consensus around stable macroeconomic policy-making, including judicious fiscal management and a low level of public debt, and institutional benefits from membership in the European Union (EU) and the euro area. The ratings are nevertheless constrained by structural challenges. These include vulnerabilities to external shocks from the country’s small and open economy, lower income and productivity levels compared to euro area partners, and remaining risks in the financial sector stemming from banks that service foreign clients.

Coalition government discussions are ongoing following the fractured result of the October 2018 parliamentary election. Seven political parties and association of parties cleared the five percent threshold necessary to secure seats in the legislature, including new or rebranded parties and alliances, which illustrated voter dissatisfaction with existing parties. DBRS does not expect policy discontinuity from the new government. Authorities passed meaningful reform measures this year meant to strengthen the financial sector. Although risks related to banks servicing foreign clients continue to pose challenges, the closure of Latvia’s largest foreign-client servicing bank (ABLV Bank AS) earlier this year did not adversely affect the strong performance of Latvia’s economy, nor did it result in a fiscal cost to the government.

RATING DRIVERS

DBRS considers Latvia well-positioned in its current rating range. Continued efforts to strengthen Latvia’s financial system and reduce domestic economic vulnerabilities could place upward pressure on the ratings. Over the medium-term, effective execution of a reform agenda that enables Latvia’s income and productivity levels to converge with the European average could also be credit positive.

Conversely, the ratings could face downward pressure if Latvia’s public debt dynamics deteriorate in a marked manner. This could result from a severe external shock that causes material macroeconomic underperformance or a reversal of the Latvian authorities’ prudent fiscal management.

RATING RATIONALE

Latvia’s Exceptional Economic Growth Over the Last Two Years is Expected to Moderate in 2019

Robust domestic and external demand has encouraged the strong economic performance since 2016. After average 2.4% growth from 2014-2016, the economy expanded by 4.6% in 2017. Strong results over the first three quarters of 2018 shows the favourable trend has continued. The government expects GDP to expand by 4.2% this year. The increase in private sector investment activity and absorption of the European structural and investment funds have driven double-digit investment growth and exports are forecasted to increase by 5.0% this year. Furthermore, the strong labour market has activated a previously side-lined population and reduced the unemployment rate, 7.0% as of the third quarter, to the lowest level since before the crisis. Strong employment and wage growth have supported the steady increase in household consumption.

DBRS expects a slight economic deceleration next year. Investment growth appears to have peaked, weighing on domestic demand. EU-funded projects will continue to support investment, though at a less impressive rate than in 2017 and 2018. Likewise, budget constraints could drag down the growth of public consumption, even as private consumption is expected to remain solid. External demand is expected to weaken and slow export growth. Latvia’s export performance and its economy are inescapably linked to the economic performance of key eurozone trade partners, and weaker than expected euro area results are likely to lower growth projections across Europe. The European Commission (EC) forecasts the Latvian economy to grow by 3.2% in 2019 and 2.9% 2020, slightly below potential growth calculations.

ABLV Liquidation Accelerated Declines in Foreign Client Deposits and Triggered Regulatory Efforts to Reduce High Risk Transactions

The fallout to the Latvian banking sector from the ABLV liquidation earlier this year has been contained and it has accelerated the decline in bank deposits from non-resident serving banks. As of September 2018, foreign client deposits shrank to €3.0 billion (20% of total deposits), down from €6.9 billion (36% of the total) in February 2018 and €12.4 billion (53% of the total) in 2015. Aggressive unwinding of the part of the financial sector that services foreign clients can occur rapidly and without systemic financial stress, as non-resident serving banks tend to have highly liquid balance sheets. ABLV depositors were compensated by the sale of ABLV assets, with no notable economic spillover or public draw-down from the deposit insurance fund. ABLV has already repaid the emergency liquidity assistance extended to it by the Bank of Latvia.

Following the ABLV episode, the authorities passed reforms meant to change the business model of foreign client servicing banks. In May 2018, the amendments to the Law on Prevention of Money Laundering and Terrorism Financing went into force, and as of July 2018 banks can no longer perform any operations with high risk client accounts. This bans cooperation between banks and shell companies that have no real economic activity. DBRS expects the performance of these banks will remain volatile, though it is important to remember that the domestic financial market is disconnected from banks servicing foreign clients. Foreign client servicing banks account for only 12% of total domestic lending. The bulk of domestic financial services are delivered by stable Nordic bank subsidiaries.

The Latvian domestically-active banking sector is profitable and holds capital equal to more than one-fifth of risk-weighted assets. Non-performing loans to total loans as measured by the IMF declined to 5.9% in the second quarter of 2018, down from the crisis peak that was near 20%. Despite these favourable financial sector developments and a low interest rate environment, the cost of credit is comparatively high in Latvia due to legacy risk aversion and market concentration. Aggregate measures show that domestic lending to non-financial corporates has been contracting on an annualized basis since last year, but these results are largely distorted by one-off effects due to the structural changes in the banking sector. Excluding one-offs, private sector lending growth has turned slightly positive.

Fiscal Policy has Turned Moderately Expansionary, While Debt Continues its Gradual Decline

The fiscal deficit has widened following the small fiscal surplus reported in 2016. Significant tax reform was passed in 2017 with the aim of improving tax administration, which focuses on economic growth and combating social challenges, including the informal economy and income inequality. The reform allows corporates to defer income tax until profits are distributed and made personal income tax more progressive. These measures are partially offset by the increases in a variety of taxes and social contributions, yet the reform is moderately expansionary. The deficit widened to 0.6% of GDP in 2017 and the government expects the deficit to remain under 1.0% of GDP through 2020. The moderate expansionary position is driven by increases in defence, social payments, and public sector wages. These increases in permanent spending cause the structural deficit to rise to 1.8% of potential GDP in 2018, according to the EC, and decline thereafter as cost savings associated with the 2018 pension reform take effect.

Latvia’s public debt is on a declining trajectory and the Treasury has a favourable funding profile. General government gross debt declined to 40.0% of GDP last year, and the EC forecasts this ratio to decline to 35.5% by 2019. The IMF expects the ratio to decline to 31.0% by 2022. The favourable trajectory reflects strong growth of nominal GDP, persistent primary surpluses, and low interest expenditure – expected to remain below 1.0% of GDP for the next few years. DBRS expects the government to continue to take advantage of high demand for its Eurobonds and low interest rates to prefund its redemptions. Bonds issued in September 2018 and set to mature in 2047 have a low 1.86% yield.

DBRS Expects Macroeconomic Policy Continuity Following the October 2018 General Elections

The October 2018 parliamentary election resulted in another fragmented outcome. The existing coalition lost its majority and the social democratic party, Harmony, received the largest voting share with 19.8% of the vote. As in the past, Harmony is likely to remain excluded from the ruling coalition that emerges. This election brought about the electoral success of new parties or party alliances, including among others the anti-establishment Who Owns the State party (KPV LV) and the anti-corruption New Conservative Party (JKP). With seven political parties and alliances wining seats, coalition talks are likely to persist for some time.

Despite the fractured nature of Latvian politics, frequent government turnover, and lingering geopolitical tensions, Latvia’s political environment appears stable and policy-making generally effective. Latvia has a long history since its independence of government reshuffling, including 15 Prime Ministers since 1991, yet performs above the regional average on World Bank Governance rankings. DBRS expects the next coalition government will continue to pursue key reforms, manage fiscal policy prudently, and maintain broad consensus around the European project.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A – BBB (high) range. The main points discussed during the Rating Committee include Latvia’s economic performance, the labour market, tax reform, and the 2018 elections.

KEY INDICATORS

Fiscal Balance (% GDP): -0.6 (2017); -0.8 (2018F); -1.0 (2019F)
Gross Debt (% GDP): 40.0 (2017); 37.1 (2018F); 35.5 (2019F)
Nominal GDP (EUR billions): 27.0 (2017); 29.2 (2018F); 30.8 (2019F)
GDP per Capita (EUR): 13,946 (2017); 15,194 (2018F); 16,143 (2019F)
Real GDP growth (%): 4.6 (2017); 4.1 (2018F); 3.2 (2019F)
Consumer Price Inflation (%): 2.9 (2017); 2.7 (2018F); 2.4 (2019F)
Domestic Credit (% GDP): 145.5 (2017); 145.5 (Jun-2018)
Current Account (% GDP): 0.7 (2017); 0.0 (2018F); -0.4 (2019F)
International Investment Position (% GDP): -56.7 (2017)
Gross External Debt (% GDP): 140.7 (2017); 126.4 (Jun-2018)
Governance Indicator (percentile rank): 78.8 (2016); 78.8 (2017)
Human Development Index: 0.84 (2016); 0.85 (2017)

EURO AREA RISK CATEGORY: LOW

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: Bank of Latvia, 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 Republic of Latvia Ministry of Finance, Statistical Bureau Latvia, Bank of Latvia, European Commission, Statistical Office of the European Communities, IMF, World Bank, 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:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

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 R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: June 8, 2018

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