DBRS Confirms Republic of Latvia at A (low), Trend Changed to Positive

DBRS Ratings Limited (DBRS) confirmed the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings at A (low). At the same time, DBRS confirmed the Republic of Latvia’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trends on all ratings have been changed to Positive.

KEY RATING CONSIDERATIONS

The Positive trend reflects DBRS’s view that credit fundamentals in Latvia appear to be improving. The liquidation of ABLV Bank AS last year and the significant decrease in non-resident deposits (NRDs) in the financial system have not weighed on financial stability, nor have these developments affected Latvia’s economic or fiscal performance. Furthermore, comprehensive tax reform addresses some of Latvia’s structural challenges by making personal income taxation more progressive and improving corporate sector competitiveness. Even in a context of frequently changing governments, persistent geopolitical risks, and structural shifts in the banking sector, the country’s low government debt ratio and its sustained strong economic and fiscal results demonstrate effective macroeconomic management.

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. In contrast, the ratings are 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 EU peers, and remaining – albeit diminishing –financial sector risks stemming from banks that service foreign clients.

RATING DRIVERS

DBRS would upgrade Latvia’s ratings if there is clear evidence that the authorities continue to strengthen the financial system, specifically by executing on the action plan to address Moneyval Committee recommendations on reducing risks from the flow of cross-border funds for illicit activity. DBRS is also looking for continued fiscal discipline in the context of the ongoing tax reform.

Conversely, the trend could return to stable if momentum to reduce financial sector vulnerabilities is reversed, or if additional cases of illicit activity in the banking sector cause reputational or operational damage to domestically focused banks. The ratings could also face downward pressure if there is a marked deterioration in Latvia’s public debt dynamics. 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 has Increased Regulatory Efforts to Reduce NRDs and High-Risk Transactions – A Key Credit Positive

The fallout to the Latvian banking sector from the ABLV self-liquidation last year was contained and has accelerated the decline in bank deposits from non-resident serving banks. As of March 2019, foreign client deposits shrank to €3.5 billion (21.1% of total deposits), down from €7.9 billion (38.8% of the total) in January 2018 and €12.4 billion (53.4% of the total) in December 2015. Latvian banks continue to reduce the amount of high-risk deposits and replace them with customer deposits from EU jurisdictions. The decline in NRDs has reduced Latvia’s short-term external debt without undermining the confidence of domestic depositors, the financial system, the economy, or the country’s fiscal position.

Following the publication of the US Treasury FinCEN report that resulted in ABLV’s self-liquidation, the authorities passed reforms meant to change the business model of banks servicing foreign clients. In May 2018, the amendments to the Law on Prevention of Money Laundering and Terrorism Financing (ML/FT) 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. It is important to remember that the domestic financial market is disconnected from banks servicing foreign clients. Banks servicing foreign clients account for only 6% of total domestic lending. The bulk of domestic financial services are delivered by the subsidiaries of stable Nordic banks, whose financial performance and capitalization levels are strong.

In July of 2018, the Moneyval Committee of the Council of Europe assessed Latvia’s ability to prevent cross-border flow of funds for criminal purposes as low. Moneyval identified several recommendations to strengthen supervision, transparency, judicial oversight, and international cooperation to monitor and prosecute illicit financial behaviour. The Latvian government in October 2018 approved the action plan measures necessary for the implementation of Moneyval’s recommendations, and Latvia is expected to report its progress at the last Plenary meeting this year.

Tax and Pension Reforms are Positive Developments for Latvia, Even if Current Fiscal Policy is Slightly Expansionary

Fiscal deficits are expected to remain small and manageable through 2020, when the implementation period of the 2017 tax reform ends. Following a small fiscal surplus reported in 2016, the headline deficit widened to 0.6% of GDP in 2017 and 1.0% in 2018, driven by increases in defence spending, social payments, and public sector wages. Latvia’s headline fiscal position is perhaps moderately procyclical given strong economic results and the economy’s positive output gap. However, the 2019 Budget expects small primary surpluses and narrow headline deficits (within 0.5% of GDP) throughout the forecast period as a result of budgeted expenditure restraint.

While the structural deficit is complicated by recent tax legislation, DBRS considers the significant tax reform to be integral to improving Latvia’s economic growth prospects and combating social challenges, including the informal economy and income inequality. The reform makes personal income tax more progressive and includes a 1% increase in social contribution meant to offset increases in healthcare spending. It also lowers corporate taxes and allows corporates to defer income tax until profits are distributed. These measures are partially offset by the increases in a variety of taxes and social contributions.

The increase in the structural deficit due to the tax changes are expected to decrease over time. In the 2019 Budget, the government expects a structural deficit of 0.5% of potential GDP this year. Due to methodological differences, the EC calculates a structural deficit of 1.6% in 2019. All structural measures are expected to decline slowly in the coming years as cost savings associated with the ongoing changes to the pension system take effect. Several rounds of pension reform – that gradually increases the retirement age and mandatory contributions – have positioned Latvia well to address fiscal challenges arising from an aging population. Age-related spending in Latvia is among the lowest in the EU.

Latvia’s Public Debt is on a Declining Trajectory and the Treasury has a Favourable Funding Profile.

From 40.0% in 2017, the general government gross debt declined to 35.9% of GDP in 2018, according to EUROSTAT data. The ratio is set to decline to 33.5% by 2020, according to the EC Spring 2019 economic forecast. 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.

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

Robust domestic 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 and 4.8% in 2018. The increase in private sector investment activity and absorption of the European structural and investment funds have driven double-digit investment growth, including the 16.4% real expansion of fixed capital formation in 2018. Furthermore, the strong labour market has activated a previously side-lined population and reduced the unemployment rate, 6.6% as of March 2019, to the lowest level since before the crisis. Strong employment and wage growth, which expanded by 8.4% in 2018, have supported the steady increase in household consumption.

DBRS expects a slight economic deceleration this year as investment growth slows. EU-funded projects will continue to support investment, though at a less impressive rate than in the last two years. 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 3.1% in 2019 and 2.8% in 2020, slightly below potential growth calculations.

DBRS Expects Macroeconomic Policy Continuity from the New 5-Party Coalition Government

The October 2018 parliamentary election resulted in another fragmented outcome. After four months of negotiations, Arturs Krisjanis Karins of the New Unity party (receiving only 6.7% of the vote) was chosen as Prime Minister to lead a coalition of five disparate parties. This election brought about the electoral success of new parties or party alliances, including the anti-establishment Who Owns the State party (14.3%) and the anti-corruption New Conservative Party (14.4%). The Development/For! alliance (12.0%) and the National Alliance (11.0%) are the other two coalition partners.

The most popular party in Latvia, the social democratic party Harmony, received the largest voting share with 19.8% in the election. As in the past, the party was excluded from the ruling coalition by the other parties due to Harmony’s strong ties with Russian parties. Roughly a quarter of Latvians identify as ethnic Russian. Russia’s strategic involvement in Latvia and Europe more broadly is an ongoing concern among NATO alliance members.

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. It nonetheless performs above the regional average on World Bank Governance rankings. The current coalition government has vowed to maintain macroeconomic stability, manage fiscal policy prudently, continue to pursue key reforms, 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 the changes to the financial sector, the tax reform, and expectations around EU structural funds.

KEY INDICATORS

Fiscal Balance (% GDP): -1.0 (2018); -0.6 (2019F); -0.2 (2020F)
Gross Debt (% GDP): 35.9 (2018); 34.5 (2019F); 33.5 (2020F)
Nominal GDP (EUR billions): 29.5 (2018); 31.3 (2019F); 32.8 (2020F)
GDP per Capita (EUR): 15,357 (2018); 16,425 (2019F); 17,334 (2020F)
Real GDP growth (%): 4.8 (2018); 3.1 (2019F); 2.8 (2020F)
Consumer Price Inflation (%): 2.6 (2018); 2.8 (2019F); 2.4 (2020F)
Domestic Credit (% GDP): 145.5 (2017); 138.0 (2018)
Current Account (% GDP): -0.8 (2018); -0.2 (2019F); -0.2 (2020F)
International Investment Position (% GDP): -56.4 (2017); -49.0 (2018)
Gross External Debt (% GDP): 140.7 (2017); 120.9 (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 Euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balance for 2018 from latest MoF assessment. 2019-2020 fiscal balance from EC. Public debt, GDP, and inflation figures from EC. Domestic credit and external indicators from Bank of Latvia. 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.

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: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: November 23, 2018

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