DBRS Upgrades Republic of Lithuania to A, Stable Trend

DBRS Ratings GmbH (DBRS) upgraded the Republic of Lithuania’s Long-Term Foreign and Local Currency – Issuer Ratings from A (low) to A, and maintained the Stable trend. At the same time, DBRS confirmed the Republic of Lithuania’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low) with a Stable trend.

KEY RATING CONSIDERATIONS

The upgrade reflects improved credit fundamentals. In particular, the key drivers for the upgrade include the strong investment dynamic that raises growth potential, and the accumulated improvement in Lithuania’s public finances. GDP growth is again expected to reach over 3% this year, with a strong contribution from domestic demand, according to Bank of Lithuania forecasts. Investment growth is likely to average over 5% pa in 2018-2020 as business investment has increased production capacity and improved firms’ competitiveness; the construction sector has expanded; and EU funds’ uptake increased. This investment will improve Lithuania’s growth potential and is already contributing to exports being more resilient against the global trade slowdown. The 2018 and 2019 tax and pension reforms are a step towards addressing the country’s structural challenges including the high labour tax wedge and income inequalities. Moreover, Lithuania has run fiscal surpluses since 2015 and the debt-to-GDP ratio is moderate. Improvements in DBRS’s building blocks of “Fiscal Management and Policy”, “Debt and Liquidity” and “Economic Structure and Performance” were the key factors for the rating upgrade.

The A ratings are underpinned by Lithuania’s sound fiscal position and its low public debt ratio. DBRS views Lithuanian membership of the OECD last year as a credit strength; meeting OECD standards and benchmarks, for example, underpin sound governance. Euro system membership since 1st January 2015 is another key credit strength. Progress with the reform agenda, including measures that reduce the tax burden on low income earners and narrow the employers’ tax wedge, as well as efforts to improve tax compliance, further support the ratings. Credit challenges relate to structural factors including income inequality; the need for further productivity improvements; a still low investment rate; the declining and ageing population; and economic informality.

RATING DRIVERS

Factors for positive rating action include: (1) measures to improve Lithuania’s long-term fiscal sustainability (2) active government policies to raise the supply of skilled workers.

Negative rating drivers include: (1) a return of significant macroeconomic imbalances, particularly if accompanied by high credit growth or private sector dis-savings or (2) a material deterioration in the public debt metrics.

RATING RATIONALE

A Good Fiscal Management Track Record

Lithuania has since 2014 had primary surpluses and lower debt servicing costs. This was underpinned by expenditure ceilings and an independent fiscal council - the fiscal framework allows for effective counter-cyclical policy. As a euro system member, Lithuania also benefits from the European Commission’s (EC) economic governance and fiscal frameworks. The general government budget position remained in surplus in 2018, 0.7% of GDP compared with 0.5% in 2017 and is forecast by the authorities to remain in surplus at 0.4% this year. The surplus position is narrowing related to the 2018 and 2019 reform package. Robust economic growth and higher revenues have allowed the government to increase spending while maintaining a surplus position. The 2018 and 2019 tax and pension reforms are a step towards addressing the country’s structural challenges, including the high labour tax wedge and income inequalities.

At the Same Time, An Ageing Population and Other Factors Weigh on Lithuania’s Fiscal Position

Lithuania has one of the fastest ageing populations in the European Union (EU). To illustrate the demographic challenge, the old-age dependency ratio (15-64) is expected to rise to 63.9% in 2060 from 29% in 2016 according the European Commission. To help combat the challenge, the government implemented a reform in 2012 that gradually increases the retirement age for both men and women to reach 65 years in 2026, from 63.5 years for men and 62 years for women in 2017.

Another key government challenge is fighting tax evasion from Lithuania’s informal economy, measured as one of the largest relative to the size of its economy among EU countries. The practice of under reporting business income and of unreported envelope wages remains pervasive and obstructs a more efficient allocation of resources. Statistics Lithuania published official estimates of the non-observed economy at 14% of GDP in 2016. According to the IMF, when comparing revenues with the economy’s tax capacity, Lithuania’s tax collection level is estimated at 61% against 77% for central European economies in 2014.

Public Debt Vulnerabilities to External Shocks are Mitigated by a Low Public Debt Ratio and Strong Debt Management

With its small and open economy, Lithuania’s public debt ratio, albeit currently low, is vulnerable to external shocks. Following the global financial crisis, the debt-to-GDP ratio rose to 36.2% in 2010 from 14.6% in 2008. However, Lithuania still has one of the lowest debt ratios among European countries, at 34.2% in 2018 compared with the Euro Area average of 85.1%. The debt ratio is expected to rise to 37.0% this year, due to planned pre-financing of 2020 bond redemptions, declining to 36.2% of GDP in 2020.

With just EUR 109 million of short-term central government debt at end-April 2019, the government applies a conservative debt management strategy of extending debt duration in a low yield environment. The weighted-average term to maturity of central government debt was 6.7 years at end-April 2019. Almost all central government foreign debt is fixed rate and all the debt is in euros. Several debt controls are in place, including limits for municipalities’ borrowing and debt, while the Social Security Funds (Sodra) can only borrow with the permission of the Ministry of Finance.

During the crisis, net capital outflows occurred, and as internal demand contracted while maintaining the peg to the euro, internal devaluation improved competitiveness, thereby rebalancing the economy. The current account deficit as a share of GDP peaked at 15% in 2007, but swiftly narrowed due to the internal devaluation. In 2018, the Bank of Lithuania published a current account surplus of 1.6% of GDP and forecasts a surplus of 0.2% this year and a small deficit of 0.7% next year. From a stock perspective, a net international investment liability position of 28% of GDP was recorded at end-March 2019.

The Lithuanian Economy is Benefitting from Improving Net Migration, but Competitiveness Could Start to be Hampered by High Wage Growth Although the Comparative Wage Base Level is Favorable

After annual average GDP growth of just over 2.0% in 2015-16, growth advanced in 2017 to 4.1% and 3.5% last year. Recovering EU funds and high capacity utilization are providing support to investment growth. In addition, high wage growth underpins private consumption growth, and Lithuania’s elevated inflation rate has slowed as the effects of excise duty hikes in 2017 fade. The country will remain a net beneficiary of EU structural funds, with planned EU net inflows of 4.2% of GDP in 2017, rising to 5.4% in 2020. The Central Bank forecasts growth of 3.2% and 2.5% this year and next year, respectively. The likely shrunken EU budget for Lithuania in 2021-2027 could have negative implications for Lithuania’s economic development, but over time Lithuania will adjust to become more self-reliant with respect to infrastructure-type project funding.

Wage growth is highly linked to policy changes such as the higher minimum wage and to skills shortages, despite an improving net migration balance. Income per capita adjusted for purchasing power parity is still only slightly above two-thirds of the euro area average. Future improvement is partially contingent on productivity gains.

Risks to Financial Stability Appear Contained

Most of the Lithuanian banking sector is foreign-owned, therefore, spill overs from vulnerabilities in parent banks is a persistent risk. That said, the financial sector is well capitalized and highly liquid. Nordic-Baltic cooperation is also being strengthened. While mortgage growth is high, at an annual growth rate of 9.0%% as of May 2019, DBRS views the credit recovery consistent with extended catch-up following the significant crisis-related de-leveraging. The loan-to-deposit ratio has more than halved from 200% before the crisis. Moreover, private sector debt is relatively low. The debt-to-GDP ratio of non-financial corporations amounted to 42.26% and the household debt-to-GDP ratio was 22.79% in Q1 2019. The Bank of Lithuania has a countercyclical capital buffer (CCyB) of 1% in place in a period described as moderate systemic risk and among other factors credit and real estate market activity is high.

Notwithstanding the Stable Political Environment, Unexpected Geopolitical Shifts in Europe Could Pose Significant Risks

Presidential elections in May delivered a changed leadership, as Dalia Grybauskaitė’s presidency since 2009, was term limited. Her successor Gitanas Nauseda is expected to maintain policy continuity. DBRS is of the view that EU and NATO membership are likely to provide a broadly stable political environment for Lithuania, but unexpected geopolitical shifts in Europe could pose significant risks.

Successive multi-party government coalitions have helped to promote stable policies and institutions. There are 141 seats in Lithuania’s unicameral legislature (Seimas) with a multi-party system. Usually no single party wins an outright majority, so coalitions are needed. Since independence in 1990, Seimas has had 16 prime ministers from six different political parties. Since the 2016 election, Seimas has included politicians representing six factions and a mixed group of five independents. After having only three seats during the previous four years, Farmers and Greens Union managed to obtain 56 seats in the last election, mostly because of the Liberal Movement’s corruption scandal.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. The main points discussed during the Rating Committee included public debt finances, economic performance, socio-political factors and the country’s resilience to future economic shocks.

KEY INDICATORS

Fiscal Balance (% GDP): 0.7 (2018); 0.4 (2019F); 0.2 (2020F)
Gross Debt (% GDP): 34.2 (2018); 37.0 (2019F); 36.2 (2020F)
Nominal GDP (EUR billions): 45.1 (2018); 47.8 (2019F); 50.2 (2020F)
GDP per Capita (EUR): 16,119 (2018); 17,172 (2019F); 18,175 (2020F)
Real GDP growth (%): 3.5 (2018); 3.2 (2019F); 2.5 (2020F)
Consumer Price Inflation (%): 2.5 (2018); 2.4 (2019F); 2.3 (2020F)
Domestic Credit (% GDP): 112.7 (2018)
Current Account (% GDP): 1.6 (2018); 0.2 (2019F); -0.7 (2020F)
International Investment Position (% GDP): -29.5 (2018); -28.0 (Mar-2019)
Gross External Debt (% GDP): 78.4 (2018); 74.1 (Mar-2019)
Governance Indicator (percentile rank): 80.3 (2017)
Human Development Index: 0.86 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal Balance (Ministry of Finance), Gross Debt (Ministry of Finance), Nominal GDP (EC), GDP per Capita (EC), Real GDP Growth (Bank of Lithuania), Inflation (Bank of Lithuania), Current Account (Bank of Lithuania), International Investment Position (EC), Gross External Debt (Bank of Lithuania, Lithuania Department of Statistics), 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 Ministry of Finance, International Monetary Fund, OECD, European Commission, United Nations Development Program (UNDP), Haver Analytics, Eurostat, World Bank, Bank of Lithuania, Stockholm School of Economics in Riga, Lithuania Department of Statistics, European Central Bank. 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.

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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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Lead Analyst: Nichola James, Senior Vice President, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 21, 2017
Last Rating Date: January 11, 2019

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