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

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Estonia's (Estonia) 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 remain Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trends reflect Morningstar DBRS' view that Estonia's credit metrics remain solid, underpinned by low levels of debt and a flexible economy, despite the current economic and fiscal challenges. The recession in Estonia has proven deeper and longer than previously anticipated and growth remained weak at the start of the year. However, Estonia's GDP growth is expected to regain strength in coming quarters driven by the improvement in real incomes and external conditions. Lower inflation and a less restrictive monetary policy should provide some relief to households and firms. The fiscal position deteriorated significantly over the last two years reflecting the recession and higher public spending. The fiscal deficit as a share of GDP widened to 3.4% in 2023 from 1.0% in 2022 and is expected at 3.5% in 2024, driven mainly by structurally higher expenditures on public salaries, pensions, child benefits, education and defence at the same time as revenue growth has decelerated. The reform of the personal income tax system coming into force in 2025 will lead to a further deterioration of the deficit if no compensatory measures are introduced. Morningstar DBRS expects the government to achieve fiscal savings to help narrow the fiscal deficit ratio over time, although the full implementation of its ambitious fiscal consolidation plan remains unclear. Estonia's public debt as a share of GDP is expected to increase gradually, however, it is still the lowest in the European Union.

The credit ratings reflect Estonia's very low public debt ratio and its strong fiscal track record. Also, Estonia's membership of the European Union (EU) and the euro area as well as its strong institutions support the credit ratings. The free movement of goods and services offered by its single market membership supports the country's economy, which will also benefit from EU funding programmes in the coming years. Conversely, Estonia's comparatively small and volatile economy constrains its credit ratings. The weakness in Estonia's key trading markets, especially acute in the manufacturing and construction and real estate sectors, amplified the downturn in the country. Per capita income adjusted for purchasing power parity, which has steadily converged in recent years, was about four-fifths that of the euro area in 2023 and remains below that of sovereigns with higher credit ratings.

CREDIT RATING DRIVERS
Morningstar DBRS could upgrade Estonia's credit ratings if the following occurs: (1) evidence of increased economic resiliency, potentially linked to improvements in income and productivity; and (2) a significant improvement in the fiscal position over time.

Morningstar DBRS could downgrade Estonia's credit ratings if one or a combination of the following occur: (1) persistent economic and fiscal weakness that leads to materially higher public debt over time; or (2) the emergence of significant macroeconomic imbalances that could negatively affect economic and/or financial stability.

CREDIT RATING RATIONALE

Fiscal Deficit Widened During 2022-23 And Rebalancing Will Require Decisive Corrective Measures

Estonia's fiscal performance pre-pandemic was very strong as reflected by the average fiscal surplus of 0.4% of GDP during 2000-19. The support measures to deal with the pandemic and the fallout of Russia's invasion of Ukraine weakened Estonia's fiscal position. Still, the fiscal deficit ratio during 2020-22 was on average 3.0% in Estonia, below the 4.9% for the EU aggregate, benefitting from a quick post-pandemic recovery and strong revenue growth. Indeed, Estonia's fiscal deficit ratio stood at 1.0% in 2022 as the stronger-than-expected revenue growth, underpinned by very high inflation and employment growth, more than compensated for the higher spending needs related to the energy crisis, defence, and refugee accommodation. The fiscal deficit widened again last year to 3.4% of GDP mainly driven by structurally higher expenditures on public salaries, pensions, child benefits, education and defence at the same time revenue growth slowed due to the economic contraction and narrowing inflation.

The government's latest projections are for a fiscal deficit at 3.5% of GDP in 2024, wider than the 2.9% of GDP included in its 2024 Draft Budgetary Plan, due to slower growth in tax revenues and increased investments. This takes into account the legislated increase in the VAT rate from 20% to 22% and higher excise duties for alcohol and tobacco for 2024. In coming years, unless the government takes measures to improve the structural deficit, fiscal pressures will increase in 2025, given the changes to the personal income taxation system. In its budget strategy for 2024-2027, the government announced a fiscal adjustment package worth around 2.2% of GDP starting in 2025 but measures are still not sufficiently detailed, especially on the revenue side. Assuming only legislated taxes and known expenditures, the government projects the fiscal deficit would increase to 5.3% of GDP in 2025 and gradually narrow to 4.2% by 2028. On the contrary, assuming full implementation of its budget strategy, the government projects the deficit would begin to narrow already in 2025 to 3.0% and decline to 0.8% by 2028. Therefore, fiscal uncertainties remain elevated and will hinge on the government's ability to follow through on its fiscal plan. While the full implementation of these measures is subject to risks, Morningstar DBRS expects progress in this direction to help durably rebalance Estonia's fiscal deficit in the coming years. On the other hand, a prolonged slowdown and more persistent expenditure pressures could challenge the intended fiscal consolidation and weaken Estonia's credit metrics.

Estonia's Public Debt Ratio is Increasing but Remains the Lowest in the EU

Estonia's debt-to-GDP ratio, at 19.6% of GDP in 2023, remains the lowest in the EU, even after increasing from 8.5% of GDP in 2019, reflecting the exceptional financing needs related to the pandemic and the conflict in Ukraine. The government debt ratio is projected to increase driven by still high fiscal deficits in coming years. The evolution of the debt ratio will likely hinge on the ability of the government to implement the announced fiscal consolidation plan starting in 2025 and the pace of the economic recovery. Assuming no savings measures are implemented, the government projects that the public debt ratio could reach 35.9% of GDP by 2028. However, if the announced fiscal consolidation package is fully implemented, the government projects the debt ratio could peak at 26.0% in 2027 and then fall to 25.0% in 2028. Estonia's favourable debt profile, small debt burden, and financial reserves further strengthen the country's debt and liquidity profile. The higher indebtedness and interest rates are pushing up the interest burden to moderate levels of 0.3% of GDP in 2023 and could increase to 0.5%-0.9% by 2028 depending on the policy path. The relatively long average maturity of Estonia's debt around 7 years and small annual gross financing needs help smooth out the impact of higher interest rates. In addition, the MoF's two reserve funds worth 6.6% of GDP as of end-December 2023 serve as a liquidity cushion.

Recession Is Proving More Protracted Than Expected, But Conditions Are Set For a Recovery in Coming Years

Estonia's real GDP grew strongly in the years before the pandemic crisis, averaging 3.7% between 2011 and 2019. The post-pandemic recovery was quick, with real GDP exceeding its pre-pandemic level by 7.9% at end-2021, thanks to healthy domestic demand components and solid export growth, including high value-added sectors such as information and communications technology (ICT). Since then, the economy has entered a protracted recession, contracting by 0.5% in 2022 and 3.0% in 2023, making Estonia one of the worst performers in Europe during this period. The implications of Russia's invasion of Ukraine¿including higher energy and food prices, higher interest rates, and supply disruptions¿as well as weaker external demand, have taken a significant toll on Estonia's small and open economy. The labour market is showing some signs of deterioration, with the unemployment rate reaching 7.8% in Q1 2024 from 4.4% in Q4 2019, although the employment and labour force have expanded since the pandemic. Inflation, which was the highest in the EU in 2022 at 19.4%, slowed down significantly in recent months to 2.8% in April 2024.

The contraction in 2023 was broad-based. Exports, especially of goods, fell sharply driven by the weak performance of its key trading partners dragged by the downturn in construction and manufacturing. Despite recovery in purchasing power of households after the inflationary shock, private consumption contracted last year dented by higher interest rates and weak consumer confidence. Investment contracted for a second year in a row in 2023 as higher interest rates and relatively low operating capacity held back new projects. From a supply side perspective, the energy, transportation and storage, and industrial sectors were the main contributors to the contraction in activity in 2023. Falling natural gas and electricity prices and high CO2 prices negatively affected electricity production from oil shale-fired plants. The manufacturing sector was particularly hit by the downturn in the Nordic economies, especially their demand for construction materials and buildings. The transportation and storage sectors suffered from the reduction in trade with Russia as well as from the contraction of transit business.

The weak momentum continued at the beginning of the year with real GDP contracting by 0.5%. Still, economic growth is expected to pick up in the coming quarters related to a continued recovery in real incomes, less restrictive monetary policy, stronger growth in Estonia's trading partners, and the impulse from EU funds. In this context, private consumption should return to growth this year, while the recovery in investment and exports will likely be more gradual. The impulse from the EU's Multiannual Financial Framework 2021‑2027 (EUR 5.3 billion) and Estonia's updated Recovery and Resiliency Plan (EUR 953.3 million) help offset the drag from private investment because of low demand and high interest rates. The main risks to the growth outlook remain linked to the evolution of geopolitical tensions, inflationary and competitiveness pressures, and the economic developments in its main trading partners.

The Current Account Deteriorated Amid External Demand and Competitiveness Pressures, But Overall Position Remains Sound

The decline in Estonian exports has been significant since the second half of 2022 and particularly sharp for goods exports adversely affected by the downturn in the manufacturing, real estate and construction sectors in the Nordic countries and Germany. On the other hand, exports of services have performed better, underpinned by the strong performance of ICT and the recovery in tourism exports, although transport exports are suffering from the decline in trade volumes. The sanctions have affected sectors that relied on cheap inputs from Russia and Belarus (e.g., the wood processing industry) and curtailed economic activity in the transport sector (e.g., transport of petroleum products). The appreciation of the euro against the Swedish and Norwegian currencies also played a role, although these pressures have eased.

Going forward, exporters should benefit from the eventual recovery in demand from Estonia's key trading partners, provided no significant and lasting competitiveness deterioration takes place. Higher growth in price levels and labour costs per employee in Estonia than in the euro area since 2019 suggest cost-competitiveness has deteriorated. If prolonged over time this could pose challenges to its external sector. Still, the flexibility of the economy, high level of education, and favourable tax and business environment continue to support the overall competitiveness of the country. Furthermore, Morningstar DBRS notes that Estonia's external position has improved markedly since the global financial crisis. On average, Estonia recorded an annual current account surplus of 0.2% of GDP during the 2009-23 period, reversing the external imbalances accumulated previously. This helped to lower external debt and to narrow the net negative international investment position, which improved to -21.6% in 2023 from -78.7% of GDP in 2009.

Banking Sector Well Placed to Face Potential Asset Quality Deterioration

Estonia's strong banking-sector metrics limit financial stability risks. Estonian banks are among the most strongly capitalised in the EU, with a CET1 ratio of 22.1% at Q4 2023, and compare positively on profitability metrics. Estonian banks' profits reached record levels in 2023 benefitting from the repricing of their predominantly variable-rate loan portfolio amid the high interest rate environment. Asset quality remained very strong, with non-performing loans as a percentage of the loan portfolio at 0.7% in Q4 2023, among the lowest in the EU. Several factors contributed to this including the resiliency of the labour market, households and firms financial buffers, and the relatively good performance of the real estate sector in Estonia. Nevertheless, the protracted recession and rapid increase in higher interest rates have weakened the ability of households and companies to service their debts and could eventually lead to a manageable increase in problem loans.

The Estonian banking sector is highly exposed to the real estate market. Loans to construction and real estate companies account for 39% of the corporate loan portfolio, one of the highest in the EU, and mortgages account for close to 80% of outstanding loans to households. While risks stemming from the commercial real estate sector remain high, the payment behaviour of companies in the sector has remained good and banks' lending to the sector has been fairly conservative (e.g., loan-to-value ratios). After years of strong price growth, the residential real estate market has cooled down in response to the tighter monetary policy, with the number of transactions falling by 16% and house price growth decelerating in 2023. From a structural perspective, the majority of the banking system is foreign owned (e.g., by Nordic banks) and, as such, risks are linked to spill overs from Nordic economies and to the economic performance of Baltic neighbours. The Estonian central bank notes that if Swedish banks come under severe pressure, this could constrain loan supply in Estonia. Still, Morningstar DBRS notes that Estonian banks are principally funded by local deposits, which helps reduce their exposure to global financial stress and their reliance on cross-border parent banking group financing, which is much lower than prior to the 2008-9 crisis.

Estonia's Political Environment Benefits from Strong Institutions and EU and NATO Membership

Estonia benefits from a sound political and institutional framework, reflected in its strong performance on the World Bank Governance indicators. Prime Minister Kaja Kallas (centre-right Reform Party), who has been in power since 26 January 2021, is leading a coalition government with the liberal Estonia 200 and the centre-left Social Democrats after the parliamentary elections on March 5, 2023. The coalition, which has a 60-seat majority in the 101-seat parliament, plans to invest in the areas of defence, energy, and competitiveness while remaining committed to rebalancing public finances. The government remains committed to an ambitious fiscal consolidation package starting in 2025 that will remain crucial to avoid a further deterioration in Estonia's fiscal position and help address its medium-term fiscal pressures. Estonia's fiscal track-record and the return of the fiscal rules at the European level mitigate the risks.

Russia's invasion of Ukraine has heightened geopolitical risks in the Baltic region. Conversely, Estonia's EU and NATO membership provide a stable macroeconomic and institutional framework and a strong security agreement that mitigate the risks from an escalation of the current conflict. In response to Russia's invasion, NATO has increased its military presence in eastern Europe, including Estonia, and the country stepped up significantly its multiyear military spending plans.

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 (S) affects the credit ratings assigned. Estonia's GDP per capita, estimated at USD 29,839 in 2023 according to the International Monetary Fund (IMF), remains 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 Risk Factors in Credit Ratings (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/434058.

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 (October 6, 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings 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 the Ministry of Finance (Stability Programme 2024, Spring 2024 Economic Forecast, State Budget Strategy for 2024-2027, Investor Presentation January 2024, MoF's Economic, Debt Management and Fiscal Presentations May 2024), Bank of Estonia (The Estonian Economy and Monetary Policy 2024/1, Financial Stability Review 2024/1), Statistical Office of Estonia, EC (Spring 2024 Economic Forecast; 2023 Country Report - Estonia), The North Atlantic Treaty Organization (NATO), European Banking Authority, European Central Bank, Statistical Office of the European Communities, International Monetary Fund (WEO and IFS), World Bank, Bank for International Settlements, Social Progress Imperative (2024 Social Progress Index), and Haver Analytics. 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: YES
With Access to Management: NO

Morningstar 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.

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 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/434060.

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

Lead Analyst: Javier Rouillet, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: January 19, 2024

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