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

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Estonia's Long-Term Foreign and Local Currency -- Issuer Ratings at AA (low). At the same time, Morningstar DBRS confirmed the Republic of Estonia's Short-Term Foreign and Local Currency -- Issuer Ratings at R-1 (middle). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS

The Stable trend reflects Morningstar DBRS' view that Estonia's economic recovery and the government's fiscal consolidation measures mitigate high expenditure pressures. Restoring purchasing power, lower Euro Area interest rates and EU investment subsidies support a strengthening of domestic demand over the next year. Nevertheless, U.S. tariffs add uncertainty to an already challenging external environment for Estonia and could subdue exports in the near term. Overall, the IMF projects firm economic growth of close to 2% per year from next year on. Geopolitical uncertainties and domestic political pressures have contributed to structurally higher public spending in recent years, in particular for defence. Fiscal consolidation measures, entailing broad tax increases, mitigate those expenditure pressures to some extent over the medium-term. Still, Estonia's fiscal deficit is set to widen to over 3% of GDP over the next years, facilitated by the loosening of EU-fiscal rules for higher defence spending. While Estonia's public debt ratio is on an upward trajectory, it is set to remain at comparatively low levels of around 30% of GDP over the medium-term.

Estonia's credit ratings are underpinned by its strong institutions, anchored by memberships of the European Union (EU), the Euro Area and NATO. The free movement of goods and services facilitated by the EU's single market and Estonia's business-friendly framework support its export-oriented economy. The low public debt ratio is resulting from a strong fiscal track record and generally prudent fiscal policies, which further support the credit ratings. Conversely, Estonia's small, open economy is prone to adverse external developments, making the economy susceptible to more volatile performance, as experienced in recent crises, compared to peers at similar rating levels. Moreover, per-capita income levels remain below those of higher-rated peers. Estonia's external position remains solid, although competitiveness pressures have mounted, posing a longer-term challenge to the country's economic growth prospects.

CREDIT RATING DRIVERS

Morningstar DBRS could upgrade the credit ratings if: (1) structural reforms bolster economic resilience with increases in per-capita income and productivity; and (2) fiscal performance over the medium-term is significantly stronger compared to current projections.

Morningstar DBRS could downgrade the credit ratings if: (1) persistent economic and fiscal weaknesses lead to a significantly higher public debt burden over time; or (2) significant financial and macroeconomic imbalances emerge due to changing external conditions.

CREDIT RATING RATIONALE

Economic Recovery Driven by Domestic Demand Expected to Gain Strength Over the Next Year; But External Vulnerabilities Persist

Estonia's economy has started to recover from a protracted recession induced by the adverse spillovers from the Russia/Ukraine war. GDP contracted by about 4% in real terms over 2022-24. Economic growth has resumed over the past year, although momentum appears to remain slow in early 2025 with real GDP edging up by 0.1% year-over-year in Q1. Consumer sentiment remains subdued, as the restoration of households' purchasing power remains incomplete after the stark inflationary shock in 2022/23; and is additionally being dragged down by the broad-based tax hikes as part of the fiscal consolidation measures. Still, firmly growing real wages and lower interest rates are anticipated to strengthen private consumption over the next year. While cyclical demand weaknesses from key European trading partners have faded to some extent, U.S. tariffs on EU exports will likely weigh on Estonia's exports at least over the near term. Higher trade policy uncertainty and slack in export industries are also currently holding back more pronounced business investments. Nevertheless, EU investment subsidies (grants and loans of about 11% of GDP remaining available to spent) in combination with high public spending are set to gradually strengthen investments over the next year. The IMF projects Estonia's economy to return to growth of 0.7% in 2025, before accelerating to 1.9% per year on average over the forecast horizon until 2028.

Nevertheless, Estonia faces structural challenges from increased global competitiveness pressures to continued sound growth. Higher energy and other commodity costs after the restrain from Russian supplies and strong wage increases have outweighed productivity gains in recent years. The country's unemployment rate (at 7.5% at the end of 2024, ILO definition) is comparatively high, amid reported labour shortages in certain services sectors, which points to some labour market mismatches. Moreover, Estonia's ageing workforce will likely increasingly weigh on economic growth potential. As a small and open economy, Estonia also remains generally susceptible to spillovers from the international trade environment, in particular from demand fluctuations from its main Nordic trading partners. Still, Estonia's economic income-levels are sound compared to peers in the region. Its economy also benefits from a competitive tax environment, low energy import dependence and a skilled workforce, in particular in the high-value-added ICT sector.

Morningstar DBRS expects that Estonia's external position will remain solid over the medium term. The IMF projects moderate current account deficits of around 2% of GDP on average over 2025-28. Estonia's structurally large service export surplus (of 7.4% of GDP in 2024) is outweighed by deficits in goods trade and smaller profit income outflows on the large inward FDI stock in Estonia (amounting to about 100% of GDP). High-value-added business and computer services exports have strengthened in recent years. Still, the goods trade balance appears to have structurally weakened, reflecting prolonged subdued demand from European trading partners and supply-side disruptions in industry and transport sectors as a result of the EU-sanctions regime against Russia and Belarus. Also, elevated imports of defence equipment will likely weigh on the trade balance over the next years. The country had reduced external imbalances after joining the Euro area in 2011, improving the net IIP markedly after the great financial crisis. Estonia's net IIP stands at -9.5% of GDP at YE2024, improving from around -50% of GDP a decade ago.

Consolidation Measures Stabilising Fiscal Performance Amid High Expenditure Pressures

Morningstar DBRS takes the view that Estonia's fiscal deficit will remain elevated over the medium-term. Structural expenditure pressures for public sector wages, social benefits and defence amid prolonged weak economic performance have raised fiscal challenges in recent years. Estonia's expected utilization of exemptions for higher defence spending under EU fiscal rules (activation of the national escape clause) will likely lead to higher deficits compared to current government projections. Responding to potentially higher external security risks in Eastern Europe, Estonia announced in May a marked increase in defence spending to a minimum of 5% of GDP per year from 2026 on at least until the end of the decade, up from an estimated 3.8% in 2025. Moreover, pensions and other social benefits increased beyond inflation adjustments in recent years and public sector wages were hiked to increase competitiveness over the private sector. To counterbalance these spending pressures, the current government is implementing a broad set of fiscal consolidation measures amounting to about 1.5% of GDP per year from 2025 on. The IMF projects Estonia's fiscal deficit to widen to 2.7% of GDP this year (after 1.5% in 2024) and to remain at around 3% on average until 2028.

Estonia's fiscal consolidation measures significantly contribute to stabilising fiscal performance over the medium-term. The country is in the process of introducing broad tax increases over 2024-26, to permanently strengthen the revenue side. This includes large VAT and PIT rate increases and the introduction of a new motor vehicle tax. Still, Estonia's tax burden at about 36% of GDP remains moderate in an EU comparison. In addition, operating cost savings and the stabilisation of social expenditure are foreseen to contribute stabilising fiscal performance over the next years. Nevertheless, in May the new government agreed to dial back more extensive consolidation measures, abolishing an additional corporate profit tax and reinstate PIT basic allowances, which limits the overall consolidation impact to some extent compared to previous projections. Morningstar DBRS takes the view that fiscal risks for Estonia remain tilted to the downside over the medium-term, which is considered with a negative qualitative adjustment in the "Fiscal Management and Policy" building block assessment. For instance, a weaker economic trajectory or further revisions of fiscal measures prior to the 2027 parliamentary elections could lead to a material widening of fiscal deficits compared to current projections.

Public Debt Increasing from Low Levels, Still Remaining Among the Lowest in the EU

Estonia's public debt ratio is set to continue trending upward over the medium-term, while remaining at overall low levels. Additional borrowings to finance Estonia's elevated fiscal deficits and somewhat higher public interest costs are set to outweigh gradually strengthening economic growth on public debt dynamics, at least over the medium-term. The IMF projects Estonia's gross government debt to rise to 30% of GDP in 2028 from currently 25% in 2025. Public sector net interest costs are projected to remain contained, increasing only slightly to 0.4% of GDP in 2028. Morningstar DBRS takes the view that Estonia could receive a material amount of subsidised loans for additional defence investments under the EU's SAFE EUR 150 billion financing envelope, limiting financing costs for higher defence spending to some degree. All public sector debts are denominated in domestic currency EUR at fixed rates, mitigating currency and interest rate risks. Material cash reserves and liquid financial assets under management of the state treasury, amounting to about 7% of GDP at the end of April, further strengthen the public debt profile.

Coalition Government Reshuffled in March Ahead of Upcoming Local Elections Later This Year; Institutional Quality Remains High

Estonia's high institutional quality is anchored by its membership of the EU and reflected in the country`s generally strong and stable rankings in World Bank's Worldwide Governance Indicators. The country's trade openness is facilitated by the EU's single market, freedom of movement and common trade policies with the rest of the world. Estonia is member of NATO and subject to the common defence agreements within the EU. It has greatly increased its own efforts to increase national defence capacities and is additionally benefitting from security commitments from the U.S. and European partners. Still, Morningstar DBRS takes the view that external security risks for Estonia, sharing a direct border with Russia, remain potentially heightened which it takes into account with a negative qualitative adjustment in the "Political Environment" building block assessment. These heightened external security risks are exemplified by occasional maritime and aviation security incidents, including physical damage to Estonia's infrastructure (for instance to undersea cables in the Baltic Sea).

Prime Minister Kristen Michal from the conservative Reform Party is now leading a coalition government only with the liberal junior coalition partner Estonia 200 since March 2025, after a cabinet reshuffle that saw the Social Democrats leave government. The new coalition maintains a narrow majority in parliament and has set new political priorities, in particular revised tax, regulatory and defence policies, ahead national local elections later this year and the next parliamentary election due in early 2027. Morningstar DBRS expects the government to remain committed to EU fiscal rules and to an extensive set of fiscal consolidation measures, that will remain key in addressing medium-term fiscal pressures.

Inflation Sticking Above Target Over the Medium-term Due to High Services Price Pressures; Financial Stability Risks Muted

Inflation in Estonia remains elevated in the first months of 2025 (above 4% year-over-year, HICP), sticking significantly above the Euro area's aggregate levels and the ECB's policy target rate of 2%. The IMF projects inflation to reach 5.3% in 2025 and to converge to 2.6% by 2028. The expected uptick in inflation this year is resulting from the large tax hikes and continued high services price pressures. Morningstar DBRS takes the view that more restrictive U.S. trade policies could lead in the short term to some downward pressure on inflation, given lower global energy prices and additional supply from excess export capacity in Asia. Medium-term upside risks to inflation persist domestically from continued high services wage growth and externally from the increase in debt-financed defence spending across Europe.

Estonian banks are among the most strongly capitalised in the EU, with a CET1 ratio of 19% in Q4 2024, and compare favourably on profitability metrics. Banks' profits have moderated in 2024 along with the cuts in the ECB's policy rates. Asset quality remains exceptionally strong supported by the resilience of the labour market, households and firms' moderate financial buffers, and the relatively good performance of the Estonian real estate sector. Non-performing loans as a percentage of the loan portfolio at 1.2% in Q4 2024, among the lowest in the EU. Still, risks to Estonian banking sector from its large exposure to the real estate market remain elevated. Loans to construction and real estate companies account for about 40% of the corporate loan portfolio, one of the highest in the EU, and mortgages account for close to 80% of outstanding loans to households. The Estonian banking system is at large foreign owned, in particular by Nordic banks, and as such there is elevated exposure to spillovers from economic performances of Nordic and Baltic neighbours. Estonian banks are mainly funded by local deposits, which helps reduce their susceptibility to external financial stress and their reliance on cross-border parent group financing.

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. Estonia's GDP per capita is relatively low compared to its EU peers, estimated at around USD 32,800 in 2025. This factor has taken it into account within the Economic Structure and Performance Building Block.

Governance (G) Factors

The following Governance factor had a relevant effect on the credit analysis: Peace and Security. Morningstar DBRS takes the view that Estonia would likely respond to hostilities with neighbouring governments as indicated by the expansion of national defence capacities and increased border security in recent years. Elevated security risks are also exemplified by occasional maritime and aviation security incidents, an increased number of cyberattacks and physical damage to Estonia's infrastructure (for example, undersea cables). Morningstar DBRS considers this factor relevant and has taken it into account within the Political Environment Building Block.

Since the last rating action the relevance or significance of the following Governance Factor changed: The Peace and Security factor is changed to relevant. Morningstar DBRS takes the view that Estonia would likely respond to hostilities with neighbouring governments as indicated by the expansion of national defence capacities and increased border security in recent years. Elevated security risks are also exemplified by occasional maritime and aviation security incidents, an increased number of cyberattacks and physical damage to Estonia's infrastructure. Morningstar DBRS considers this factor relevant and has taken it into account within the Political Environment Building Block.

The following relevant or significant Governance factor was not relevant or significant in the last rating action: Peace and Security. Morningstar DBRS takes the view that Estonia would likely respond to hostilities with neighbouring governments as indicated by the expansion of national defence capacities and increased border security in recent years. Morningstar DBRS considers this factor relevant and has taken it into account within the Political Environment Building Block.

There was no Environmental factor that had a relevant or significant 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 Factors in Credit Ratings (16 May 2025) https://dbrs.morningstar.com/research/454196

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/455771.

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.

The principal methodology is the Global Methodology for Rating Sovereign Governments (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/454196 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 Eesti Pank (Bank of Estonia): The Estonian Economy and Monetary Policy (1/2025), Financial Stability Review (1/2025); Ministry of Finance of the Republic of Estonia: Annual Progress Reports (April 2025), Medium-Term Fiscal-Structural Plan 2025-2028, Annual State Budget and Economic Forecasts, Government Debt Report; Estonian Fiscal Council; Statistics Estonia (SE); International Monetary Fund (IMF): Staff Report for the Art. IV Consultation (2024), World Economic Outlook (April 2025); World Bank (WB); European Commission: Economic Forecast (Spring 2025), Eurostat; European Central Bank (ECB); Bank for International Settlements (BIS); Macrobond. 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 credit 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 credit 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://dbrs.morningstar.com/research/455770.

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

Lead Analyst: Marius Schulte, Assistant Vice President - Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director - Global Sovereign Ratings
Initial Rating Date: 14 July 2017
Last Rating Date: 06 December 2024

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