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

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

KEY RATING CONSIDERATIONS
The confirmation of the Stable trends reflects DBRS Morningstar’s assessment of Estonia’s stable macroeconomic policy framework and strong sovereign balance sheet, even when confronted with the current crisis. The Coronavirus Disease (COVID-19) and the associated confinement measures will lead to a severe economic contraction this year, albeit milder compared to its EU peers. The extraordinary policy measures to mitigate the impact of the pandemic will result in a significant deterioration in its public finances. However, Estonia arrived to the crisis with years of fiscal prudence and the lowest public debt burden in the euro area, allowing officials ample capacity for expansionary measures to support the economy during the shock.

The ratings are also underpinned by Estonia’s membership of the European Union (EU) and the Euro area. The economy is supported by the free movement of goods and services offered by the single market. Furthermore, Estonia is a net recipient of EU structural funds. The EU’s Recovery and Resilience Facility is set to allocate roughly 3.6% of GDP in grants to Estonia through 2023. Conversely, the ratings are constrained by structural challenges that existed prior to the pandemic. This crisis illustrates the growth vulnerability to external shocks of Estonia’s small and open economy, and the crisis will likely further slow the convergence of Estonia’s income levels with the EU. Income per capita in Estonia adjusted for purchasing power parity remains around three-quarters of the Euro area average.

RATING DRIVERS
DBRS Morningstar would consider upgrading the ratings if there is increased evidence of a persistent reduction in economic volatility inherent to Estonia’s small and open economy, or successful implementation of measures that improve income and productivity.

The ratings could be downgraded if the current external shock causes lasting material macroeconomic underperformance and permanent relaxing of fiscal discipline that over time significantly weakens Estonia’s public debt position; or if a return of excessive credit growth leads to private sector over-indebtedness and financial sector instability.

RATING RATIONALE

COVID-19 Health Outcomes have Been Better in Estonia Compared to European Peers

Due to lower population density, less cross-border transit, and an early and effective policy response, Estonia has avoided the severe health crisis seen in many countries in Europe. Given the low infection and death rates, containment measures and travel restrictions started to ease partially in mid-May, allowing for the gradual reopening of the economy. Cases have again started to increase in Estonia, as they have elsewhere in Europe. Still, as of November 6, 2020, Estonia reported less than 6,000 confirmed cases of COVID-19 and 73 deaths from the virus. These comparatively favourable outcomes in part reflect Estonia’s policy decisions and its strong public institutions. Estonia is an exemplary performer, especially among its Baltic peers, on the World Bank Governance Indicators.

Estonia’s 2020 Economic Contraction Will Likely Be Milder Compared to EU Peers

The early and effective response to prevent the spread of the virus led to the smooth reopening of the economy in May 2020. The economy contracted by 6.5% year-over-year in the second quarter, compared to the average 14.8% in the euro area. Various service sectors, such as transport and travel and accommodation were affected the hardest, while high value added sectors such as information and communications technology (ICT) services continued to grow. The government expects a contraction of 5.5% in 2020. This is a 2.5 percentage point increase from its April forecast due to the stronger than expected rebound in consumption and more resilient export performance. Nonetheless, the recent escalation in coronavirus cases in Estonia and across Europe increases the economic uncertainty in the months ahead.

The government expects 4.5% real GDP growth next year, assuming that no restrictions are in place across Europe during the second half of 2021. However, the outlook of the Estonian economy is tightly linked with the evolution of the pandemic among key trading partners as well as how the crisis affects conditions domestically. Policy measures that were implemented to support employment and limit damage to companies have for the time being been unwound. The recovery now depends on ample public sector consumption, the capacity of the labour market to reabsorb side-lined employment, and the degree to which the private sector can recover from the economic damage.

After years of current account surpluses, Estonia’s external position has strengthened significantly, mitigating the impact of the COVID-19 disease shock. Driven by a milder than expected trade deterioration, the IMF expects the current account surplus to reach 4% this year and to decline to 2% in 2021. The current account surpluses each year since 2009 have helped lower external debt and narrow the net liability international investment position, which improved from -80.0% of GDP in 2009 to -19.7% in June 2020.

Economic Support Measures will Result in a Large Increase in the Fiscal Deficit and Public Debt

In response to the COVID-19 shock, the government introduced a series of measures to ensure the survival of solvent businesses and to preserve the current level of household income. The majority of measures included direct spending for additional health funding, tax reductions for businesses and the self-employed, the reduction of excise duties on fuel and electricity, support to the unemployment insurance fund, a worker compensation programme, and a temporary suspension of second pillar pension payments. The support package also includes public loan guarantees that may have less impact on fiscal accounts. The IMF estimates that the general government budget deficit will amount to -6.8% of GDP this year and -4.5% in 2021. The IMF projects deficits to remain above 3% through 2025. Though, DBRS Morningstar expects that because of the country’s historically conservative fiscal policy, Estonia is likely to overperform current projections.

Estonia’s very low debt level at the start of the year placed it in a good position to manage the shock. From 8.4% of GDP in 2019, the government expects the public debt ratio to increase to 18.2% this year as a result of the extraordinary policy measures and the contraction of the economy. Current forecasts expect the ratio to remain above 20% over the medium term. Despite the significant increase in the debt level and the funding needs, Estonia’s debt ratio remains the lowest in the euro area. The government is planning to cover the increased financing needs through T-bills and bond issuances, and by securing loans from European supranational institutions. In addition, Estonia’s two reserve funds worth 11.9% of GDP in June 2020, serve as a liquidity cushion to the current crisis.

Financial Sector Risks from Nordic Parent Banks Appear Contained

The Estonian banking sector entered the COVID-19 crisis with good asset quality and strong capitalisation, with the CET1 ratio standing at 28.8% in Q2 2020. The majority of the banking sector is foreign owned, and the liquidity and funding position of the Estonian financial sector is directly and indirectly affected by the performance of Nordic economies. Risks to financial stability are associated with spill overs from Nordic economies and its increased exposure to the Baltic peers, after the structural changes at Luminor Group and the consolidation of the Latvian and Lithuanian branches in the Estonian banking system. The global COVID-19 economic shock could reduce capital flows from the Nordic region into Estonia, and affect the income of Estonian exporters and their ability to service loans. However, DBRS Morningstar considers these risks to be mitigated by the strong asset quality, deposit funding, and capitalisation of banks operating in Estonia.

ESG CONSIDERATIONS
Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Estonia’s per capita GDP is relatively low at $24,000 in 2019 compared with its euro system peers. A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments:
https://www.dbrsmorningstar.com/research/369754

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.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883

The principal methodology is the Global Methodology for Rating Sovereign Governments (July 27, 2020) https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments

The sources of information used for this rating include Ministry of Finance (2021 Draft Budgetary Plan of Estonia, October 2020), Bank of Estonia (Estonian Economy and Monetary Policy Statement 3/2020), Statistical Office of Estonia, European Commission, Statistical office of the European Communities, International Monetary Fund, World Bank, United Nations Development Programme, Bank for International Settlements, Johns Hopkins University Coronavirus Resource Center, Haver Analytics. DBRS Morningstar 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.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

DBRS Morningstar 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 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/369752

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: May 8, 2020

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