DBRS Morningstar Changes Trend on Latvia To Positive, Confirms at A (low)

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

KEY RATING CONSIDERATIONS

The Positive trend on the A (low) ratings reflect DBRS Morningstar’s assessment that the challenges to Latvia’s macroeconomic performance posed by the current health and economic crisis are offset by ongoing credit improvements. Years of prudent fiscal policy allowed officials ample capacity for support measures to offset the shock to the economy brought on by the Coronavirus Disease (COVID-19). Assuming a durable exit from the pandemic, Latvia’s large crisis-related fiscal deficit is expected to be temporary. The country’s economic performance proved comparatively more resilient to the shock and the economic recovery will likely be strong. Latvia has also made progress reducing financial sector risks stemming from banks that service foreign clients.

Ratings are underpinned by stable macroeconomic policy-making, including a long track record of judicious fiscal management and low levels of public debt. Latvia also benefits from membership of the European Union (EU) and the euro area. The ratings are nevertheless constrained by structural challenges that existed prior to the pandemic, including vulnerabilities to external shocks from the country’s small and open economy, and lower income and productivity levels compared to euro area partners.

RATING DRIVERS

DBRS Morningstar could upgrade Latvia’s ratings if there is evidence of: (1) effective policies to deal with the current crisis, leading to a rapid reduction in the fiscal deficit once crisis conditions have passed; (2) continued economic resilience to external developments; and (3) sustained progress reducing risk stemming from the segment of the banking sector that services foreign clients.

Conversely, DBRS Morningstar could downgrade Latvia’s ratings if: (1) the crisis causes lasting deterioration to Latvia’s medium-term economic outlook and significantly weakens fiscal discipline; or (2) momentum to reduce financial sector vulnerabilities is reversed. The trend could return to Stable if there is a longer than expected economic shock that significantly delays repair to the public balance sheet.

RATING RATIONALE

The COVID-19 Economic Shock Has Been Less Severe In Latvia Compared To Previous Expectations And EU Peers

COVID-19 cases and deaths during the first wave of infections last year were significantly lower in Latvia than in larger European countries, as was the case in other Baltic states. This was primarily due to lower population density, less cross-border transit, and an early and effective policy response. There has been more limited success in containing the second wave of infections that began at the end of last year. The first quarter 2.6% quarter-over-quarter contraction was the result of high viral spread in Latvia and EU partners, tight containment measures, and a slow vaccination roll-out.

The economy contracted by 3.6% in 2020, a result much better than the contraction DBRS Morningstar expected last Spring. Given the restrictions, transport and storage, accommodation and catering, recreation and entertainment services, and retail trade to a lesser extent were the hardest hit sectors of the Latvian economy, while some sectors like manufacturing, construction, agriculture, public administration, education and health services were broadly unaffected by the crisis. Latvia also benefitted from less severe economic contraction of its main partners. Latvia’s ten largest trade partners (including Baltic peers, Poland, Denmark, and Sweden) contracted by 3.3% last year, compared to the 6.6% contraction of the entire euro area.

Despite the first quarter contractions, several factors should support a strong recovery. Starting in May 2021, the Latvian economy began to operate broadly without restrictions. A rebound in economic activity will also stem from: the improving vaccine roll-out in Latvia and across Europe, the less severe employment loss in Latvia from an effective employment furlough scheme, the extensive income support programs, and the ramping up of large investment projects, including Rail Baltica. Latvia will also benefit for years to come from access to EU Structural Funds and the Recovery and Resilience Facility (RRF). Latvia is expected to receive EUR 1.8 billion (over 6% of 2020 GDP) in grants under RRF. In its 2021 Stability Programme (SP), the government forecasts GDP rebounding by 3.0% this year and expanding by 4.5% in 2022.

Despite The Crisis, Key External Sector Indicators Improved Last Year

Latvia’s external savings position increased in 2020, notwithstanding the shock to the economy from weaker external demand. The increase in the exports of goods and the large contraction of imports meant the goods trade deficit improved in 2020 from a year earlier. Along with still healthy surpluses in the service and income balances, the current account advanced from near balance in 2019 to a 3.0% of GDP surplus in 2020. Consequently, Latvia’s net liability international investment position (NIIP) narrowed to -36.6% of GDP in 2020, from -41.7% in 2019 and increasingly improved from -83.5% in 2010.

The COVID-Related Shock To Public Finances Will Be Significant; Rapid Fiscal Repair Is Likely

Following a near balanced budget position in 2019, the general government budget deficit widened in 2020 to 4.5% of GDP. This result significantly overperformed the deficit projection of 9.4% made in last year’s Stability Programme. The government delivered EUR 1.3 billion (4.5% of GDP) in direct and indirect support measures in 2020, and an additional EUR 2.9 billion (9.6% of GDP) is provisioned for 2021. Measures include tax holidays, support to households, employment protection, loans and credit guarantees to businesses, and an increase in spending on human and physical capital.

As a result of larger support this year than previously envisaged – the direct impact of state aid on the balance sheet in 2021 amounts to 6.2% of GDP – the Stability Programme forecasts the deficit to reach 9.3% in 2021. This downside risk to the fiscal outlook weighs negatively on DBRS Morningstar’s “Fiscal Management and Policy” building block assessment. In its recent Spring Forecast, the EC is more optimistic and forecasts a 7.3% deficit this year for Latvia. As temporary spending measures unwind, the EC expects the deficit to narrow to 2.0% in 2022.

The economic shock and the crisis response underpin Latvia’s general government debt increase of thirteen percentage points of GDP by 2022 compared to 2019 to roughly 50% of GDP. The country arrived to the crisis with a modest level of debt after reducing the ratio to 37% in 2019, from its 2010 peak of 47%. Despite the crisis-related rapid rise in the debt ratio, the cost of servicing Latvia’s debt declined to 0.7% of GDP in 2020, down from 1.2% of GDP in 2015. The total financing requirement, including crisis-related public spending has been funded with issuances of Eurobonds in international financial markets at historically low interest rates, regular government bond auctions in the domestic financial market, and credit facility from Nordic Investment bank and SURE lending from European Union.

Well Capitalized And Liquid Banking Sector; Increased Regulatory Efforts To Reduce High-Risk Transactions

Even with the complexities of Latvia’s banking system, the bulk of domestic financial services are delivered by the subsidiaries of large Nordic banks, whose financial performance and capitalization levels are strong. As in most countries, the banking sector will be challenged by the pandemic. However, the negative short-term effects of the COVID-19 outbreak on financial stability are mitigated by government support packages for businesses and households, ultra-accommodative monetary policy, prudent lending practices since the Global Financial Crisis, and strong regulation.

The part of the Latvian banking sector servicing foreign clients has received attention in recent years. The share of non-resident deposits (NRDs) in the Latvian banking sector led to accusations of noncompliance with rules around the use of funds for illicit purposes. However, Latvian authorities have managed the challenges without disruption to the domestic economy and the deposit guarantee scheme has operated effectively. Combating Money Laundering and Terrorism Financing (ML/TF) has been very high on the political agenda in Latvia, which has led to financial sector reforms designed to change the business model of banks servicing foreign clients.

DBRS Morningstar identifies several important areas of progress in recent years that address legacy ML/TF shortcomings. Perhaps most importantly, there has been effective de-risking of the financial sector. NRDs in the Latvian banking system have rapidly declined, and there has also been a distributional change to NRDs. Customer deposits from EU jurisdictions, rather than from outside the EU, now make up a majority of remaining foreign deposits. Further reducing risk, recent legislation forbids financial institutions from cooperating with high risk shell companies that have no economic activity or do not file annual statements. Progress is also evident by the authorities’ improved capacity to investigate and prosecute cases of financial crime, and the strengthened framework for targeted financial sanctions.

Independent institutions tasked with monitoring Latvian banks point to progress. In February 2020, Moneyval, the Council of Europe’s anti money laundering body, announced Latvia is compliant or largely compliant with the recommendations and the Financial Action Task Force announced it would not place Latvia on the list of countries with strategic deficiencies, but the country remains under enhanced monitoring. After carrying out 12 onsite inspections of banks in the area of ML/TF last year, the Financial and Capital Market Commission (FCMC) concluded that Latvian banks have improved internal control systems. The FCMC is set to perform 38 onsite inspections in 2021, of which 10 are focused on ML/TF concerns.

The 5-Party Coalition Government Appears Stable And Latvia Is A Strong Performer On Governance Indicators

The October 2018 parliamentary election resulted in another fragmented outcome. Arturs Krišjānis Kariņš of the New Unity party was eventually chosen as Prime Minister to lead a coalition of five disparate parties. 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 regaining its independence of government reshuffling. It nonetheless performs above the regional average on World Bank Governance rankings.

ESG CONSIDERATIONS

Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Latvia’s per capita GDP is relatively low at USD17,600 in 2020 compared with its euro system peers. This factor has been taken into account within the “Economic Structure and Performance” building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/378822.

EURO AREA RISK CATEGORY: LOW

Notes:
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

All figures are in 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 (July 27, 2020) https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments. Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021) https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings

The sources of information used for this rating include Republic of Latvia Ministry of Finance (Investor Presentation March 2021, Stability Programme 2021), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Development Report March 2021), European Commission (Spring Economic Forecast), Statistical Office of the European Communities, IMF (April 2021 WEO), World Bank, ECB, UNDP, Bank for International Settlements, Johns Hopkins University Coronavirus Resource Center, European Centre for Disease Prevention and Control, Social Progress Imperative, Global Carbon Project, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/378821.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: June 30, 2017
Last Rating Date: November 20, 2020

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