DBRS Morningstar Confirms Republic of Latvia at “A”, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Latvia’s Long-Term Foreign and Local Currency – Issuer Ratings at “A.” At the same time, DBRS Morningstar confirmed its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s assessment that previous credit improvements help offset the challenges to Latvia posed by the pandemic and Russia’s invasion of Ukraine. The Russian invasion occurred at a time when Latvia’s public sector balance sheet was already strained by the ongoing health and economic crises. Following strong economic growth in the first quarter of this year, extremely high prices have dampened Latvia’s growth prospects for the second half of the year. However, the country’s comparatively mild economic contraction during the worst of the pandemic and its strong recovery last year illustrate Latvia’s improved economic resiliency. The country’s effective de-linking of trade and of its banking system away from Russia limit systemic consequences to Latvia from the invasion. Strong domestic fundamentals and EU-transfers will also support medium-term economic performance.

The ratings are underpinned by Latvia’s membership of the European Union and the euro area, and stable macroeconomic policy-making. Years of counter-cyclical fiscal policy and low levels of public debt prior to the pandemic provided ample capacity for offsetting support measures. It also allowed the government to help safeguard households and corporates from security risks and rising energy prices. The ratings are nonetheless constrained by structural challenges. These include economic and geopolitical external vulnerabilities, deteriorating demographic trends, and lower income and productivity levels compared to euro area partners.

RATING DRIVERS
DBRS Morningstar could upgrade Latvia’s ratings if there is evidence that policy-makers successfully rebalance the structural fiscal position and improve the economy’s resilience by rising income and productivity levels.

DBRS Morningstar could downgrade Latvia’s ratings if the economic consequences to Latvia from Russia’s invasion into Ukraine are severe and protracted, there is a weakening of fiscal discipline, or momentum to reduce financial sector vulnerabilities is reversed.

RATING RATIONALE
Following Strong First Quarter Economic Performance, Latvia’s Growth Is Decelerating Due To The Global Price Shock

The Latvian economy contracted by 3.8% in 2020 when the pandemic’s influence was most acute. That 2020 contraction was less severe than the average 6.4% euro area decline. Strong consumer spending and healthy export performance drove the 4.2% recovery in 2021. The easing of pandemic restrictions and reduction of accumulated savings generated strong 3.4% q-o-q growth in the first quarter of 2022. Russia’s invasion of Ukraine has stalled the momentum by exacerbating the global rise in energy and food prices from pandemic-induced supply chain disruptions. Price growth in Europe is most severe among the Baltic countries where energy costs have spiked the most. The consumer price index in Latvia expanded by 21.4% in August compared to a year earlier, suppressing real disposable incomes. GDP contracted in the second quarter by 1.0% q-o-q. The European Commission forecasts the Latvian economy to expand by 3.9% in 2022 and slow to 2.2% in 2023, when it expects the adverse consequences of the price shock to be most felt on private consumption and investment. Over the medium-term, the EU Cohesion Funds and the Recovery and Resiliency Facility support structural growth prospects. Taken together, the EU transfers throughout the decade amount to EUR 6.8 billion (23% of 2020 GDP).

Despite Healthy Export Performance, Successive Shocks Have Weakened Latvia’s External Position

From the 2.9% of GDP surplus in 2020, the current account weakened to a 2.9% deficit in 2021, and the IMF expects deficits to remain over its five year forecast period. The rise in energy imports and imports linked to investments have outpaced the healthy export performance of wood products, and electrical and machinery goods. While a moderate external deficit is reasonable and reflects Latvia’s large investment needs, a healthy surplus over the longer term is key to further narrowing the country’s net international investment position. NIIP was -28.1% of GDP in 2021, a steady improvement from -83.5% in 2010.

The Shock To The Public Balance Sheet Has Been Significant; Eventual Fiscal Repair Is Likely To Remain A Priority

Following years of prudent general government budgeting, the pandemic caused the deficit to deteriorate to 4.5% of GDP in 2020 and then widen further to 7.3% in 2021. Measures to mitigate the health and economic crisis included income support to households and business, and spending towards public health and investment. Russia’s invasion of Ukraine will keep fiscal policy expansionary. Latvia increased public spending to shield households and firms from rising energy prices and to buttress security. Defence spending will rise from 2.2% of GDP this year to 2.5% by 2025. As a result, the government’s Stability Programme expects a 6.5% of GDP deficit in 2022, well above the 3.6% EU average. The government nonetheless commits to narrowing that deficit to 2.8% of GDP by 2023.

The Government Debt Ratio Expected To Peak In 2022 And Decline Gradually

The combined public health and energy price shock and the government crises response underpin the large increase in Latvia’s general government debt. The 2022 Stability Programme forecasts the ratio to peak this year at 45.7% of GDP, up from 36.7% in 2019, and decline gradually to 43.4% by 2025. Despite the rise in the debt ratio, funding conditions are strong and interest payments are low. The cost of servicing Latvia’s debt declined to 0.5% of GDP in 2021, where it is expected to remain through 2025. Interest expenditures were 1.2% of GDP in 2015. It is worth noting that recent reforms to the pension system protect Latvia’s public finances from the adverse effects of an aging population. At under 16% of GDP in 2019, Latvia’s age-related spending is among the lowest in the EU.

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

In Latvia’s complex 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 consequences of the pandemic and of Russia’s invasion of Ukraine. The negative short-term effects on financial stability from the pandemic were mitigated by government support packages for businesses and households, ultra-accommodative monetary policy, prudent lending practices since the Global Financial Crisis, and prudent regulation. Furthermore, the largest banking groups have low direct financial sector exposure to Russia, Belarus and Ukraine.

The part of the Latvian banking sector servicing foreign clients 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, the Latvian authorities have managed the challenges without disruption to the domestic economy. 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 and de-risking the financial sector. NRDs in the Latvian banking system rapidly declined, and there has also been a distributional change to NRDs. Customer deposits from EU jurisdictions, rather than from outside the EU, make up a majority of foreign deposits.

The 2022 Election Will Likely Produce A Continuity Government; Build-Up Of NATO Forces In Baltics

Latvia’s political environment appears stable and policy-making generally effective. It performs above the regional average on World Bank Governance rankings. The October 2022 parliamentary election is likely to result in another fragmented outcome that produces a continuity government. No political party in Latvia currently garners support above one-fifth of the electorate, according to recent polling from Politico. Popularity of Prime Minister’s Arturs Krišjānis Kariņš Unity party has remained strong at 16% in August 2022. Conversely, support for the Social Democratic Party (Harmony), which has historically drawn support from Latvia’s Russian speaking minority, has declined from 16% when Russia invaded Ukraine to 11% in August 2022. Russia’s actions have triggered additional build-up of NATO forces in the Baltics. DBRS Morningstar is of the view that a more muscular European security apparatus reduces downside risks to the Baltic States and their respective economies from notional or actual Russian aggression.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
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 USD20,600 in 2021 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/396929/dbrs-morningstar-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/402845.

EURO AREA RISK CATEGORY: LOW

Notes:
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 (29 August 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (17 May 2022) https://www.dbrsmorningstar.com/research/396929/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 July 2022, Stability Programme 2022), Statistical Bureau Latvia, Bank of Latvia (Macroeconomic Development Report March 2022, Financial Stability Report 2022), European Commission (Summer 2022 Economic Forecast), Statistical Office of the European Communities, IMF (April 2022 WEO), World Bank, ECB, Bank for International Settlements, Social Progress Imperative, Global Carbon Project, Politico Poll of Polls, 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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/402844.

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: March 18, 2022
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