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’ assessment that Estonia's very low public debt ratio and its proven track-record of fiscal prudence mitigate the risks that the higher fiscal deficits and the economic underperformance becomes prolonged. The recession in Estonia last year is expected to have been steeper than anticipated, the sharpest in the European Union (EU), as the weakness in its key export markets exacerbated the effects of higher interest rates and high inflation on growth. While there is a risk that the recession could continue into this year, improving household purchasing power and external demand are expected to lead to faster economic growth in the coming quarters, provided no significant and lasting competitiveness deterioration takes place. The fiscal deficit ratio is expected to have risen to around 3.0% of GDP in 2023 from 1.0% in 2022, driven in part by higher spending on public wages, pensions, child benefits and defence to cope with the inflationary shock and the consequences of Russia’s invasion of Ukraine. If not addressed, fiscal pressures are likely to increase, especially after 2025. The government announced adjustment measures worth 2.0% of GDP that, if implemented, would help rebalance Estonia's fiscal deficit in the coming years. Estonia’s public debt ratio is expected to increase gradually, although it should remain the lowest in the euro area.

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, is amplifying the ongoing economic 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 2022 and remains below that of sovereigns with higher credit ratings.

CREDIT RATING DRIVERS
Morningstar DBRS could upgrade Estonia’s credit ratings if one or a combination of the following occur: (1) evidence of increased resilience to economic volatility inherent to Estonia’s small and open economy; or (2) successful implementation of measures that improve income and productivity.

Morningstar DBRS could downgrade Estonia’s credit ratings if one or a combination of the following occur: (1) external shocks that cause lasting economic underperformance and a permanent relaxation of fiscal discipline that significantly weakens Estonia’s public debt position over time; or (2) renewed excessive credit growth that leads to over-indebtedness in the private sector and instability in the financial sector.

CREDIT RATING RATIONALE

Fiscal Deficit Expected to Have Widened in 2023 but Corrective Measures Should Help Reduce it Gradually

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. The fiscal deficit reached 5.4% of GDP in 2020 before narrowing to 2.5% of GDP in 2021 and 1.0% of GDP in 2022, benefiting from a strong post-pandemic recovery and the phaseout of pandemic-related fiscal support. Despite the higher spending needs related to the energy crisis, defence, and refugee accommodation in 2022, the fiscal improvement was better than anticipated because of strong revenue growth, underpinned by very high inflation and employment growth, and some under-execution on the expenditure side.

The European Commission (EC) projects the deficit ratio to widen to 2.9% of GDP in 2023, principally driven by structurally higher expenditures on public wages, pensions, child benefits, and defence. Revenue growth is slowing down significantly as inflation moderated and output contracted. For 2024, the EC expects the deficit ratio to decline to 2.4% of GDP helped by the increase in the VAT rate and environmental taxation, and assuming an economic rebound this year. These fiscal forecasts are more favourable than those in the Stability Programme (above 4.0% of GDP) and the 2024 Draft Budgetary Plan (3.3% of GDP for 2023 and 2.9% for GDP in 2024), in part reflecting better budget execution for the first half of 2023, especially with under-execution on public investments. In the absence of new measures, fiscal pressure will increase markedly starting in 2025, given the recent changes to income taxation and because of structural spending pressures. The government estimates that a series of tax changes and expenditure cuts that have been announced – but not detailed yet – could improve the fiscal balance by about 2.0% of GDP starting from 2025. 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.

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

The Estonian government's debt-to-GDP ratio, at 18.5% of GDP in 2022, 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 over the next years; however, Morningstar DBRS is of the view that it will remain at low levels. The EC projects the public debt ratio to increase to 19.2% in 2023 and further to 23.2% by 2025. 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. 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 0.5% of GDP in 2023. The relatively long average maturity of Estonia’s debt at 7.1 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.

The Expected Easing of Inflation and External Pressures Should Help the Economy Recover After Strong Contraction; Preserving Competitiveness Will be Key

The worsening of economic conditions exacerbated by Russia’s invasion of Ukraine—including higher energy and food prices, higher interest rates, and supply disruptions—as well as weaker external demand are taking a toll on Estonia’s small and open economy. The erosion of purchasing power, with Estonia recording the highest annual inflation among EU member states in 2022 at 19.4%, the rapid tightening of financial conditions, and subdued economic sentiment have weakened private consumption and investments. In addition to the downbeat external demand, the weakness in manufacturing and construction/real estate activities in Estonia’s key trading partners is affecting both Estonia’s exports and industrial production, especially for wood and metal related products.

The contraction in economic activity has been more pronounced than anticipated and the EC expects real GDP to contract by 2.6% in 2023 after the 0.5% contraction seen in 2022. Real GDP contracted for seven consecutive quarters until Q3 2023, resulting in a cumulative decline of 7.0% and significantly underperforming the euro area and its Baltic neighbours. That said, Estonia has experienced a strong post-pandemic recovery, with real GDP surpassing its pre-pandemic level by 7.9% by the end of 2021 on the back of healthy domestic demand components and solid growth in exports, including high value-added sectors such as information and communications technology (ICT).

The labour market has held up better with a moderate increase in unemployment, however, the downturn started to translate into job losses in the manufacturing, construction, and transport sector during 2023. Inflation remains high but it has moderated significantly in 2023. Estonia is projected to return to growth in 2024 on the back of the expected recovery in real incomes, improving trade outlook, and a pickup in execution of EU funds. The EC projects real GDP growth at 1.9% in 2024 and 2.7% in 2025, while Estonia’s central bank projects a further contraction of 0.4% in 2024 but faster growth above 3.0% in 2025-26. The EU’s Multiannual Financial Framework 2021‑2027 (EUR 5.3 billion) and Estonia’s updated Recovery and Resiliency Plan (EUR 953.3 million) together amount to a large transfer into the Estonian economy and should continue to uplift growth. The main risks to the growth outlook remain linked to the evolution of geopolitical tensions, inflationary and competitiveness pressures, and the effects associated with the monetary policy tightening cycle.

External Accounts Remain Sound but Softness in Key Export Market and Competitiveness Pressures Pose Headwinds

The decline in Estonian exports has been significant since 2022, dragged down by weaker demand in its main export markets, including in Scandinavia, the Baltic countries and in Germany. The decline has been particularly sharp for goods exports because of the downturn in the manufacturing sector triggered by the energy crisis and the higher interest rates affecting demand, while services exports have proven to be more resilient. The appreciation of the euro against the Swedish and Norwegian currencies also played a role. 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). On top of this, exports by companies in the wood sector continue to struggle in the face of the real estate and construction downturn in Scandinavia. 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.

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 recently. 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 0.5% of GDP during the 2009–22 period, reversing the external imbalances accumulated previously. This helped to lower external debt and to narrow its net negative international investment position, which improved to -20.2% in 2022 from -78.7% of GDP in 2009.

Banking Sector Well Placed to Face Potential Asset Quality Deterioration

Weak macroeconomic conditions and higher interest rates are increasing pressure on the capacity of households and businesses to service their debts. So far, non-performing loans as a percentage of the loan portfolio, at 0.6% in the second quarter of 2023, remain one of the lowest in the EU, supported by the resilience of its labour market and the financial cushion provided by the private sector. The ability of companies to maintain healthy earnings growth over time and unemployment not increasing substantially will continue to be key to keeping asset quality deterioration moderate. On the other hand, according to Eesti Pank, the vulnerability of the banking system to the risks of the real estate market, given its large exposure to the sector, has decreased. This reflects a sharp slowdown in property price growth, as well as the cooling of transactions and credit growth in recent months in response to the rapid tightening of monetary policy in the euro area. According to Eesti Pank, the overvaluation of house prices reduced to 5% in the second quarter of 2023 from 10-15% in the second quarter of 2022. Moreover, Eesti Pank’s decision to raise the countercyclical buffer requirement for banks to 1.5% from 1.0% starting in December 2023 should help ensure banks hold sufficient capital to deal with the risks associated to the rapid growth of credit in the past, even if these risks appear to have eased lately.

Estonia’s strong banking-sector metrics limit financial stability risks. According to the European Banking Authority, Estonian banks are among the most strongly capitalised in the EU, with a CET1 fully phased-in ratio of 23.0% at Q3 2023, and compare positively on profitability metrics. Provided asset quality deterioration remains limited, Estonian banks should benefit from higher interest rates given the predominance of variable-rate loans. In general, Estonian banks comfortably exceed regulatory liquidity requirements. As deposit growth slowed in 2022, banks have resorted to other sources of financing such as bonds and loans from parent banks. Nevertheless, 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. The majority of the banking system is foreign owned (e.g., by Nordic banks) and, as such, risks are linked to spillovers from Nordic economies and to the economic performance of the Baltic neighbours.

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. After the parliamentary elections on March 5, 2023, Prime Minister Kaja Kallas (centre-right Reform Party) formed a coalition government with the liberal Estonia 200 and the centre-left Social Democrats. 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 implementation of its ambitious fiscal consolidation package starting in 2025 will remain crucial to address medium-term fiscal pressures.

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 a potential Russian aggression. If anything, NATO has increased its military presence in eastern Europe, including Estonia, as a direct result of Russia’s invasion. In addition, Estonia has stepped up 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 28,136 in 2022 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 (July 4, 2023) https://dbrs.morningstar.com/research/416784/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 at: https://dbrs.morningstar.com/research/426916/.

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/416784/dbrs-morningstar-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 (2024 Draft Budgetary Plan of Estonia, State Budget Strategy for 2024-2027, Investor Presentation January 2024, MoF’s Economic and Fiscal Presentations December 2023), Bank of Estonia (The Estonian Economy and Monetary Policy 2023/4, Financial Stability Review 2023/2), Statistical Office of Estonia, EC (Autumn 2023 Economic Forecast; 2023 Country Report – Estonia; Opinion on Draft Budgetary Plan 2024), 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 (2022 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’s 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://dbrs.morningstar.com/research/426918/.

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

Lead Analyst: Javier Rouillet, Senior Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: July 21, 2023

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