Scope Ratings AG today affirms Latvia’s long-term local-currency issuer rating at A-, following the release of its revised sovereign rating methodology, and converts its status from subscription to public. The agency also assigns a long-term foreign-currency issuer rating of A-, along with a short-term issuer rating of S-1 in both local and foreign currency. The sovereign’s senior unsecured debt in both local and foreign currency was also rated at A-. All Outlooks are Stable.

Rating drivers

The A- rating reflects Latvia’s sound economic performance, commitment to structural reform, effective fiscal consolidation and prudent debt management, and increased economic and external resilience underpinned by euro area membership. The ratings are constrained by challenges stemming from Latvia’s large share of short-term debt in external liabilities, subdued potential growth and unfavourable demographics. The Stable Outlook reflects Scope’s assessment that risks are broadly balanced.

Latvia’s economic growth is gaining momentum. Following modest performance in 2016 due to a lower-than-excepted absorption of European Union (EU) funds, Latvia’s GDP growth has accelerated in 2017 spurred by strong consumption, exports and a recovery in investment. In the first half of 2017, real GDP grew by 4.0% compared to the previous year. Scope expects the Latvian economy to continue growing vigorously through 2017 and 2018, by around 4% annually. The main drivers of growth include: i) the more active absorption of EU funded investments; ii) robust private consumption buoyed by an upturn in domestic credit helped by low levels of private indebtedness (88.3% of GDP in 2016); and iii) real wage increases, supported by tax reform, demand for high-skilled labour and minimum wage hikes. Despite the recent recovery in the trade balance due to improvements in the terms of trade, net trade is projected to result in a negative contribution to growth in the coming years. Latvia is a major beneficiary of European Structural and Investment Funds and is expected to receive up to EUR 5.6bn by 2020, making it one of the largest recipients in relation to GDP.

Latvia has progressed with structural reform. Notably, the country ranks first on actions taken on structural reform priorities of the OECD’s 2017 Going for Growth. In July 2017, a tax reform package was introduced proposing modifications to income and excise taxes aimed at making taxation more equitable and supporting inclusive growth. In Scope's view, the reform is likely to have a positive effect on long-term growth. Measures designed to improve the quality of education and reduce administrative and regulatory barriers to business have also been introduced.

Latvia benefits from a track record of effective fiscal policy and a prudent fiscal framework, which has contributed to a sizeable reduction in public debt in the post-crisis period. In Scope’s opinion, Latvia has adequate fiscal space, supported by low and decreasing levels of debt. In 2016, Latvia recorded a balanced budget, representing a 1.2 pp improvement on the previous year. The primary balance stood at 1.0% of GDP, compared with 0.1% in 2015. This improvement was due mostly to below-expected levels of expenditures, reflecting lower-than-anticipated absorption of EU funds, which has delayed public investments.

Scope assesses Latvia’s medium-term public debt dynamics as sound – the result of relative robustness across several adverse scenarios over the projected horizon to 2022. According to IMF, general government debt stood at 37.2% of GDP in 2016. Scope expects the debt to GDP ratio to fall under 28% by 2022, in line with the IMF baseline scenario, thanks to solid economic performance and low financing costs. Latvia has a favourable public-debt portfolio structure reflected in a large portion of fixed-rate debt (92% of the total as of Q2 2017) and low refinancing costs, as the share of debt due within the next 12 months stood at only 11.4% of the total stock in Q2 2017. Debt is mainly issued in local currency (euros), with only 12% in foreign currency.

Latvia’s A- rating is also supported by the country’s euro area membership, affording the advantages of a large common market, strong reserve currency, independent European Central Bank effectively acting as a lender of last resort, and an economic governance and macro prudential framework supporting credible macroeconomic policies. Scope believes that these are important elements which reflect better protection of Latvia from external shocks, underpinning the sovereign’s resilience, effectiveness of policymaking and creditworthiness.

Despite these strengths, Latvia faces a number of challenges, not the least of which stemming from subdued potential growth. Over the past three years, potential growth averaged 1.7% and is expected to reach 3.7% in 2018 on the back of productivity gains. However, in the pre-crisis period (2003-2007), potential GDP grew by 7.6% on average on the back of a rapid catch up process from notably lower levels of per capita GDP. This decline in potential growth is mostly due to decreasing capital accumulation, which Scope expects to improve gradually along with the rebound in investment.

Latvia’s small, open economy remains vulnerable to external shocks, and is reliant on external demand, as reflected in a large negative net international investment position of around -60% of GDP at the end of 2016. Gross external debt stood at 148.5% of GDP at the end of 2016, around 5 pp higher than for the same period in the previous year. This figure is materially above Estonia’s 91% of GDP and Lithuania’s 86%. Much of Latvia’s external debt reflects borrowing from and by banks. About 27% of the stock consists of short-term deposits, leaving the economy vulnerable to shifts in external financial confidence. However, Latvia’s external debt is mainly in local currency, with only 22% in foreign currency, bolstering resilience to exchange rate movements. Furthermore, a large share of external liabilities is counterbalanced by external assets, reflected in a significantly lower net external debt position of 28.6% of GDP in 2016.

With total assets of around 117% of GDP in 2016, Latvia’s banking sector is the largest in the Baltic region. The sector’s profitability remained robust over the period of accommodative monetary policy in the euro area. Banks continue to be well-capitalised, reflected in average tier 1 capital ratios of around 18% over the past three years. Nordic banks dominate the sector and provide most of the credit to the economy. However, the large share of non-resident deposits (mostly from Russia and other CIS countries, and Scandinavian parent bank funding), concentrated in banks servicing foreign clients, poses potential risks. Scope notes that non-resident banks are subject to more stringent capital requirements and the share of deposits from non-residents has significantly declined since 2015 as a result of regulatory initiatives by the Financial and Capital Market Commission alongside the economic slowdown in Russia.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, signals an indicative “A” (“a”) rating range for Latvia. This indicative rating range can be adjusted by up to three notches on the Qualitative Scorecard (QS) depending on the size of relative credit strengths or weaknesses versus peers based on analysts’ qualitative findings.

For Latvia, the QS signals relative credit strengths for the following analytical categories: i) debt sustainability. Relative credit weaknesses are signalled for: i) macroeconomic stability and imbalances; ii) external debt sustainability; iii) vulnerability to short-term shocks; iv) geo-political risks; and v) macro-financial vulnerabilities and fragility.

Relative credit strengths and weaknesses generate a downward adjustment of one notch and signal a sovereign rating of A- for Latvia.

The results have been discussed and confirmed by a rating committee.

For further details, please see Appendix 2 of the Rating Report.

Outlook and rating-change drivers

The confirmation of the Stable Outlook reflects Scope’s view that risks to the ratings remain broadly balanced.

The ratings/outlook could be upgraded if: i) there is a sustained reduction in short-term external debt; ii) there is a further reduction in public sector debt stock; and/or iii) implementation of structural reforms drives growth potential higher.

Conversely, the rating could be downgraded if: i) public finances deteriorate due to a reversal in fiscal consolidation; and/or ii) the absorption of EU funds is lower than anticipated, lowering investment and growth.

For the detailed research report, please click HERE.

Rating committee

The main points discussed by the rating committee were: i) Latvia’s growth potential and outlook; ii) demographics and productivity growth; iii) public finance performance and debt sustainability; iv) external position and resilience; v) economic imbalances and structural reforms; vi) financial sector performance; vii) recent geo-political developments; and viii) peer considerations.

Methodology

The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available at www.scoperatings.com.

The historical default rates used by Scope Ratings can be viewed in the rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA) at http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.

The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months. A rating change is, however, not automatically ensured.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.

Rating prepared by John Francis Opie, Lead Analyst.

Person responsible for approval of the rating: Dr Stefan Bund, Chief Analytical Officer.

The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The subscription ratings/outlooks were last updated on 05.05.2017.

The senior unsecured debt ratings as well as the short-term issuer ratings were assigned by Scope for the first time.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on Latvia are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of ratings under review, in order to conclude the review and disclose ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.

The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: The Bank of Latvia, Central Statistical Bureau of Latvia (CSB), Ministry of Finance of Latvia, European Commission, Eurostat, ECB, IMF, OECD, WB and Haver Analytics.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability
© 2017 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings AG, Scope Analysis, Scope Investor Services GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope cannot, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided “as is” without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be, viewed by any party as opinions on relative credit risk and not as a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will independently assess the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk; they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell or store for subsequent use for any purpose the information and data contained herein, please contact Scope Ratings AG at Lennéstraße 5, D-10785 Berlin.

Scope Ratings AG, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 161306, Executive Board: Torsten Hinrichs (CEO), Dr. Stefan Bund; Chair of the supervisory board: Dr. Martha Boeckenfeld.