Scope affirms Latvia’s credit rating of A-, Outlook remains Stable
Scope Ratings has today affirmed Latvia's A- long-term issuer and senior unsecured local- and foreign-currency ratings, along with the short-term issuer rating of S-1 in both local and foreign currency. All Outlooks are Stable.
The A- rating reflects Latvia’s effective fiscal consolidation and prudent debt management, structural reform measures, robust growth, and increased economic and external resilience underpinned by the sovereign’s euro area membership. The ratings are constrained by challenges stemming from Latvia’s large share of short-term debt in external liabilities, falling labour supply and lagging productivity levels. The Stable Outlook reflects Scope’s assessment that risks are broadly balanced.
Latvia’s economy performed strongly in 2017. Following relatively modest expansion in 2016 due to a lower-than-excepted absorption of EU funds, Latvia’s GDP growth has accelerated to 4.5% in 2017, driven by a recovery in investment, strong consumption and exports. Scope expects the Latvian economy to continue growing by 4% and 3.5% through 2018 and 2019. Robust private consumption buoyed by an upturn in real wages and domestic credit, alongside investments and a favourable external environment, will drive this growth. Labour supply and increased capacity utilisation will be important for economic performance in the medium term. Latvia is one of the largest recipients of European Structural and Investment Funds in relation to GDP and is expected to receive up to EUR 5.6bn by 2020.
Latvia has progressed with structural reforms. Notably, the country ranks first on actions taken on structural reform priorities of the OECD’s 2017 Going for Growth. Authorities introduced a tax reform package 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 moderately positive effect on growth. Measures designed to improve the quality of education and public-sector efficiency by streamlining administrative procedures have also been introduced.
Latvia’s effective fiscal policy and debt management has led to a sizeable reduction in its public debt in the post-crisis period. In Scope’s opinion, Latvia has adequate fiscal space, supported by low and decreasing levels of debt on the back of modest fiscal deficits, sound economic growth, and low financing costs bolstered by the ECB’s accommodative monetary policy. Medium-term fiscal plans have been formed around the 2017 tax reform, which introduces more progressive personal-income taxation and a lower tax burden for most businesses. These tax decreases will be counterbalanced partly by higher excise duties and measures to improve tax collection.
In 2017, Latvia recorded a headline deficit of 0.5% of GDP compared to the modest surplus of the previous year, in part due to expansionary measures reflecting the pickup in public investments linked to the improved take-up of EU funds. The 2018 budget targets a fiscal deficit of 1% of GDP (Scope expects the deficit to be around 0.5%). Fiscal priorities include healthcare, demographics (e.g. higher outlays for child benefits) and defence. Scope anticipates the deficit to remain below 1% over the medium term, reflecting the broad fiscal discipline, tax reform, which proposes modifications to income and excise taxes aimed at making taxation more equitable and supporting inclusive growth, and improved take-up of EU funds.
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 2023. According to the IMF, general government debt stood at 34.8% of GDP in 2017. Scope expects this figure to fall to under 27% of GDP by 2023, in line with the IMF’s baseline scenario, driven by robust economic performance and a strong fiscal position. Latvia has a favourable public-debt portfolio structure, reflected in a large portion of fixed-rate debt (around 94%) and low financing costs, as the share of debt due within the next 12 months was only 10.2% of the total stock in Q1 2018. Most of the country’s debt (89%) is issued in local currency.
Latvia’s A- rating is supported by the country’s euro area membership, affording the advantages of a large common market, a strong reserve currency, the independent European Central Bank (ECB) effectively acting as a lender of last resort, and an economic governance and macro prudential framework sustaining credible macroeconomic policies.
Despite these strengths, Latvia faces a number of challenges. Latvia’s small, open economy remains vulnerable to external shocks and is reliant on external demand, reflected in a large negative net international investment position (56.5% of GDP) and external debt (141.4% of GDP) at the end of 2017. About 25% of the external debt stock consists of short-term deposits (mostly from Russia and other CIS countries), concentrated in banks servicing foreign clients, leaving the economy vulnerable to shifts in investor confidence. The share of external deposits, however, has declined significantly since 2015 due to regulatory initiatives and the Russian economic slowdown.
The liquidation of ABLV Bank, due to deposit outflow followed by the money laundering and corruption allegations mentioned in the U.S. Department of the Treasury’s Financial Crimes Enforcement Network finding and notice of proposed rulemaking published on 13 February 2018, threatens to undermine investor confidence in Latvia, but the long-term financial implications are limited, according to Scope. ABLV accounted for around 13% of total bank assets, corresponding to 13.8% of GDP as of Q4 2017. However, as a mostly non-resident bank with a sizeable share of foreign deposits, its links to the Latvian economy are weak. In addition, ABLV has already transferred the full amount for paying guaranteed deposits (EUR 480m) to Latvia’s Deposit Guarantee Fund, covering 88% of the bank’s clients. Thus, Scope does not expect any material fiscal risks stemming from the liquidation of the ABLV bank.
Over the long run, unfavourable demographics and the need to improve the quality and accessibility of healthcare will put pressure on public finances, in Scope’s view. According to the European Commission, the old-age dependency ratio in Latvia is estimated to increase by circa 35 pp between 2016 and 2060 (from 30.5% to 65.2%), one of the fastest such increases across EU countries. Acknowledging this, authorities have adopted measures to address the poor demographic outlook and low-pension concerns, such as increasing outlays for child benefits, indexing pension growth to 50% of wage growth, and raising the retirement age to 65 years from 2025.
While the labour market has recovered with unemployment rate falling to 8% in February 2018, this figure remains somewhat higher than that in peers like Estonia (6.5%) and Lithuania (7.3%), reflecting persistent rigidities. The size of the labour force continues to decline by an annual average of around 1% since 2012 due to negative demographics and net migration, weighing on employment outcomes, and pushing inflation above its target. Though gradually increasing, labour productivity in Latvia amounts to only 64.8% of EU average, the third lowest in Europe after Bulgaria and Romania. The economic diversification towards higher value-added production will be key to maintaining the steady catch-up process.
The next parliamentary elections are scheduled for October 2018. According to the March 2018 opinion polls, the dominance of centre-right political parties is set to continue. Scope excepts only a limited change in policy direction underpinned by the country’s relatively sound institutions.
Core Variable 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 a relative credit strength for the following analytical category: 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; v) financial sector oversight and governance; and vi) 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 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) the 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; ii) the absorption of EU funds is lower than anticipated, weighing on investment and growth; and/or iii) financial sector vulnerabilities increase.
The main points discussed by the rating committee were: (i) ABLV’s liquidation and possible fiscal costs; ii) Latvia’s growth outlook; (iii) economic imbalances and structural reforms; (iv) tax reform measures and debt sustainability; (v) short-term external debt; (vi) demographics and productivity; (vii) financial sector performance; (viii) recent geo-political developments; and (ix) peer considerations.
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
The historical default rates used by Scope Ratings can be viewed in the rating performance report on 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): 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 on www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Levon Kameryan, Lead Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003.
The ratings/outlook were last updated on 27.10.2017. The senior unsecured debt ratings as well as the short-term issuer ratings were last assigned by Scope on 27.10.2017.
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
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