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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Republic of Latvia’s long-term issuer and senior unsecured debt ratings at A- in both local and foreign currency and revised the Outlooks to Positive. The short-term issuer ratings have been affirmed at S-1 in both local and foreign currency, with Stable Outlooks.

Summary and Outlook

The Outlook revision to Positive on Latvia’s ratings reflects the following two key drivers:

• Solid recovery prospects from the Covid-19 crisis, underpinned by the authorities’ credible and effective macroeconomic policymaking and ongoing access to substantial EU investment and recovery fund inflows, and
   
• Lowered financial sector vulnerabilities, reflecting banks’ reduced reliance on short-term non-resident funding, facilitated by the authorities’ implementation of financial sector reforms.

The Outlook revision reflects updated assessments of the ‘domestic economic risk’ and ‘financial stability risk’ categories under Scope’s sovereign rating methodology.

The affirmation of the A- long-term ratings incorporates Latvia’s high institutional strength, underpinned by the country’s EU and euro area memberships. The latter also confers advantages via a strong reserve currency in euros and access to ECB asset purchases and refinancing operations, which have supported Latvia’s debt financing rates at favourable levels. The ratings recognise still-moderate levels of general government debt on the back of a pre-crisis track record of fiscal prudence.

However, Latvia’s ratings remain constrained by credit challenges relating to: i) unfavourable demographic trends in the form of an ageing population and net emigration, alongside still moderate per-capita income relative to the euro-area average; ii) a large export sector relative to the size of the economy, increasing its vulnerability to external shocks; and iii) risks in the banking sector related to the dependence on large Nordic banks.

The Positive Outlook represents Scope’s opinion that risks to the sovereign ratings are tilted to the upside over the next 12 to 18 months.

The ratings could be upgraded if, individually or collectively: i) the economy’s growth potential was raised by means of structural reforms in the labour market, innovation and education and/or infrastructure; ii) public debt-to-GDP were set on a persistent downward course, supported by the authorities’ fiscal consolidation; and/or iii) there was a further sustained reduction in external vulnerabilities and/or financial sector risk.

Conversely, the Outlooks could be revised to Stable if, individually or collectively: i) the fiscal outlook weakened resulting in deteriorating public debt dynamics; ii) financial sector vulnerabilities re-emerged; and/or iii) Latvia’s external position deteriorated or an external shock or heightened geopolitical risks undermined Latvia’s macroeconomic stability.

Rating rationale

The first driver for the Outlook revision to Positive reflects the solid and broad-based recovery prospects of the Latvian economy from the Covid-19 shock. Scope projects that Latvia’s real GDP will grow 5% in 2022 and 4.1% in 2023, after an estimated 4.6% growth in 2021 and contraction of 3.6% in 2020, a reflection of Latvia’s improved macroeconomic resiliency.

The economic recovery is being boosted by an upturn in private consumption and investment, assisted by Latvia’s good absorption of EU funds. Latvia spent over 60% of EU funds allocated under the 2014–20 budget as of September 2021, one of the highest absorption rates in the EU’s Central and Eastern European region. Latvia has been allocated a sizeable EUR 1.8bn in grants (equivalent to around 6% of 2020 GDP) via the EU’s Recovery and Resilience Facility. The European Commission has endorsed Latvia’s investment and reform plan¹. Another EUR 8bn (27% of 2020 GDP) of structural funds is accessible via the Cohesion Policy and Common Agricultural Policy under the new 2021-2027 EU budget. This substantial allocation of EU monies helps anchor solid medium-run growth through strategic public investment projects.

Scope estimates Latvia’s medium-term potential growth at around 3% annually, bolstered by strategic public infrastructure projects co-financed by the EU. By 2026, Latvia should be connected to Rail Baltica, which will link the Baltic region with the European rail network via Poland. Scope notes positively Latvia’s enhanced ability to improve the security and sustainability of its energy supply and diversify domestic energy sources, key for medium-term growth and economic resiliency. Completion of the Baltic states’ connection to continental Europe’s gas and electricity networks is planned by 2022 for gas and by 2025 for electricity².

As a result of favourable economic performance, Latvia’s per-capita income is projected to increase substantively to almost 70% of the euro-area average in 2021 in purchasing-power-standard terms, from 61% in 2016 and 49% in 2010. Nonetheless, this still compares poorly to other sovereign peers such as Estonia and Lithuania (around 84% of the euro-area average in 2021 for both).

The Covid-19 crisis has not exacerbated Latvia’s macroeconomic imbalances. Debt ratios of households and non-financial corporations (20% of GDP and 55% of GDP respectively at end-2020) are among the lowest in the EU and have remained virtually unchanged during the pandemic.

The second driver for the Outlook revision to Positive is Latvia’s reduced financial sector risk, underpinned by the authorities’ implementation of reforms designed to reduce risk from the part of the banking system that services foreign clients with increased money laundering and terrorist financing risk exposure. The authorities have been committed to implementing anti-money laundering reforms based on the recommendations of Moneyval (Council of Europe). Latvia has made important progress in strengthening its anti-money laundering and terrorist financing legal and supervisory framework. Among other measures, banks in Latvia have terminated the cooperation with shell companies with no affiliation to real economic activity as well as with entities registered in countries that do not require a submission of financial statements. As a result, Moneyval upgraded its assessment of Latvia in January 2020 on ten Recommendations initially rated as ‘partially compliant’ and one Recommendation initially rated as ‘largely compliant’. These include the regulation and supervision of financial institutions and designated non-financial businesses and professions, sanctions related to terrorism and proliferation financing and international cooperation.

This has led to Latvian banks cutting reliance on short-term non-resident deposits, which has not affected banking sector liquidity or the favourable business environment. The share of non-resident deposits fell to 15% of the banking sector’s total deposits in Q3 2021 from nearly half of total deposits in Q3 2017. Latvia’s net external debt declined to 13% of GDP in Q3 2021, from 23% of GDP in Q3 2017. During the same period the share of short-term non-resident deposits in gross external debt declined to 6.5% from over 23%.

This development mitigates Latvia’s exposure to possible global financial stress, as short-term deposits are more prone to flight in times of market volatility, compared to other sources of inward investment such as long-term debt instruments or foreign direct investments. It also significantly lowers potential future money-laundering risks to Latvia’s banking sector.

Furthermore, Latvia's Nordic-dominated banking sector presents a limited contingent liability for the sovereign balance sheet and can absorb the current economic shock given its ample buffers. The banking sector is highly profitable compared with those of euro-area peers. It is also highly capitalised and has strong asset quality. As of Q2 2021, the return on equity was 11.1% and the system-wide Tier 1 capital ratio was 25.1% of risk-weighted assets, both among the highest in the euro area. The non-performing loan ratio was low at 1.7%³.

In addition, Latvia’s ratings also reflect the following key rating drivers.

Latvia has a good track record of effectively consolidating public finances. This should, over time, help heal the significant scarring to near-term fiscal dynamics caused by the Covid-19 shock. Scope projects that the general government deficit will narrow to 4.1% of GDP in 2022 and further to 2% in 2023, from 9% in 2021. This is being actively assisted by an improved outlook for tax revenue growth and the gradual expiry of Covid-19-related temporary support measures, the impact of which is estimated at around 7% of GDP for 2021⁴.

Enhanced tax administration to increase tax collection will be important for the medium-term budgetary outlook, given Latvia’s still-sizeable shadow economy⁵ and comparatively restricted tax base. The realisation of such reforms could improve Latvia’s fiscal space and Scope’s fiscal forecast for the country in the medium term.

Latvia has moderate public debt compared to sovereign peers, even after factoring in the Covid-19-related shock to public finances. Scope projects that Latvia’s general government debt will stabilise at 49% of GDP in 2022, well below the EU’s 60% Maastricht threshold, and gradually approach pre-pandemic levels of about 40% of GDP over the next five years. This should be supported by solid growth in nominal GDP and narrowing fiscal deficits in the medium term. Latvia’s debt outlook benefits from favourable financing conditions and a supportive debt profile. The yield on the 10-year government bond was close to 0.4% at the time of writing, supported by access to the European Central Bank’s asset purchase facilities. The average maturity of Latvian debt is long at 8.5 years, which helps keep general government gross financing needs moderate at around 6% of GDP annually over 2022-23. The debt portfolio is almost entirely denominated in euros and carries a fixed rate.

Latvia’s medium-to-long-term growth is hampered by unfavourable demographics, reflecting an ageing population and net emigration, which constrain the labour supply. The old-age dependency ratio (those aged 65 years or over as a percentage of those aged 15-64) is projected to increase to around 41% by 2030⁶, from 33% in 2021. Strong productivity growth will be necessary to mitigate the negative impact of demographic trends and the resulting labour supply shortages – that contribute to strong wage growth exceeding productivity growth – on external competitiveness.

Despite unit labour costs growing by 2.8% annually over the last five years relative to the euro-area average, the relative wage level in Latvia still compares favourably to relative productivity when compared with the euro-area averages. Wage growth has not severely undermined the competitiveness of Latvia’s export sector. Net earnings in purchasing power standard terms amounted to around 50% of the euro-area average in 2020, while productivity per hour was 55% (and 67% per person) of the euro-area average in the same year.

Net migration has improved over the last five years, to around -3,000 persons in 2020 from -12,000 persons in 2016, mostly reflecting reduced emigration. Should this improved migration trend be sustained, it could mitigate sectoral labour shortages and support growth.

The ageing population will also cause budgetary pressures, exacerbated by the currently low levels of pensions, which may be socially unviable and could thus increase over the medium term. Latvia’s pre-retirement income replacement rate through pensions was a modest 42% as of 2020, among the lowest of the EU-27.

Latvia’s small, open economy is reliant on external demand and vulnerable to external shocks – such as an intensification of trade tensions and a prolonged period of subdued growth in western Europe. This is reflected in its large export sector (in goods and services) relative to the size of the economy, of around 63%. Furthermore, Latvia’s banking sector is exposed to concentration and spill-over risks due to its integration with Nordic and Baltic banking systems. Two Swedish banking groups, Swedbank and SEB, account for half of Latvia’s total bank assets⁷, amounting to around 40% of GDP.

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, provides a first indicative rating of ‘a+’ for Latvia. Latvia receives a one-notch positive adjustment to this indicative rating based on the reserve currency adjustment under Scope’s methodology. As such, an indicative rating of ‘aa-’ can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Latvia, no relative qualitative credit strengths have been identified. The following relative qualitative credit weaknesses have been identified: i) growth potential of the economy; ii) macroeconomic stability and sustainability; iii) fiscal policy framework; iv) current account resilience; v) external debt structure; vi) resilience to short-term external shocks; vi) financial imbalances; and vii) social risks.

The QS generates a three-notch downward adjustment and indicates A- long-term ratings for Latvia.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during the rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar. This pillar has a 20% weighting in the quantitative model (CVS) and the qualitative overlay (QS). Under governance-related factors, Latvia’s performance is stronger than that of most Central and Eastern European peers as assessed under the World Bank’s Worldwide Governance Indicators. In general, policymaking in Latvia has largely been effective and enjoyed relative continuity. Latvia’s EU and euro-area memberships enhance the quality and stability of its governance framework.

Latvia’s performance across key social factors is mixed. This is reflected in the above-EU-average poverty ratio, although the ratio is declining (26% of the population was at risk of poverty or social exclusion in 2020, compared with the EU-27 figure of 22%); relatively high income inequality; an unemployment rate (7% as of October) at around the EU average; and high labour participation rates. The European Commission’s Digital Economy and Society Index 2021, which ranks the EU-27 countries for digital competitiveness, placed Latvia 17th (average).

Environmental factors are explicitly considered in the rating process via the environment sub-category under the ESG risk pillar. In 2020, around 53% of Latvia’s electricity was produced from renewables. The share of renewable energy in total energy consumption in Latvia is estimated at 42.1% in 2020, which is the highest such share in the EU-27 after that of Sweden (60.1%) and Finland (43.9%).

Rating committee
The main points discussed by the rating committee were: i) Latvia’s growth outlook; ii) fiscal and debt dynamics; iii) labour market and demographics; iv) external sector developments; v) financial sector developments; vi) ESG; and vii) peers.

Rating driver references
1. European Commission, Press release
2. Baltic Energy Market Interconnection Plan (BEMIP)
3. ECB, Supervisory banking statistics
4. Draft Budgetary Plan of Latvia
5. SSE Riga, Shadow Economy Index for the Baltic Countries
6. Eurostat, Old-age dependency ratio increases across EU regions
7. Finance Latvia Association, Industry data

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings’ 8 October 2021), is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation   YES
With Access to Internal Documents                                 NO
With Access to Management                                           NO
The following material sources of information were used to prepare the Credit Ratings: public domain and the Rated Entity.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Levon Kameryan, Senior Analyst
Person responsible for approval of the Credit Ratings: Alvise Lennkh, Executive Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 27 April 2018.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings

Conditions of use / exclusion of liability
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