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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Republic of Estonia’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at AA-. Scope has also affirmed the short-term issuer rating at S-1+ in both local- and foreign-currency. All Outlooks are Stable.

Summary and Outlook

The affirmation of Estonia’s AA- long-term ratings reflects: i) its sound institutions underpinned by its EU, euro area and NATO memberships, which provide a robust framework for fiscal and economic policy and strongly mitigate external security risks that have risen amid the current geopolitical tensions; ii) solid economic growth and improved macroeconomic resilience that have favoured a rapid convergence to euro area income levels over the past years; and iii) prudent fiscal policies and conservative debt management that have resulted in the country having one of the lowest debt-to-GDP ratios globally, backed by high financial reserves.

The ratings are constrained by: i) the still moderate per-capita income relative to the euro-area average, which, coupled with the economy’s high exposure to external shocks, increase Estonia’s vulnerability to the current inflationary pressures and cost-of-living crisis; and ii) the ageing population and skilled-labour shortages that are constraining the medium-run growth outlook.

The Stable Outlook reflects Scope’s view that risks to Estonia’s ratings over the next 12 to 18 months are balanced.

The ratings/Outlooks could be upgraded if, individually or collectively: i) structural reforms and investment continued to sustain solid growth and income convergence; ii) the fiscal outlook improved, supported by a rapid rebalancing of government finances; and/or iii) external vulnerabilities saw a further sustained reduction.

Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) fiscal fundamentals weakened, leading to a significant increase in debt-to-GDP; ii) macroeconomic imbalances increased, weakening medium-run growth prospects; iii) external and/or financial sector vulnerabilities increased substantially; and/or iv) heightened geopolitical risks undermined macroeconomic stability.

Rating rationale

Estonia’s AA- ratings reflect a sound institutional set-up, underpinned by its EU, euro area and NATO memberships that support effective policymaking and access to investment funds and strongly mitigate external security risks.

Estonia’s ratings benefit from effective policymaking anchored to the country’s EU and euro area memberships. These provide a sound and credible framework for economic, fiscal and monetary policies, confer the benefits of issuing in a reserve currency, especially when the market is volatile, and ensure sound banking sector supervision. Together with ample access to and efficient absorption of EU funding for public investment, these memberships have supported the country’s remarkable economic convergence over recent years and provide comfort over its economy’s continued modernisation and technological upgrade. Estonia’s GDP per capita was 63% of the euro area average last year, up from just 37% in 2011; the figure reaches above 80% in terms of purchasing power standards. Access to EU funding will speed up convergence as the funds will total almost 20% of (2021) GDP over 2021-27, which will include the Recovery and Resilience Facility, Cohesion Policy and Common Agricultural Policy.

External security risks for Estonia, which shares a border with Russia, have increased since the Russia-Ukraine war escalated. However, the NATO memberships of Estonia and the other Baltic states strongly limit the risk that the conflict expands into the Baltic region. Estonia’s security guarantees are underpinned by NATO’s Article 5, which states that an armed attack on one member constitutes an armed attack against all members, which will then provide support. Both NATO and Estonia have continually confirmed a commitment to Article 5.

Estonia’s AA- ratings are also underpinned by the improved resilience of its economy, supported by solid growth prospects over the medium run, anchoring the country’s debt-to-GDP trajectory to moderate levels.

Estonia’s economic growth has been robust over recent years. Growth averaged 3.7% in the five years before the Covid-19 pandemic. The economy also proved resilient to the Covid-19 crisis, with the contraction in GDP contained to 0.6% in 2020. In 2021, the rebound was exceptional with 8% GDP growth, supported by a boost in consumption through pensions withdrawals (a reform allowed voluntary participation in the second pillar) and by robust exports and investment growth. The Russia-Ukraine war is significantly affecting the country’s growth outlook, however, via high inflationary pressures, supply-chain disruptions, and weaker trade and confidence. The impact was already visible in H1 2022, including a contraction in Q2. Scope expects moderate annual GDP growth of 0.4% and 0.8% in this year and the next respectively, followed by a 3.2% rebound in 2024.¹

The Russia-Ukraine war is unlikely to have a permanent impact on the economy, helped by the continued improvement in Estonia’s energy security. Estonia rapidly substituted its energy imports from Russia in the first half of this year thanks to the availability of local shale oil, a prompt diversification of gas sources and its progress on developing renewable energy. The country’s trade links to Russia have declined over recent years with exports consisting mostly of re-exports, limiting the loss of value added caused by trade sanctions. Further, the rapid development in high-value-added export sectors such as information and communication technology is strengthening economic growth, resilience and productivity. This is also reflected in a resilient current account, which was in surplus in the year to Q2 2022 (1.6% of GDP) notwithstanding the high energy and commodity prices and is expected to continue posting moderate surpluses in the coming years.

In the medium term, Scope estimates solid growth potential of 2.2% for Estonia, supported by ample access to EU funds. Estonia’s attractive business environment and highly digitalised public administration also underpin the continued advancement in income and productivity. Further support stems from the labour market’s flexibility and wide participation. Employment was high as of Q2 2022 at over 670,000 people, marking a return to pre-pandemic levels. Participation is also very high, at above 80% of the labour force, while the unemployment rate is moderate, at 5.7% in September. However, Scope expects unemployment to rise in coming months, to an average of 6% for 2022 and 6.5% in 2023-24 as the economic outlook weakens.^2,3

Estonia’s AA- ratings are also supported by its low public debt, backed by the government’s high financial reserves and characterised by a low-risk profile.

Estonia’s prudent fiscal policies have resulted in the country having one of the lowest debt-to-GDP ratios globally, at 17.6% by end-2021, against over 95% for the euro area. The interest burden was just 0.1% of government revenue over the past six years and should remain close or below 1% in the medium run despite the marked increase in debt and the normalisation of the interest rate environment, underpinning strong debt affordability and ample fiscal space.

Estonian authorities have shown their commitment to fiscal prudence, reflected in broadly balanced government budgets in the 10 years before the Covid-19 crisis. Pandemic-related fiscal support caused government finances to deteriorate significantly: the deficit reached 5.5% of GDP in 2020 but then rapidly recovered to 2.4% in 2021. In 2022, despite measures to address the cost-of-living shock on top of the need to strengthen energy and external security and support Ukrainian refugees, the deficit is likely to further decline to about 2.0% thanks to strong revenue growth and spending delays. However, Scope expects the deficit to increase to about 3.0% in 2024-26 after a peak of 3.8% in 2023, accounting for further support to households and businesses. The deficit should then markedly decline by 2027 as planned defence spending catches up.^4,5

Despite the fiscal costs of the current crisis and rising interest rates, Scope expects Estonia’s public debt ratio to remain moderate. Debt-to-GDP will remain on a slightly upward trajectory over the next five years before stabilising to about 26% of GDP by 2027, up from 17.3% this year and 20.0% in 2023. The debt ratio is thus expected to remain one among the lowest in the EU, though in absolute terms debt would be twice today’s levels. Scope notes, however, that a failure to rebalance government finances after the shock while economic growth is less buoyant than in the past would pose risks to the debt trajectory.

The ratings also benefit from a favourable debt profile, moderate funding needs and prudent liquidity management. Estonia has no foreign currency exposure and a long average debt maturity of close to eight years reducing annual redemptions. The central government debt portfolio comprises EUR 1.7bn (close to 40% of total debt) in long-term amortising loans from international financial institutions including the EIB and the EC. Estonia also re-entered debt capital markets in 2020, issuing for the first time since 2002 a long-term bond for EUR 1.5bn followed by a EUR 1bn issuance in 2022, which attracted considerable investor and market demand despite the volatile market. The central government maintains exceptionally high financial reserves, at above EUR 2bn currently or half of the total debt size, which can cover years of redemptions.⁶

Despite these credit strengths, Estonia’s ratings face important challenges.

First, the country’s still moderate income levels, coupled with its economy’s small size and openness, increase its exposure to external shocks, in particular to the current inflationary pressures and cost-of-living crisis.

Along with the other Baltic states, Estonia is heavily affected by the exceptional inflationary pressures. The economy was already at risk of overheating before the Ukraine war escalated, given its tight labour market and loose monetary policy. A large share of energy and food items in its consumption basket on top of deregulated gas and electricity markets makes Estonia heavily exposed to the current supply-side price shocks. Inflation reached 22.5% in October, and Scope expects 19% for 2022 and a still elevated 7% in 2023. The ECB is rapidly normalising monetary policy, with rate increases totalling 200 bp so far in 2022 and a halt to net asset purchases under quantitative easing. Purchasing power erosion and tighter financing conditions will contribute to an economic slowdown in 2023. The exceptional price increases of this year are also creating large cost-overruns in the investment projects of the Recovery and Resilience Plan, which carry downside risks to the economic outlook.⁷

The global economic slowdown will also take a toll on Estonia’s near-term growth given its economy’s small size and openness, reflected in a nominal GDP of just EUR 31bn, combined with its large export and import sectors, each representing around 78% of GDP in 2021. At the same time, Scope notes that the country’s external position has markedly strengthened. The current account has remained broadly in balance over the past decade, while the net debtor position halved from over 40% of GDP in 2016 to 21% in Q2 2022. More than 60% of external liabilities are foreign direct investments, a source of inward investment that is less prone to flight in times of market volatility.

A second challenge to Estonia’s ratings is represented by adverse demographic trends, which are exacerbating labour market shortages and potentially harming competitiveness and medium-run growth.

Adverse demographic dynamics include the decreasing working-age population and rapid population ageing. The UN forecasts a 20% decline in Estonia’s working-age population over the next 30 years. The old-age dependency ratio will exceed 50% by 2025 from 32% today; in other words, working-age people outnumber those aged over 65 by threefold today, but by 2050 this will reduce to only twofold.

Such population trends will exacerbate pressures in the labour market, where labour and skills are already in short supply. These pressures will hinder growth as well as fuel wage rises, already at close to double-digit growth over recent quarters. Wage growth that outpaces productivity growth could erode the country’s external competitiveness and ability to sustain solid growth over the medium run. Ageing will also weigh on government finances. Implicit liabilities related to ageing-related expenditure over the next 30 years are low, according to IMF and EC estimates. However, the currently low healthcare and pension spending also comes with its own risks, especially in the aftermath of the pandemic and with purchasing power eroding quickly. Positive net migration, as seen over recent years, possibly supported by a large inflow of Ukrainian refugees (about 60,000 so far) could mitigate such risks.

Estonia’s ratings are also exposed to potential financial spill-over risk stemming from a highly concentrated banking sector, interconnected with Nordic banks, though the sector’s resilient funding profile, sound capitalisation and profitability substantially limit contingent risks for the Estonian government.

The Estonian banking sector is one of the most concentrated in the EU, with the five largest credit institutions representing over 90% of sector assets. The sector is dominated by foreign-owned banks: two Swedish groups hold more than 60% of sector assets. Such high interconnection represents spill-over risk from the Swedish banking sector, which is vulnerable to a potential downturn in the Swedish housing market where risks have recently increased. However, the sector’s funding profile has improved in recent years, following robust growth in resident deposits that lowered the reliance among foreign-owned credit institutions on their parent for funding.

Financial stability risks are further largely mitigated by the banking sector’s high capitalisation and sound profitability. Capital adequacy ratios are among the highest in the EU, as reflected in an aggregate CET1 ratio of 24.4% as of Q2 2022 as reported by the European Banking Authority. Profitability remains stronger than peers’ despite some moderation relative to pre-pandemic levels, with an aggregate return on equity ratio of 8.7%, and should remain comfortable despite the slower economic momentum, thanks to favourable cost-efficiency and asset quality metrics with cost-to-income and non-performing loan ratios of 53.8% and 0.7% respectively. The direct exposure to Russia, Ukraine and Belarus is low, representing only about 0.1% of Estonian banking sector loans. Estonia has also made important progress in combatting money laundering, a priority since 2016. Anti-Money Laundering/Countering the Financing of Terrorism (AML/CFT) measures were strengthened through legislative and institutional policies, including tighter licencing and reporting requirements. Estonia’s Recovery and Resilience Plan includes measures aimed at strengthening the capacity of AML/CFT supervisors, in line with IMF recommendations.⁸

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 an indicative rating of ‘a+’ for the Republic of Estonia. The country receives a one-notch positive adjustment for the euro’s status as a global reserve currency under the reserve currency adjustment. The resulting ‘aa-’ indicative rating can be adjusted in the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses versus a peer group of countries.

For Estonia, ‘banking sector performance’ has been identified as a relative credit strength. Conversely, ‘resilience to short-term shocks’ and ‘environmental factors’ have been identified as relative credit weaknesses.

The QS does not generate further notch adjustments to the indicative rating, indicating AA- long-term ratings for Estonia.

Factoring of Environmental, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during its ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and in the qualitative overlay (QS).

With respect to environmental factors, Estonia’s performance among CVS indicators is mixed. The country receives weak scores for emissions per GDP and per capita, but obtains top scores for the exposure and vulnerability to natural disaster risks and the ecological footprint of consumption compared with available biocapacity. Estonia’s QS adjustment for ‘environmental factors’ is ‘weak’. Estonia has expanded renewable energy production capacity significantly, which now covers around 30% of gross final energy consumption. The government reinforced its energy transition and security objectives in the wake of the Ukraine war, notably aiming to cover all electricity needs from renewable resources by 2030. At the same time, the Estonian economy remains one of the most carbon-intensive in the EU, reflecting its reliance on oil shale (around 60% of energy consumption) and the energy-intensiveness of some key sectors including transport. The high economic relevance of the oil shale industry represents a challenge for Estonia’s green transition. Further environment-related credit challenges result from the low efficiency of the economy’s resources, as reflected in the poor ranking against EU peers on resource productivity, though the country performs well for its circular economy.

Regarding social criteria, in the CVS model Estonia receives positive scores for income inequality and labour force participation but a weak score for the old-age dependency ratio. The complementary QS assessment of ‘social factors’ is ‘neutral’, accounting for positive labour market metrics relative to euro area peers, including high participation (80%) and low gender employment gaps (3.7%). However, income inequality and poverty risks are still slightly above EU averages, despite significant improvements. Adverse demographic trends also pose a key social challenge, in part mitigated by net migration having turned positive since 2015.

Under governance-related factors in the CVS, Estonia has strong scores in the World Bank’s Worldwide Governance Indicators. In the QS assessment of Estonia’s ‘governance factors’, Scope evaluates this qualitative analytical category as ‘neutral’ versus Estonia’s indicative sovereign peer group. The ruling government is led by Prime Minister Kaja Kallas from the liberal Reform Party, with the Christian-democratic Isamaa party and centre-left Social Democratic party as junior partners. The coalition was formed in July 2022 following a fallout within the previous coalition between the Reform and Centre parties. The next election will occur by March 2023. Policymaking has a record of effectiveness and continuity, supported by the highly digitalised public services. External security risks have increased since the Ukraine war escalated in February 2022 in view of the country’s proximity to Russia. At the same time, Estonia’s strong preparedness underpinned by its NATO membership strongly reduces the likelihood of the conflict escalating to a point at which economic stability is threatened.

Rating Committee
The main points discussed by the rating committee were: i) Estonia’s economic outlook and medium-term growth potential; ii) fiscal and debt sustainability developments; iii) external sector vulnerabilities; iv) banking sector and non-financial private sector balance sheet developments; v) ESG considerations; and vi) peer comparisons.

Rating driver references
1 Eesti Pank: Estonian Economy and Monetary Policy 3/2022
2 IMF Article IV September 2022
3 EC 2022 European Semester Country Reports
4 MoF: 2023 Draft Budgetary Plan
5 Opinions of the Fiscal Council
6 MoF: Investor Presentation October 2022
7 ECB – Monetary Policy Decisions
8 Eesti Pank: Financial Stability Review 2022/1

Methodology
The methodology used for these Credit Rating(s) and/or Outlook(s), (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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                                           YES
The following substantially material sources of information were used to prepare the Credit Rating(s): public domain, 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: Giulia Branz, Senior Analyst.
Person responsible for approval of the Credit Ratings: Henrik Blymke, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 21 February 2020.

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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