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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Republic of Latvia’s (Latvia) long-term issuer and senior unsecured local- and foreign-currency ratings at A- and revised the Outlook to Stable from Positive. Scope has also affirmed Latvia’s short-term issuer rating at S-1 in both local and foreign currency with a Stable Outlook.

Summary and Outlook

Scope’s decision to revise the Outlook to Stable from Positive on Latvia’s A- credit ratings reflects the prolonged effects of the cost-of-living shock and heightened geopolitical risks on its economic and fiscal fundamentals. In the absence of a rapid resolution of the conflict between Russia and Ukraine along its economic ramifications, these challenges significantly reduce the likelihood of a rating upgrade in the short-term, despite the resilience demonstrated so far by Latvia.

Latvia is notably exposed to the ongoing cost-of-living crisis, whose ramifications are proving persistent, affecting growth prospects and external competitiveness, besides adversely impacting government finances. In view of its history and location, Latvia is exposed to heightened geopolitical tensions caused by Russia’s invasion of Ukraine, though a direct military threat to Latvia remains a low likelihood and tail risk for the ratings. Still, geopolitical risks have risen enough to be meaningful since the Positive Outlook was assigned in January 2022.

The Outlook revision reflects updated Scope assessments of Latvia under the ‘domestic economic risk’ and ‘external economic risk’ category of its sovereign methodology.

The affirmation of Latvia’s A- long-term ratings is underpinned by its significant rating strengths including: i) Latvia’s sound institutions, anchored to its euro area and NATO memberships, which ensure a robust framework for fiscal and economic policy, besides strongly mitigating external security risks; ii) the country’s improved economic resilience and solid medium-run growth prospects, underpinning Scope’s expectation of continued income convergence to euro area levels over the coming years; and iii) a moderate public debt, which is fundamental to preserve strong debt affordability despite the fiscal costs of the shocks and higher financing costs for the government following the rapid tightening of monetary policy in the past months.

The main challenges to Latvia’s ratings are: i) moderate income levels, despite continued convergence over the past decades; ii) its exposure to external shocks, given the small-size and openness of the economy; iii) the adverse demographic trends that are increasing labour shortages and fiscal pressures; and iv) financial sector risks related to the banking sector concentration and interconnectedness with the Nordic region.

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

The ratings/Outlooks could be upgraded if, individually or collectively: i) geopolitical risks in the region declined; ii) solid economic growth and income convergence continued through reform implementation and investment; iii) the public debt-to-GDP ratio remained moderate, supported by balanced government finances in the medium run; and/or iv) external and/or financial sector vulnerabilities continued to moderate.

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

Rating rationale

The Outlook revision to Stable from Positive on Latvia’s A- credit ratings reflects the prolonged effects of the cost-of-living shock and heightened geopolitical risks on the country’s economic and fiscal fundamentals.

Latvia is notably exposed to the cost-of-living crisis, as reflected in very high inflation, an economic slowdown, and wider current account deficit in recent months. In view of its history and location, Latvia is particularly exposed to the heightened geopolitical tensions following Russia’s invasion of Ukraine, though a direct military threat to Latvia remains a very low likelihood and tail risk for the ratings. Still, geopolitical risks have risen to a non-negligible extent since the escalation of the war and are requiring significant fiscal efforts to strengthen external and energy security.

The Latvian economy proved resilient to the Covid-19 shock, with real GDP growth of 2.8% and 4.3% in 2022 and 2021, following a contained contraction of 2.3% in 2020. The escalation of the war in Ukraine is, however, having a significant impact, given Latvia’s important (albeit declining) trade links with Russia and the exceptional shock on commodity prices. Last year the economy grew moderately despite the relaxation of Covid-19 restrictions in the beginning of the year, with average quarterly growth of 0.3%. Scope expects some recovery over 2023 and 2024 as energy prices are declining rapidly, but the outlook remains constrained by tight financing conditions along with weaker confidence and external demand. Scope expects GDP to grow moderately by 0.7% in 2023 and 2.7% in 2024.¹

Along with the other Baltic states, Latvia is heavily affected by the exceptional inflationary pressures owing to the large share of energy and food items in its consumption basket and the deregulation of gas and electricity markets. Scope expects inflation to normalise rapidly through the tightening monetary policy and lower energy prices. The harmonised inflation rate stood at 17.2% in March 2023, down from the peak of 22.0% in September 2022. At the same time, however, core inflation is elevated (10.7%) and decreasing only moderately, signalling continued risks for macroeconomic stability and external competitiveness. Scope expects an annual inflation rate of about 10% for 2023, after 17.2% in 2022, then declining to 2-3% in 2024-2025.²

The shocks are also affecting Latvia’s external sector. Latvia’s current account remained close to balance in the pre-pandemic period, with deficits in the goods and primary income balances broadly offset by surpluses in the services and secondary income accounts. After swinging to a 4.2% of GDP deficit in 2021, from a 2.6% surplus in 2020, the current account balance worsened to a 6.4% deficit in 2022. This deterioration followed the impacts of soaring energy and raw materials prices, but also the stockpiling of resources, large imports of aircrafts and exceptional import volumes related to trade flows with Russia in anticipation of sanctions coming into power. These factors are largely of temporary nature. However, in view of Latvia’s still significant, albeit declining, trade exposures to Russia, which accounts for 5-6% of exports, and the loss of Russian import markets for raw materials at low prices, Scope expects the recovery of the current account to be gradual, with deficits of 2-3% of GDP over the coming years. This, also as the exceptional inflation of current years is likely to have some lasting impact on external competitiveness. Persistent current account deficits are likely to slow the rebalancing of the economy’s external position. The country’s net debtor position declined from 51.5% of GDP in 2017 to 27.0% in 2022.

These shocks are also impacting government finances. Latvia had a good record of moderate fiscal deficits before the Covid-19 crisis. The pandemic had a significant impact on the government budget, however, due to the support required for health and social systems. The fiscal deficit narrowed to a still elevated 4.4% of GDP in 2022, after 7.1% in 2021 and 4.4% in 2020. This was because robust growth in government revenue was offset in part by the still significant support needed for the Covid-19 and energy crises on top of spending for enhancing security. The 2023 budget, adopted in March after the new government was formed, sets aside less for the energy crisis, but includes higher resources for healthcare, education, public wages and investment, with the latter boosted by NGEU funds. Scope expects the deficit to decline to about 4% of GDP in 2023 and further to about 1-1.5% by 2028. Latvia’s low tax revenue, at just above 30% of GDP, or more than 10 pp less than the EU average, remains a constraint for its fiscal policy.^3,4

A direct military threat by Russia remains very unlikely for Latvia, thanks to its strong international alliances. Still, external security risks have increased since the Russia-Ukraine war escalated. Latvia shares borders with Russia and Belarus, and tensions could rapidly intensify, as it was the case during the imposition of sanctions and following Russia’s announcements of escalation threats, such as plans to build storage facilities for nuclear weapons in Belarus.

The affirmation of the ratings at A- reflects Latvia’s significant credit strengths including its sound institutions, underpinned by euro area and NATO memberships, ensuring a robust framework for fiscal and economic policy, besides strongly mitigating external security risks.

Latvia’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 financial markets are 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 development. Latvia’s GDP per capita was at 54% of the euro area average last year, up from just 30% in 2010, although significantly lagging the other Baltic economies. As measured in purchasing power standards, Latvia’s GDP per capita is over 70% of the euro area average.

The NATO memberships of Latvia and the other Baltic states strongly limit the risk that the conflict could expand into the Baltic region. Latvia’s security guarantees are underpinned by Article 5 of the NATO Treaty, which states that an armed attack on one member constitutes an armed attack against all members, which will then provide support. Both NATO and Latvia have continually confirmed a commitment to Article 5.

The affirmation of the A- long-term ratings for Latvia also reflects the country’s improved economic resilience and solid medium-run growth prospects, underpinning Scope’s expectations of continued income convergence over the coming years.

The Latvian economy was resilient during recent global shocks, such as Covid-19, but also currently, when considering its strong exposure to the ramifications of Russia’s war in Ukraine. In the medium term, Scope estimates a robust growth potential of about 2.5% for Latvia, underpinned by ample access to EU funds, exceeding 25% of (2021) GDP over 2021-27 (Recovery and Resilience Facility, Cohesion and Common Agricultural Policy), which will support the continued convergence in productivity with euro area levels. The Russia-Ukraine war is having significant direct and indirect negative impacts on the country’s economy, primarily through the inflation shock. At the same time, Scope does not expect the conflict to cause permanent scarring in the country’s growth potential, supported by the continued improvement of Latvia’s energy security, which has allowed a rapid and complete substitution of Russian energy imports. Further, the connection of the Baltic states’ and continental Europe’s electricity networks is due for completion by 2025, with synchronisation under emergencies already possible.⁵

Latvia’s economic progress is also supported by the country’s flexible and inclusive labour market. Employment continued to recover through 2022, though still counting about 20,000 fewer workers than before Covid-19. The influx of Ukrainian refugees is likely to support employment and offset the decline in the working-age population. Participation and employment rates are rather high, at 77% and 71% in Q4 2022, respectively, while the unemployment rate is low at 6.7% as of February 2023.

Latvia’s A- ratings are also underpinned by its moderate public debt levels, fundamental to preserve strong debt affordability despite the fiscal costs of the shocks and higher financing costs following the rapid tightening of monetary policy in the past months.

Latvia’s public debt is lower than sovereign peer levels. Scope expects Latvia’s general government debt to slightly rise to 41.3% of GDP in 2023, up from 40.8% in 2022 and then stabilise at about 40-43% over the next five years. This will be supported by solid nominal growth and gradually narrowing fiscal deficits in the medium term. Also, the interest payment burden will remain moderate despite rising interest rates, underpinning strong debt affordability. Contingent liabilities in the form of government guarantees (below 2% of GDP) and the implicit costs of the ageing population are also contained vis-à-vis peers, though here Scope expects some downside risks given the current modest spending for healthcare and pensions, especially after the Covid-19 pandemic and given the current cost-of-living shock.

Latvia’s debt outlook benefits from a robust debt profile and favourable financing conditions, despite rising interest rates in the euro area and heightened market volatility. The average maturity is relatively long, at close to seven years, which will help to keep the government’s annual gross financing needs moderate at 5-8% of GDP over the coming years. Liquidity management is prudent under the current volatile market conditions, with a large cash buffer of 6% of GDP as of February 2023 supporting funding flexibility. The debt portfolio is entirely denominated in euros and mostly carries a fixed rate. Debt securities are mostly issued on international capital markets, although Latvia is developing its creditor base by tapping existing Eurobonds in the domestic market. In December 2021, Latvia issued its inaugural Sustainability Bond.⁶

Despite these strengths, Latvia’s ratings face several challenges.

First, a narrow economic size (GDP of EUR 39bn), characterised by a large degree of openness (export and import sectors accounting for over 70% of GDP), and still moderate wealth levels (GDP per capita of EUR 20,710) expose Latvia to external shocks and make its growth dependent on external funding for investments. Also, Latvia has relatively high external debt levels vis-à-vis the other Baltic economies, at over 100% of GDP last year, although gradually declining.

Second, adverse demographic trends are increasing labour shortages and fiscal pressures. The UN projects that Latvia’s working-age population will decline cumulatively by 20% over the next 20 years. At the same time, the population aged over 85 will grow by almost 30%, with important social, economic and fiscal implications. These trends represent an obstacle to sustained economic growth, as the labour market will face increasing labour and skill shortages, which are also like to further fuel wage pressures, adversely affecting competitiveness. Adverse demographic trends are also a challenge for fiscal sustainability in the long run.

Finally, the ratings account for financial sector risks related to the banking sector interconnectedness with Nordic banks and cross-border financial flows, which are however mitigated by the sound fundamentals of Latvian banks.

Latvia’s banking sector is exposed to concentration and spillover risks due to its integration with the Nordic and Baltic banking systems. At the same time, reliance on cross-border parent banking group funding is limited by a stable domestic customer deposit base. The share of non-resident deposits stood at 15.4% of the total as of Q4 2022, down from above 40% in 2018, which mitigates Latvia’s exposure to possible global financial stress and capital flight in times of market volatility. The reduced share also significantly lowers risks of a re-emergence of money laundering in the Latvian banking sector, supported by the country’s progress in strengthening its anti-money laundering framework. The sector’s resilience is also bolstered by strong capitalisation and asset quality metrics, with aggregate CET 1 and non-performing loan ratios of 21.3% and 1.8% as of Q4 2022, respectively, as reported by Latvijas Banka. Low cost-to-income ratios will support profitability over the coming years, even with the risks stemming from the challenging economic outlook and the uncertainty over the global banking sector following a rapid normalisation in monetary policies.⁷

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 ‘bbb+’ for the Republic of Latvia. 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 ‘a-’ 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 Latvia, no relative credit strength or weakness has been identified qualitatively. The QS does not generate further notch adjustments to the indicative rating, resulting in A- long-term ratings for Latvia.

A rating committee has discussed and confirmed these results.

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 20% weighting in the qualitative overlay (QS).

With respect to environmental factors, Latvia’s performance among CVS indicators is strong. The country receives a weak score for emissions per capita, but obtains top scores for emissions per GDP, the exposure and vulnerability to natural disaster risks and the ecological footprint of consumption compared with available biocapacity. Latvia’s QS adjustment for ‘environmental factors’ is ‘neutral’. Latvia already meets a large share of its domestic energy consumption with renewables (44% as of 2021), the highest share in the EU after Sweden and Finland. The country’s system of environmental taxation yields around 3% of GDP in government revenue annually, one of the highest levels in the EU. The country, however, faces challenges from rising emissions outside of the Emissions Trading System due to a fossil fuel-reliant transport system and an energy-intensive building stock. The government plans to address these challenges via large public investments under its Recovery and Resilience Plan, 38% of which is allocated to climate objectives. The Latvian government recently approved proposals to accelerate the scaling-up of the country’s renewable energy generation and its energy independence, including relaxing regulatory barriers for the development of wind and solar energy projects.

Regarding social criteria, in the CVS model Latvia receives a very strong score in labour force participation, an average mark for income inequality and a very weak score for the old-age dependency ratio. The complementary QS assessment of ‘social factors’ is ‘neutral’, accounting for Latvia’s inclusive labour market and gradual progress on social exclusion and poverty risks, which however remain above the EU average. Adverse demographics are a key social challenge, as captured by the quantitative indicators.

Under governance-related factors in the CVS, Latvia has strong scores in the World Bank’s Worldwide Governance Indicators. In the QS assessment of Latvia’s ‘governance factors’, Scope evaluates this qualitative analytical category as ‘neutral’ versus its indicative sovereign peer group. Policymaking in the country has been underpinned by the country’s EU and euro area memberships and has enjoyed relative continuity despite its multi-party political system. The October 2022 elections produced large gains for incumbent Prime Minister Krišjānis Kariņš’ party, which formed a new centre-right coalition government. External security risks for Latvia have increased since the escalation of the war in Ukraine. However, Scope believes that Latvia’s and other Baltic states’ membership in NATO strongly limits the risk that the conflict will expand into the Baltic region.

Rating Committee
The main points discussed by the rating committee were: i) Latvia’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. Latvijas Banka – Forecasts March 2023     
2. ECB Monetary policy decisions          
3. Draft budgetary plan (updated) 2023       
4. European Commission – Opinion on the 2023 Draft budgetary plan       
5. European Commission – Recovery and Resilience Facility      
6. The Treasury - Investor presentation March 2023     
7. Latvija Banka – Supervision statistics     

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (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                                             NO
The following substantially material sources of information were used to prepare the Credit Ratings: 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: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 14 January 2022.
 
Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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