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Rating action

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

Summary and Outlook

The revision of the Outlook to Negative from Stable on Estonia’s AA- credit ratings reflects the following drivers:

1. The prolonged effects of the cost-of-living crisis and heightened geopolitical risks on Estonia’s economic fundamentals. Estonia is particularly exposed to the cost-of-living shock, with the persistent ramifications of the crisis affecting growth and external-sector competitiveness. In view of its history and geography, Estonia is especially at risk amid heightened geopolitical tensions following Russia’s invasion of Ukraine, although a direct military action against Estonia and Baltic states remains a low likelihood and a tail risk affecting the ratings. Nevertheless, geopolitical risks have risen sufficiently as to be meaningful, while the possibility of a rapid resolution of the conflict has significantly diminished in recent months.

2. A weakening in Estonia’s fiscal position. The challenging economic outlook and the fiscal costs of the muted external environment are heavily affecting government finances, amplifying the effects of a looser fiscal policy stance adopted in recent years. Scope expects the government budget to remain structurally in deficit over the coming years driving the debt-to-GDP ratio on a rapid upward trajectory. While the new government has committed to implementing fiscal consolidation measures to contain imbalances in public finances, in Scope’s view, stabilising the debt trajectory will prove challenging in the near-term.

Further challenges for the ratings are: i) the still moderate per-capita income levels relative to euro-area peers, which, coupled with the economy’s small size and openness, increase its vulnerability to external shocks; and ii) an ageing population and skilled-labour shortages that are constraining the medium-run growth outlook and are likely to result in mounting fiscal pressures over the long run.

The Outlook revision reflects updated Scope assessments of Estonia under the ‘domestic economic risk’, ‘public finance risk’ and ‘ESG risk’ categories of its sovereign methodology.

Estonia’s ratings remain nevertheless anchored to the country’s strong economic and fiscal fundamentals, which are reflected in the good economic resilience demonstrated so far despite a high exposure to the current crises and in an ample fiscal space built through consistently prudent fiscal management over recent years.

The affirmation of Estonia’s AA- long-term ratings is underpinned by significant credit rating strengths including: i) the country’s sound institutions underpinned by 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) a low public debt burden and prudent debt and liquidity management, which will ensure strong debt affordability relative to peers for Estonia in the coming years, notwithstanding the fiscal costs of the current crises and significantly higher financing costs for the government following the ECB’s rapid normalisation of monetary policy.

The Negative Outlook reflects Scope’s view that risks to the ratings are tilted to the downside over the next 12 to 18 months.

The Outlook could be revised back to Stable if, individually or collectively: i) geopolitical risks affecting the region moderated significantly; ii) the fiscal outlook improved, supported by a rapid rebalancing of government finances; iii) structural reforms and investment continued to sustain solid growth and income convergence; and/or iv) external vulnerabilities saw a further sustained reduction.

Conversely, the ratings could be downgraded if, individually or collectively: i) the fiscal position were not rebalanced, preventing the stabilisation of the debt-to-GDP at moderate levels; 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

The revision to Negative from Stable for the Outlook on Estonia’s AA- credit ratings reflects the significant and prolonged effects of the cost-of-living crisis and heightened geopolitical risks affecting the country’s economic and fiscal outlooks, even though the country’s improved macroeconomic resilience and solid credit fundamentals are important mitigating factors.

Estonia is particularly exposed to the cost-of-living crisis, as reflected in high inflation and an economic slowdown over recent months. In view of its history and geography, Estonia is comparatively more exposed to heightened geopolitical tensions following Russia’s full-scale invasion of Ukraine, although direct military actions against Estonia remain a low likelihood and tail risk affecting the ratings. Still, geopolitical risks have risen non-negligibly since the escalation of the war in Ukraine and already require significant fiscal outlays for the strengthening of its external and energy security. The possibilities of a rapid resolution of the conflict have significantly diminished in recent months, underpinning expectations of prolonged negative effects on Estonia’s fundamentals.

The Estonian economy was resilient during Covid-19, experiencing a narrow contraction in 2020 (0.6%). This was followed by an exceptional rebound in 2021 with real GDP growing by 8.0%, also driven by one-off withdrawals of pension savings. Russia’s war in Ukraine is significantly affecting economic activity, however, via high inflation, trade disruptions and weaker confidence. Last year, GDP shrank by 1.3%, driven by weak investment and net exports, though this was also a consequence of growth above potential in 2021. This year Scope expects some recovery in economic activity, which will though be restrained by lasting effects of high inflation and the cost-of living crisis. While robust wage growth will gradually reduce the erosion of purchasing power following the price shock last year, this will also contribute to erode external competitiveness, dampening exports amid timid external demand. In addition, tight financing conditions are likely to discourage investment, though this will in part be offset by the ramping up of EU funds inflows. Negative carryover effects from 2022 are likely to result in a further economic contraction this year. GDP will likely contract by 1.0% in 2023 and then moderately rebound by 2.8% in 2024.¹

Estonia’s elevated exposure to the cost-of-living shock is signalled by the current exceptional inflationary pressures. The ramifications of the conflict were rapidly felt due to the large share of energy and food items in the country’s consumption basket on top of deregulated gas and electricity markets. Inflation is declining rapidly from the peak in August 2022 of 25.2% (harmonised rate, YoY), and reached 15.6% in March 2023. Declining energy prices, a subdued economic outlook and the ECB’s rapid tightening of monetary policy, with rate hikes totalling 375 bps since July 2022, suggest price pressures will continue declining over the coming months. Core inflation, however, remains very high, above 12%, and is declining only at a moderate pace, signalling persistent effects of the price shock on the economy. Scope expects inflation to moderate to about 8.5% in 2023 and 3.0% in 2024, from 19.4% in 2022. Such inflation levels, combined with related pressures on wages, are likely to have a lasting impact on external competitiveness.^2,3

Direct military risk from Russia remains very low due to Estonia’s strong international alliances. Still, external security risks have risen meaningfully since the war in Ukraine escalated. Given Estonia’s border with Russia and its strategic location in the Baltic Sea, tensions could intensify quickly. That was the case when the EU imposed sanctions on Russia as well as when Russia announcements of escalation dangers such as plans to construct storage facilities for nuclear weapons in nearby Belarus.

The Outlook revision on Estonia’s ratings also reflects its weakening fiscal position, as sizeable fiscal outlays related to the crisis, on top of structural budgetary pressures, are set to keep debt-to-GDP on a steep upward trajectory over the coming years, although from a moderate level.

Estonian authorities’ fiscal prudence is reflected in broadly balanced government budgets in the 10 years prior to the Covid-19 crisis. However, structural budgetary pressures, exacerbated by the geopolitical and cost-of-living crises, are challenging the fiscal outlook for the coming years. The government fiscal deficit narrowed to 0.9% of GDP last year, after 2.4% and 5.5% in 2021 and 2020, thanks to buoyant nominal GDP growth boosting government revenue. However, Scope expects the deficit to widen significantly this year, to 4% of GDP, owing to the lagged effects of inflation on social spending and public wages and the weak economic outlook, which will amplify the impact of a looser fiscal policy stance adopted in recent budgetary cycles.

The new government, which came into power after general elections in March 2023, aims at increasing miliary spending and social benefits in the coming years, though remains committed to safeguarding government finances, as reflected in unpopular decisions to hike taxes, including VAT and the income tax, from 2024 onwards. This should help reduce the deficit to 3.0% of GDP in 2024, as targeted by the government, against forecasts of above 4% of GDP by the Ministry of Finance in a no policy-change scenario. Scope expects the fiscal deficit to remain at similar levels also in the following years, as further consolidation measures are likely to be politically challenging in the weak economic context. By 2028, the deficit should further decline owing to lower defence investments, though likely not sufficiently to stabilise the debt-to-GDP ratio. Scope expects government debt to remain on an upward trajectory over the next five years, to above 30% of GDP by 2028, up from 18.4% in 2022 and 8.5% before the Covid-19 pandemic. While this level is likely to remain one of the lowest in the euro area, according to Scope’s current economic and fiscal baseline assumptions, a stabilisation of the trajectory is not likely even at the end of the forecasting horizon, though the pace of debt increase should moderate.^4,5

Further challenges for the ratings include the economy’s small size and openness, and adverse demographic trends. Estonia’s economy is small (GDP of EUR 36bn) and characterised by a significant degree of openness (the export and import sectors accounting each for over 85% of GDP). This, coupled with still moderate wealth levels (GDP per capita of EUR 27,200), exposes Estonia to external shocks and makes growth dependent on external funding for investment. Estonia’s ratings are also constrained by adverse demographic trends, which are likely to challenge the long-run economic and fiscal outlook. The UN forecasts a 20% decline in Estonia’s working-age population over the next 30 years. By then, the old-age dependency ratio (the ratio of those aged 65 and over to those of working age) would exceed 50%, while the number of people aged over 85 would have cumulatively increased by 90% from today. Such population trends will exacerbate pressures in the labour market, where labour and skills are already in short supply and risk to further fuel wage rises, on top of pressures created by high inflation, 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. Positive net migration, as seen over recent years, possibly supported by a large inflow of Ukrainian refugees could mitigate risks related to weak demographics.

Despite these challenges, Estonia’s ratings are underpinned by strong credit fundamentals, including a sound governance and policy framework, improved macroeconomic resilience with solid growth prospects, and ample fiscal buffers thanks to very low government debt, furthermore backed by prudent liquidity management. These elements strongly mitigate the risks stemming from the muted geopolitical, economic and financing conditions in recent months.

The affirmation of the ratings at AA- reflects Estonia’s significant credit strengths including sound institutions, underpinned by euro-area and NATO memberships, which ensure a robust framework for fiscal and economic policy-making, and strongly mitigate external security risks.

Estonia’s ratings benefit from effective policy-making anchored by EU and euro-area memberships. Those memberships provide a sound and credible framework for economic, fiscal and monetary policy-making, conferring the benefits of issuing in a reserve currency for Estonia’s economy. The reserve-currency status of the euro is especially relevant for economic resilience when markets are volatile. Euro-area membership furthermore ensures sound banking-sector supervision. Together with ample access to and efficient absorption of EU funding for public investment, said memberships have supported the country’s significant economic convergence over the recent years and provided support for continued modernisation and technological development. GDP per capita was above 70% of the euro-area average as of last year, a rise from below 40% in 2010. Measured by purchasing power parity standards, GDP per capita is close to 85% of the euro-area average.

The NATO memberships of Estonia and peer Baltic states significantly reduce the risk of Russian aggression expanding to the region. Estonia’s security guarantees are underpinned by Article 5 of the NATO Treaty, stating an armed attack on one NATO member state constitutes an armed attack against all, requiring support – such as armed support. Both NATO and Estonia have continually affirmed their commitments to Article 5.

Estonia’s AA- ratings are also underpinned by the improved resilience of its economy, as demonstrated in the recent crises, and by solid growth prospects over the medium run.

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, but also to the current shocks related to the muted geopolitical environment and the cost-of-living crisis, given its high exposure. In Scope’s view, the economic scarring caused by the ramifications of the Russia-Ukraine war is strongly mitigated by the continued improvement in Estonia’s energy security. Estonia rapidly substituted its energy imports from Russia in the first half of 2022 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 production 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.

In the medium run, Scope estimates a robust growth potential of 2.2% for Estonia, supported by ample access to EU funds amounting to close to 20% of (2021) GDP over 2021-27 (aggregate funding from the Recovery and Resilience Facility, Cohesion Fund and Common Agricultural Policy). The economy benefits from an attractive business environment and a highly digitalised public administration supporting continued advancements productivity, and by a highly inclusive and flexible labour market, which is so far moderately affected by the economic slowdown, providing support to the economic outlook. Employment was record high at the end of last year, counting over 680,000 workers, also driven by the inflow of war refugees, which is offsetting some pressures from unfavourable demographic dynamics in Estonia. Employment and participation rates are very high, at 77% and 82%, respectively, while the unemployment rate is low, though moderately increasing, at 5.4% in March 2023. Scope does not expect significant upward pressures on unemployment in the coming months, despite the modest economic outlook.^6,7

Estonia’s AA- ratings are also supported by strong debt affordability, derived from its low public debt, which is furthermore backed by the government’s high financial reserves and characterised by a low-risk profile.

Scope expects Estonia’s debt-to-GDP ratio to remain among the lowest in the euro area over the next five years. Estonia will also retain an interest burden much lower than that of peers, though significantly higher than before the Covid-19 and energy crises, supporting strong debt affordability in the medium run. According to Scope, interest payments for the government are unlikely to significantly exceed 1.0% of GDP in the coming years, even in the context of a rising debt trajectory and higher funding costs.

Debt affordability is also supported by the low-risk profile of Estonia’s debt, moderate funding needs and prudent liquidity management. The central government debt portfolio comprises EUR 1.65bn in long-term amortising loans from international financial institutions and EUR 2.85bn in securities, as Estonia is becoming a more frequent issuer on bond capital markets. Even so, funding needs will remain very low in the next five years, likely below 5% of GDP, limiting refinancing risks. The Treasury implements prudent liquidity management, underpinned by an ample liquidity reserve of EUR 1.3bn as of March 2023. There is no foreign currency exposure and a long average debt maturity of over seven years, spreading the redemption profile over time.⁸

Estonia’s ratings also benefit from a solid and profitable banking sector, though potentially exposed to financial spillover risk, given its concentration and interconnectedness with Nordic banks.

Estonia’s banking sector presents low contingent liability risk to the government and is well placed to absorb the current economic shock. The sector’s resilience is underpinned by its high capitalisation levels – among the highest in the EU with an aggregate CET1 ratio of 21.9% as of Q4 2022 – and by its comfortable profitability with an aggregate return on equity of 10.7% as reported by the EBA. Strong asset quality, with a non-performing loan ratio of 0.6%, a lower cost-to-income ratio than peers and rising lending rates will support profitability over the coming years, although the weaker economic outlook and rising uncertainties in the global banking sector following monetary policy normalisation represent risks. Estonia is potentially exposed to spillover risk from the Swedish financial sector and housing market as Swedish financial groups’ market share of local deposits and loans exceeds 60%. Additionally, the Estonian banking sector is highly concentrated, with the top five credit institutions accounting for more than 90% of sector assets. Capital flight and cross-border money-laundering risks are however mitigated by the steady improvement in the financial sector’s funding profile and in anti-money laundering oversight policies.^9,10

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 methodology’s 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 Estonia, the following relative credit strengths have been identified via the QS: i) growth potential; ii) debt sustainability; iii) current account resilience; iv) external debt structure; v) banking sector performance; and vi) financial imbalances. Conversely, the following relative credit weakness has been identified: i) environmental factors. Combined, the relative credit strengths and weaknesses identified in the QS result in a two-notch positive adjustment to the indicative rating, resulting in AA- long-term ratings for Estonia.

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, Estonia’s performance in CVS variables is rather strong. The country receives weak scores for its emissions per unit of GDP and per capita but obtains strong performance scores on exposure and vulnerability to natural disaster risks, and the ecological footprint of its consumption as compared with available biocapacity. Estonia’s QS evaluation on ‘environmental factors’ is ‘weak’ against a peer group of countries. Estonia has made significant progress in the development of renewable energy. The share of renewables in the energy mix stood at 31% in 2021, above the EU average of 19% and up from 17% in 2005. However, the Estonian economy is still one of the most carbon-intensive in the EU, with fossil fuels covering 62% of energy consumption, primarily owing to its dependence on domestic oil shale. To reduce dependency from Russian energy imports, Estonia was forced to slow down its plans to phase out shale oil power plants but remains committed to end production by 2040. This transition will however come with challenges, given the systemic relevance of the sector in the economy. The government aims to have renewable resources cover all its electricity needs by 2030, reduce CO2 emissions by 70% relative to 1990 levels and reach carbon neutrality by 2050. Estonia has earmarked 41.5% of its Recovery and Resilience Plan to climate objectives, with projects aimed at expanding renewable energy production and improving the energy efficiency of the economy, particularly of the transport sector.

Regarding socially-related criteria, in the CVS model, Estonia receives a very strong score on labour-force participation, an above-average mark on income inequality and a weak score on the old-age dependency ratio. The complementary QS assessment of ‘social factors’ is ‘neutral’ compared to a peer group of countries. Estonia’s labour market is inclusive, as reflected in high participation. Income inequality and poverty risks are slightly above the EU average but have significantly declined in recent years. A key social challenge is posed by adverse demographic trends, as captured by the quantitative score.

Under governance-related factors in the CVS, Estonia holds very strong scores on 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 its sovereign peer group. Policy-making has been effective and enjoyed broad continuity despite the multi-party system that requires coalition agreements. EU and euro area memberships also enhance the quality of Estonia’s macroeconomic policies and macroprudential framework. A new government took office in April 2023, after swift negotiations following general elections held the month before. Kaja Kallas was confirmed as prime minister, leading a coalition consisting of her pro-European liberal Reform party together with the centrist Estonia 200 and the centre-left Social Democrats, which underpins Scope’s expectations of broad policy continuity. External security risks for Estonia have increased since the war in Ukraine escalated. However, Estonia’s NATO membership 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) 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 – Economic forecast – March 2023    
2. Eesti Pank – Competitiveness report - 2023      
3. ECB - Monetary policy decisions        
4. Ministry of Finance - Stability programme 2023     
5. Economic forecast of Ministry of Finance – April 2023    
6. European Commission - Recovery and Resilience scoreboard        
7. Eesti Pank – Labour market review – April 2023      
8. The State Treasury – Financial reserves and liabilities   
9. Esti Pank - Financial Stability Review – May 2023     
10. Council of Europe – Moneyval evaluation report on Estonia    

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                                           YES
The following substantially 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: Giulia Branz, Associate Director
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 25 November 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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