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Rating action

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

The downgrade of Estonia’s long-term ratings reflects the structural deterioration of the country’s fiscal position, resulting from the successive impacts of the Covid-19 pandemic and Russia-Ukraine war, as well as from a pronounced loosening of its fiscal stance relative to the pre-pandemic period due to durably higher military and social expenditures. Scope expects the government budget to remain structurally in deficit over the coming years, driving a sustained worsening in debt metrics. The downgrade furthermore reflects the prolonged effects of the Russia-Ukraine war and heightened geopolitical tensions on the country’s economic fundamentals, as well as challenges stemming from adverse demographic trends.

Key rating drivers

Structural deterioration in fiscal buffers. The first driver of the downgrade reflects the structural deterioration of Estonia’s fiscal outlook relative to the pre-pandemic period. The general government deficit widened to 3.4% of GDP last year (from 1.0% in 2022), due to the impact of weak economic growth on government revenue and significant pressures on public spending. Weak private consumption weighed on indirect tax receipts, while revaluations in public sector wages and social benefits led to higher government outlays, on top of a heightened public investment effort.

Looking ahead, Scope expects the fiscal deficit to remain broadly stable this year (3.3% of GDP) and to widen to 4.3% of GDP in 2025. Government outlays will continue to grow robustly over the medium term, in line with decisions to allocate additional funding to defence, education and research and persistent pressures on personnel costs and social transfers. Military expenditures are expected to rise to about 3.4% of GDP in 2024 and to remain elevated (close to or above 3% of GDP) over the coming years, up from around 2.0% of GDP in the pre-pandemic period. Revenue growth will only gradually pick up due to the still subdued economic momentum this year, and despite the phase-in of recent tax policy changes, including hikes to value-added and corporate income tax rates. The coming into effect of the personal income tax reform next year is expected to lead to a temporary reduction in revenue, due to the increase in the tax-free threshold, which will lead to a spike in the fiscal deficit. Scope notes that consolidating measures are presently under discussion, such as the introduction of a tax on motor vehicles, though their implementation and revenue impact remain uncertain.

Net interest payments are expected to rise steadily over coming years to about 1.9% of general government revenue by 2028 from an estimated 0.7% last year, in line with growing indebtedness and higher borrowing costs. Still, compared to peers this increase in interest payments remains comparatively moderate. The general government deficit is expected to improve somewhat after 2025, averaging 3.2% of GDP over 2026-28. This reflects a marked shift from Estonia’s pre-pandemic track record of prudent fiscal policy, with fiscal deficits averaging just 0.7% of GDP over 2017-19, which will significantly weigh on the country’s fiscal buffers over the medium-term.

Scope expects Estonia’s public debt-to-GDP ratio to remain on a rising trajectory over coming years. After increasing to 19.6% in 2023, up 1.1 percentage points from the previous year, the ratio is expected to rise to 22.8% this year and to around 33% by 2028. While indebtedness will remain low compared to euro area peers, this trend will result in the debt-to-GDP ratio nearly quadrupling from its end-2019 levels (8.5%), a time when liquid financial reserves held by the Estonian Treasury covered the near entirety of the public debt stock, a third of which reflected loans from the European Investment Bank. In contrast, Scope now expects financial reserves to remain broadly stable over the forecast horizon, at about 7% of GDP, resulting in a sharp increase in the Estonian government net indebtedness. In addition, Scope expects that government financing needs over coming years will be primarily met through increased capital market issuances, resulting in a marked increase in the share of public debt owed to the private sector relative to the pre-pandemic period. Scope therefore anticipates a deterioration in both Estonia’s fiscal space and public debt structure relative to pre-pandemic levels.

Prolonged recession and vulnerable medium-term economic outlook. The second driver of the downgrade relates to the protracted adverse effects of the Russia-Ukraine war on the Estonian economy as well as to vulnerabilities affecting its medium-term macro-economic outlook. The Estonian economy contracted by 0.7% (quarter-on-quarter, calendar- and seasonally-adjusted) in the final quarter of 2023, its eighth consecutive quarter of negative growth. Over 2023, real output shrank by 3.0%, worsening from a 0.5% decline in 2022. Domestic private demand is hindered by persistent price pressures (monthly HICP inflation averaged 9.1% year-on-year in 2023) and the significant tightening in borrowing conditions. Export-oriented sectors are suffering from weak demand from key trading partners (in particular, Germany and the Nordic countries) and elevated input prices.

Scope expects the Estonian economy to contract by a further 0.3% this year, resulting from negative carryover effects from 2023 and only gradual improvements in economic momentum. Private consumption should remain weak in the first half of 2024, in part reflecting the hike in the value-added tax rate, and should only start to meaningfully recover towards the end of the year. Similarly, business investment, supported by gradually loosening financial conditions and a catch-up in purchasing power, as wage growth remains strong and inflation normalises, should also recover during H2 2024. Similarly, foreign demand is expected to start recovering materially only in H2 2024. These factors should allow for a robust economic rebound from next year onward, with economic growth forecasted to reach 3.2% in 2025 and 2.7% in 2026.

While benefitting from a robust growth potential (estimated at 2.2% annually), Estonia’s macro-economic outlook remains constrained by the country’s vulnerability to external shocks, amid elevated geopolitical tensions, as well as by adverse demographic trends.

Estonia’s economy is small (GDP of EUR 38bn) and characterised by a significant degree of openness (export and import sectors accounting for around 80% of GDP each). This, coupled with still-moderate wealth levels (GDP per capita of EUR 27,590), exposes Estonia to external shocks. This vulnerability is exacerbated by the present environment of heightened geopolitical tensions following Russia’s invasion of Ukraine in February 2022. Scope assesses direct military risks from Russia as moderate due to Estonia’s strong international alliances. Nevertheless, the country’s geographical proximity to Russia and strategic location on the Baltic Sea make it one of the EU countries most exposed to spillovers from the conflict. This includes an increased exposure to broader security challenges, including cyber risk threats or disinformation campaigns. While Scope assesses the country’s preparedness to such hybrid forms of aggression positively compared to other Central and Eastern European peers, a protracted conflict adds significant uncertainty to the medium-term macroeconomic and fiscal outlooks.

Finally, Estonia’s ratings are constrained by adverse demographic trends, which are likely to weigh on the long-run economic and fiscal outlooks. The country’s working-age population is expected to decline by an average of 0.3% annually over 2024-30, as per projections published by the European Commission.¹ While demographic challenges were temporarily alleviated in recent years by large inflows of Ukrainian refugees, an ageing population is expected to exacerbate pressures in the labour market, where labour shortages already constitute a key bottleneck to output growth and risk fuelling further wage increases. Wage growth that outpaces productivity gains would lead to an erosion of the country’s external competitiveness and could weigh on Estonia’s ability to sustain solid growth over the medium run.

Rating strengths: sound institutional framework; solid growth potential; and still-low indebtedness. Estonia’s A+ credit ratings are supported by: 1) the country’s sound institutions, underpinned by its EU, euro area and NATO memberships, which provide a robust framework for fiscal and economic policy and strongly mitigate direct external security risks; 2) solid economic growth prospects driven by robust investment dynamics, underpinned by a favourable business environment and sizable EU funds allocations (total EU fund allocations and national co-financing for cohesion policy amounting to EUR 5.2bn, i.e. about 14% of GDP, under the 2021-27 Multiannual Financial Framework²), that will support continued convergence towards euro area income levels; and 3) still comparatively low debt levels, resulting from a pre-pandemic track record of prudent fiscal policies and conservative debt management.

Outlook and rating sensitivities

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

Upside scenarios for the ratings and Outlooks are (individually or collectively):

1. Geopolitical risks affecting the region moderated significantly;
    
2. Structural reforms and investment continued to sustain solid growth and income convergence;
    
3. The fiscal outlook improved, supported by a rebalancing of government finances;
    
4. External vulnerabilities saw a further sustained reduction.

Downside scenarios for the rating and Outlooks are (individually or collectively):

1. Geopolitical risks increased, undermining macroeconomic stability;
    
2. The fiscal outlook worsened, leading the debt-to-GDP ratio to rise significantly above its presently-forecasted trend;
    
3. Macroeconomic imbalances increased, weakening medium-run growth prospects;
    
4. External and/or financial sector vulnerabilities increased substantially.

Sovereign Quantitative Model (SQM) and Qualitative Scorecard (QS)

Scope’s SQM, which assesses core sovereign credit fundamentals, signals a first indicative credit rating of ‘a-’ for Estonia. Under Scope’s methodology, the indicative rating receives 1) a one-notch positive adjustment from the methodological reserve-currency adjustment; and 2) no negative adjustment from the methodological political-risk quantitative adjustment. On this basis, a final SQM quantitative rating of ‘a’ is reviewed by the Qualitative Scorecard (QS) and can be changed by up to three notches depending on the size of Estonia’s qualitative credit strengths or weaknesses compared against a peer group of sovereign states.

Scope identified the following QS relative credit strengths for Estonia: 1) long-term debt trajectory; 2) external debt structure; 3) banking sector performance; and 4) financial imbalances. Conversely, Scope identified the following QS relative credit weaknesses for Estonia: 1) environmental factors; and 2) governance factors. On aggregate, the QS generates a one-notch positive adjustment for Estonia’s credit ratings, resulting in final A+ long-term ratings. A rating committee has discussed and confirmed these results.

Environment, social and governance (ESG) factors

Scope explicitly factors in ESG issues in its ratings process vis-à-vis the sovereign-rating methodology’s stand-alone ESG sovereign-risk pillar, which holds a significant 25% weighting under the quantitative model (SQM) and 20% weight under the methodology’s qualitative overlay (QS).

With respect to environmental factors, Estonia’s performance in the SQM 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 38% in 2022, above the EU average of 23% 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 around two thirds 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.

Regarding socially-related criteria, in the SQM model, Estonia receives a very strong score on labour-force participation, an 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. The Estonian education system posts very strong outcomes, as reflected in the country’s high position in the latest OECD PISA assessments, which supports the labour force’s skill base. 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.

The complementary QS assessment of ‘governance factors’ is ‘weak’ compared to peers to account for Estonia’s comparatively heightened exposure to spillover from the Russia-Ukraine war. External security risks for Estonia have increased materially since the escalation of the Russia-Ukraine war, though NATO and EU memberships strongly limit the risk that the conflict will expand into the Baltic region. Under governance-related factors in the SQM, Estonia performs very strongly relative to peers, in line with high scores under the World Bank’s Worldwide Governance Indicators. Policy-making has been effective and enjoyed broad continuity despite a multi-party system that requires coalition agreements. EU and euro area memberships also enhance the quality of Estonia’s macroeconomic policies and macroprudential framework. The present 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.

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. European Commission - 2024 Ageing Report. Underlying Assumptions and Projection Methodologies
2. European Commission – Cohesion Open Data Platform, Estonia

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 29 January 2024), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlooks is (Sovereign Quantitative Model Version 3.0), available in Scope Ratings’ list of models, published under 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 rating outlook indicates the most likely direction of the rating if the rating 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                                YES
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 and/or Outlooks 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: Brian Marly, Analyst
Person responsible for approval of the Credit Ratings: Eiko Sievert, Director
The Credit Ratings/Outlooks were first released by Scope in January 2003. The Ratings/Outlooks were last updated on 12 May 2023.

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
© 2024 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5, D-10785 Berlin.