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Firch Ratings: Fitch Revises Latvia's Outlook to Positive; Affirms at 'A-'
Fitch Ratings - Frankfurt am Main - 28 Jul 2023: Fitch Ratings has revised the Outlook on Latvia's Long-Term Foreign-Currency Issuer Default Rating (IDR) to Positive from Stable and affirmed the IDR at 'A-'.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
The revision of the Outlook reflects the following key rating drivers and their relative weights:
Medium
Economy Resilient to Recent Shocks: Latvia has shown relative resilience to recent severe external shocks, despite being a small and open economy; and real GDP has exceeded its pre-pandemic level. The pandemic shock resulted in a much smaller contraction in GDP than the EU average, while the adverse impact of the shock to energy supply and prices was less than initially anticipated, despite Latvia's historical high reliance on Russian energy imports. Fitch expects inflation to fall sharply and GDP growth to resume to around 3% in 2024-2025, supported by an acceleration in investment as EU funds absorption advances, and private consumption recovers.
Reduced Exposure to Russia: Latvia has eliminated its historical reliance on Russian energy imports and reduced its non-energy trade links, although they remain a potential source of vulnerability. The share of trade with Russia had fallen to 5.9% of total goods exports and 2.3% of total goods imports in May 2023, from 10.9% and 9.7%, respectively in 2014. Latvia remains exposed to a potential renewed energy price shock. Rapid pass-through of high energy prices to the real economy resulted in the third highest inflation in 2022 among all EU sovereigns (at 17.2% vs. EU average at 9.2%).
Inflation to Fall Sharply: The recent decrease in global energy and food prices will continue to drive a deceleration of headline inflation in the coming months and we forecast HICP inflation to fall to 2.3% in 2024 and 2.9% in 2025, down from an average of 9.4% in 2023. Nevertheless, persistent high core inflation and strong wage growth are an upside risks to our forecast.
Fiscal Deficit to Narrow: Fitch expects the general government budget deficit to narrow to 3.8% of GDP in 2023, from 4.4% in 2022, reflecting strong cash-based fiscal outturns in 1H2023, the government's recent record of outperforming its targets and Fitch's more optimistic growth expectation. Solid revenue growth and lower spending on support measures were behind strong year-to-date fiscal performance.
We forecast the budget deficit narrowing to 2.1% in 2024 and further to 1.8% in 2025 as support measures (energy, pandemic and related to Ukrainian refugees) are withdrawn. Given the geopolitical situation, Latvia targets a rise in defence spending to at least 3% of GDP by 2027, from about 2.2% of GDP in 2021.
Public Debt Remains Stable: We expect gross general government debt to decrease to just below 40% of GDP at end-2023, down from 40.8% in 2022 and 43.7% in 2021. Under Fitch's baseline scenario, public debt/GDP is expected to remain stable until 2027 and below the current peer median of 55.6%. Latvia is less exposed to the current high interest rate environment than peers, given its moderate level of public debt and high share of fixed rate debt (80.9% of central government debt), while the average maturity of debt is around seven years.
We forecast the government's interest payment will increase to 1.7% of revenue in 2023 and 2.2% in 2024, from 1.3% of revenue in 2022, but will remain below the current 'A' median of 3.6%.
EU Funds to Support Growth: Absorption of EU funds is expected to average 3.1% of GDP annually in 2023-2025. Administrative capacity and potential bottlenecks in the economy in 2024-2025 are a challenge, but if these are addressed we see some upside risk to growth.
External Risks Remain: Notwithstanding Latvia's relative resilience to date from recent shocks, significant risks remain including the speed and extent of the disinflation path, the near-term growth outlook, the implementation of fiscal consolidation and geopolitical risks.
Latvia's 'A-' IDRs also reflect the following key rating drivers:
Rating Strengths and Weaknesses: Latvia's ratings reflect lower government debt levels and debt servicing costs than rating peers, a credible economic policy framework supported by EU and eurozone membership, governance indicators that are slightly above the median of 'A' category peers and moderate private sector indebtedness. Rating weaknesses include the small size of Latvia's economy, GDP per capita below 'A' category peers, a current account deficit and net external debt that is somewhat higher than peers and adverse demographic trends.
Economy to Avoid Recession: Fitch has revised Latvia's GDP growth forecast up to 1.4% in 2023, from -0.3% expected at the previous review in February. The upward revision reflects the better-than-expected performance of the economy over the last two quarters and our expectation for further easing of inflation pressures, which should result in positive real wage growth.
The negative impact of uncertainty and rising lending costs on investment activity should be balanced by increased EU funds flows. Government energy support measures have had a positive impact on growth and the Bank of Latvia estimates that these added a cumulative 0.7pp to GDP growth in 2022 and will boost it by additional 0.2pp in 2023.
External Finances to Improve: Decreasing global commodity prices should support a narrowing of current account deficit (CAD) to 3.6% of GDP in 2023, from 6.4% in 2022. We do not foresee a further significant reduction in the CAD in 2024-2025 and a return to pre-pandemic trends, as the expected pick-up in EU funds flows will boost import-intensive investments. We expect the capital account surplus to widen in 2023, and FDI inflows to remain steady at 3% of GDP in 2023-2025. Net external debt decreased to 6.1% of GDP at end-2022 and should remain broadly stable in 2023-2025 (current 'A' median: -5.2% of GDP in 2024).
Banking Sector Remains Resilient: The Latvian banking sector remains stable, with high capitalisation (total capital ratio at 21.8% at end-1Q23) and improving asset quality. The ratio of non-performing loans in the domestic loan portfolio decreased to 1.6% as of 1Q23 (vs. 4.9% at the beginning of 2019). Most loans are at a floating interest rate (95% for non-financial corporates and 96% for housing loans), but the impact of rising rates on the loan portfolio's quality should be limited due to very low indebtedness (household aggregate debt/GDP ratio was 28% in 2022).
Rising interest rates boosted banks' net interest income, while provisions have not notably changed, resulting in a substantial increase in the sector's profitability in 2022.
ESG - Governance: Latvia has an ESG Relevance Score (RS) of '5[+] for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Latvia has a high WBGI ranking at 77th percentile, reflecting its long track record of stable and peaceful political transitions, well established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade
-Structural: Substantial worsening of geopolitical risks with adverse consequences for economic growth, and public and external finances.
-Macro: Erosion in competitiveness, potentially stemming from inflation entrenched at high levels and/or renewed energy price shock, leading to materially lower GDP growth.
-Public Finances: An upward trend in government debt-to-GDP, for example, due to a sustained absence of fiscal consolidation.
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade
-Macro/ External Finances: Increased confidence in Latvia's resilience to external shocks evident in a decline of inflation, recovery of GDP growth and a narrowing in the fiscal deficit.
-Public Finances: A decline in general government debt to GDP, through fiscal consolidation.
-Macro: An increase in medium-term trend GDP growth, for example, through effective implementation of structural reforms
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Latvia a score equivalent to a rating of 'A' on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows:
- External Finances: -1 notch, to reflect Latvia's vulnerability to external shocks stemming from its main trading partners due to the small size and openness of the Latvian economy as well as its proximity to Russia.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
COUNTRY CEILING
The Country Ceiling for Latvia is 'AAA', 6 notches above the LT FC IDR. This reflects very strong constraints and incentives, relative to the IDR, against capital or exchange controls being imposed that would prevent or significantly impede the private sector from converting local currency into foreign currency and transferring the proceeds to non-resident creditors to service debt payments.
Fitch's Country Ceiling Model produced a starting point uplift of +3 notches above the IDR. Fitch's rating committee applied a further +3 notches qualitative adjustment to this, under the Long-Term Institutional Characteristics pillar, reflecting the sovereign's membership of the eurozone currency union and the associated reserve currency status. The agency views the risk of the imposition of capital or exchange controls within the eurozone as exceptionally low but not negligible.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG CONSIDERATIONS
Latvia has an ESG Relevance Score of '5[+]' for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As Latvia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.
Latvia has an ESG Relevance Score of '5[+]' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As Latvia has a percentile rank above 50 for the respective Governance Indicators, this has a positive impact on the credit profile.
Latvia has an ESG Relevance Score of '4[+]'for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As Latvia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.
Latvia has an ESG Relevance Score of '4[+]' for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Latvia, as for all sovereigns. As Latvia has a track record of 20+ years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile.
Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.
