Estonia 'AA-/A-1+' Ratings Affirmed; Outlook Stable

  • EU funds, positive net immigration, and strong underlying fundamentals have driven solid growth in Estonia.
  • At the same time, high wage and price inflation confirm that risks of overheating persist, with fiscal policy broadly neutral.
  • The impact of recent cross-border money laundering allegations could pose a reputational threat to the financial sector, but should have limited knock-on effects on Estonia's broader economy, in our view.
  • We are affirming our 'AA-/A-1+' ratings on Estonia.
  • The outlook is stable.
On Dec. 7, 2018, S&P Global Ratings affirmed its 'AA-/A-1+' long- and 
short-term foreign and local currency sovereign credit ratings on Estonia. The 
outlook is stable.

The stable outlook reflects the balance between Estonia's track record of 
prudent fiscal management and solid growth prospects, against its lower 
per-capita GDP than that of peers rated in the 'AA' category. 

In the longer term, we could raise our ratings on Estonia if average incomes 
were to converge further toward levels in the eurozone, reflecting further 
productivity gains in higher-wage sectors, particularly services. 

The rating could come under downward pressure if external imbalances 
re-emerged: for example were wage increases to outpace productivity for a 
significant period of time. We could also see downward pressure on the ratings 
if geopolitical or regional security risks were to escalate, weighing on 
Estonia's economic performance. We see such developments as unlikely, due to 
Estonia's NATO and EU membership.

The ratings are supported by Estonia's strong and predictable institutions, 
its highly educated workforce, the government's long track record of prudent 
fiscal management, which includes the preservation of substantial fiscal 
reserves, as well as its membership of the EU, the eurozone, and the North 
Atlantic Treaty Organization (NATO). The ratings are constrained by Estonia's 
moderate income levels compared with those of peers in the eurozone. 

Despite three consecutive years of buoyant demand-driven growth, Estonia's 
current account remains in surplus. The sovereign's external non-equity 
assets, both public and private, exceed external debt by an estimated 18% of 
GDP. Between now and 2021, we project recurrent, albeit narrowing, current 
account surpluses, as well as significant surpluses on Estonia's capital 
account, reflecting sizable EU fund inflows.

Much of Estonia's external and broader macroeconomic resilience reflects the 
dynamism of its services sector, which makes up around 70% of gross value 
added, and employs the majority of the labor force, according to data 
published by Statistics Estonia. We expect higher-paying services sectors' 
share of the economy to continue to increase, which partly explains why the 
recent trend of wage and salary growth may be more sustainable in Estonia's 
case, compared with trends in other economies. (Estonia's wages and salaries 
increased 7.5% year on year during third-quarter 2018.)

We do not expect any significant economic or fiscal consequences from the 
recent allegations of money laundering against financial institutions in 
Estonia. Since 2014, the share of nonresident deposits as a percentage of the 
total in Estonia's financial sector has declined from 20% to an estimated 7% 
today, as regulation has tightened. We expect this trend will continue.

Institutional and Economic Profile: Moderating growth rates will reduce risks 
associated with potential economic overheating
  • We project that growth rates will decrease from their elevated levels of 2017, but remain close to 3% over the next three years.
  • As a small, open economy, Estonia's growth outlook will depend on developments in its main export partners in the eurozone and Scandinavia.
  • Estonia's political institutions remain committed to sound public finances.
We project that Estonia's economy will continue to expand at healthy levels, 
albeit at a slower pace than the elevated growth rates in 2017, when 
investments increased by almost 13% in real terms. Gross fixed capital 
formation will likely contract marginally in 2018 after last year's 
exceptional expansion, due to the onset of EU structural funds in the new EU 
budgetary period coinciding with high investments ahead of local elections and 
one-off effects in the transportation sector. Offsetting weak investment 
growth this year, private consumption growth almost doubled to 4.4% during the 
first nine months of 2018 versus 2.3% over the same period last year. This has 
led to a marked increase in imports, with net exports contributing negatively 
to headline GDP, and Estonia's current account surplus set to halve at around 
1.5% of GDP compared with last year's multiyear high of over 3% of GDP.  

Investments, including projects to modernize the oil shale industry and 
improve rail links with the Baltic states and Poland, are expected to continue 
over the next few years. In our view, such infrastructure investment supports 
sustainable economic growth, in contrast to the credit-fueled construction 
investment growth in the real estate sector seen in the pre-crisis years.

As a small open economy, Estonia's economic performance will remain closely 
linked to demand in its largest export markets, particularly Finland and 
Sweden. Germany has overtaken Russia as its third-largest trading partner, 
indicating strengthening economic integration with the EU in general. In 
recent years, Estonia has successfully increased its presence in specific 
high-value-added export sectors, primarily related to service 
exports--particularly from Estonia's active information and communication 
technology sector. However, exports and economic activity in general also 
encompass certain lower-value-added manufacturing industries and 
lower-value-added service sectors, such as transportation. Estonia's income 
levels therefore remain well below those of most European peers in the same 
rating category.

The Estonian labor market remains a primary constraint to medium- and 
long-term economic growth prospects, given the country's adverse demographic 
profile. Nevertheless, there have been some promising shifts in demographic 
trends. In particular, since 2015, net immigration has become increasingly 
positive, meaning that Estonia's population has started to increase for the 
first time since the country regained its independence. Rising immigration 
particularly from Finland, Latvia, Russia, and Ukraine are the major 
contributors to this trend reversal. This development also appears to be 
slowing down the decline in Estonia's working age population, which is now 
decreasing by less than 4,000 per year. While at its lowest level in 10 years, 
the percentage of pensioners in the population, at 28.5%, remains one of the 
highest in the EU.  

Nevertheless, the success of the work ability reform (2016) alongside other 
labor reforms has increased the participation rate, and we consider the labor 
market to be very flexible within the European context. However, the long-term 
challenge of a shrinking working-age population remains. As in other Baltic 
countries, such a tight labor market has resulted in significant wage 
increases over recent years. These wage rises partly explain the strength of 
recent immigration data, but they may also be indicators of more challenged 
external competitiveness in the future. Generally, Estonian corporations have 
accumulated financial headroom to make additional productivity-enhancing 
investments as profit levels have exceeded investments comfortably over the 
past six years.

We continue to view Estonia's political and institutional systems as a credit 
strength. One of the challenges of the new government will be to address its 
changing position within the EU in 2020, post Brexit, since Estonia will 
potentially face reduced structural funds. The annual inflow of these funds 
still represents around 3% of 2018 GDP on average for the current multiannual 
financing framework for 2014-2020.

Despite continuous friction between government parties, there have been few 
disruptions within the overall political system, since there is broad 
political consensus backing prudent fiscal policy, a competitive tax 
framework, reforms to combat ageing demographics, as well as Estonia's 
membership in EU and NATO. Despite Estonia's EU and NATO membership, there 
remain some external geopolitical tail risks due to its close proximity to 
Russia and sizable Russian minority population. 

Flexibility and Performance Profile: Sound fiscal and external accounts over 
the coming years 
  • We do not expect that the emergence of anti-money laundering breaches of Danske Bank's Estonian branch will have any significant spillover effects on the country's economic, fiscal, or external accounts.
  • The administration will remain committed to healthy public accounts, with very contained fiscal deficits on average over the coming years.
  • Current account surpluses over the next two years and EU fund inflows will enable further net external deleveraging of the country.
We expect the government will incur only marginal deficits on average over our 
forecast horizon and will likely post a small surplus in 2018. General 
government finances in 2017 were slightly adversely affected by increased 
spending ahead of local government elections. However, we do not expect a 
similar development before the general elections in 2019. A significant share 
of public investment activity will be covered by EU structural funds. At the 
same time, the overall public sector retains relatively high fiscal buffers, 
currently around 9% of GDP. These liquidity reserves will amply cover any 
slight general government deficits if needed in the next few years. Given its 
very contained gross debt levels, the government is in a net creditor 
position, in our view, and will remain so for the foreseeable future. In our 
assessment of Estonia's overall debt, we exclude the country's guarantee 
commitments relative to the European Financial Stability Facility from our 
calculations, treating them instead as contingent liabilities (in line with 
our treatment for all eurozone members). 

With a strong fiscal track record and significant reserves, Estonia has one of 
the strongest public balance sheets of eurozone members. In terms of cyclical 
factors, its track record has been mixed and often slightly pro-cyclical. In 
particular, because of the lack of autonomy over monetary policy and the 
narrow size of its economy, we believe that fiscal policy plays a more 
important role for the country in managing aggregate demand and reducing 
economic volatility. Given current economic growth and high tax revenue 
inflows, a more counter-cyclical fiscal stance than currently will enable the 
administration to accumulate higher fiscal buffers, which will provide the 
administration with additional flexibility if fiscal pressures re-emerge.

In the next few years, we expect continued strong demand for Estonian exports, 
particularly services, which will support sustained current account surpluses 
over the next two years. Given the inflow of EU funds at the same time, we 
anticipate moderate net external deleveraging by Estonia. This reduction of 
net external debt follows almost a decade of significant external deleveraging 
in the years after the financial crisis. As a result, we expect Estonia's 
external debt, net of public and financial sector external assets (narrow net 
external debt, our preferred measure of external indebtedness), will decrease 
to around a modest 19% of current account receipts through 2021. Given the 
high savings rate of the entire economy, we also expect to see Estonian 
investments in assets abroad, in light of the narrow size of the domestic 
capital market and lack of domestic investment options.

Ninety percent of the Estonian banking sector is foreign owned and primarily 
consists of subsidiaries and branches of large Nordic financial institutions. 
In 2017, Norway-based DNB Bank and pan-Nordic Nordea Bank merged their Baltic 
activities to form Luminor, which became the third-biggest bank in Estonia. We 
understand that the banking sector remains well capitalized and liquid. 
Estonian banks report one of the lowest ratios of nonperforming loans and have 
the highest capital ratios in the EU. Funding ties to foreign parents have 
decreased but are still significant. Although close links with stable parents 
are a strength for the banking system, some risks remain, mainly relating to 
the potential for spillovers arising from parent bank exposures to 
Scandinavian economies.

Several breaches of anti-money laundering standards have also been revealed in 
the Estonian financial sector. Estonia-based Versobank's license was withdrawn 
at the beginning of the year. An investigation into the activities of Danske 
Bank's Estonian branch revealed €200 billion of suspicious transactions. The 
total stock of nonresident deposits in Estonian banks appeared relatively 
small at the time, especially compared with the Latvian financial sector, but 
these risks to the financial sector arose from high flows of money passing 
through the Estonian banking system. The direct and indirect effects of these 
cases on overall economic growth, fiscal performance, and the country's 
external position have been limited so far, and we do not expect severe 
disruption to emerge. 

As a member of the eurozone, Estonia benefits from the monetary union's highly 
developed capital market and the credibility of the European Central Bank's 
(ECB's) policies. However, in our view, the ECB's monetary policy goals are 
better aligned with the economic cycles of larger eurozone members than with 
smaller ones such as Estonia. In recent years, Estonia's economy has not been 
well synchronized with that of the rest of the eurozone. For example, it has 
seen much higher wage growth, partly explained by the shrinking workforce. 
Considering Estonia's recent above-potential economic growth rates, we 
forecast that inflation will accelerate to remain well above 3.0% this year, 
which will outpace the ECB's target and the eurozone average significantly. 
Beyond this year, we expect inflation will move toward 2%, but remain above 
the ECB's target.
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