Latvia 'A/A-1' Ratings Affirmed; Outlook Stable

  • Despite Latvia's fragmented political landscape, we anticipate broad policy continuity from the new government.
  • We expect Latvia will continue to post strong and balanced growth, averaging about 3% over the coming years, absent external shocks.
  • The unwinding of the nonresident deposit banking sector has been neutral to Latvia's growth outlook, public finances, and financial stability.
  • We are affirming our 'A/A-1' ratings on Latvia. The outlook is stable.
RATING ACTION
On March 22, 2019, S&P Global Ratings affirmed its 'A/A-1' long- and 
short-term foreign and local currency sovereign credit ratings on Latvia. The 
outlook is stable.

OUTLOOK
The stable outlook reflects our view that, over the coming years, Latvia's 
economic growth will remain resilient; fiscal deficits will remain contained; 
and residual risks relating to the rapid outflow of nonresident deposits (NRD) 
in the financial system will remain limited.

We could raise the ratings if fiscal performance markedly exceeded our current 
forecast, putting net general government debt on a stronger downward 
trajectory than we currently anticipate.

We could take a negative rating action if risks related to the NRD banking 
sector's legacy, such as additional anti-money laundering (AML) breaches, or 
resulting from the fast unwinding of NRD positions, started to materialize. 
Such a scenario could warrant sizable government and regulatory intervention 
and put stress on the broader financial sector. Downward rating pressure could 
also arise if economic growth fell significantly short of our current 
expectations, undermining fiscal performance.


RATIONALE
Despite political fragmentation and an unstable party system, underlined by 
the protracted process of government formation following 2018 elections, we 
consider policymaking in Latvia as generally effective. The country's public 
finances continue to support the current rating, given that Latvia has one of 
the lowest debt-to-GDP ratios in the EU as well as generally contained budget 
deficits. As the current business cycle matures, growth rates will abate from 
previously very high levels, which have not resulted in a build-up of external 
imbalances. Despite currently strong growth, Latvia's modest income levels--in 
a global comparison--remain a key constraint to the rating. As a member of the 
eurozone, Latvia also benefits from the European Central Bank's (ECB) 
effective monetary policy.

Institutional and Economic Profile: Complex coalition building will not result 
in severe policy divergence 
  • Despite high political fragmentation, cross-party consensus on key policy areas--such as public finances and relations with the EU and NATO--will ensure policy continuity.
  • We estimate that growth will reduce from the recent peak, but will average about 3%, supported by domestic demand.
  • As a small and open economy, Latvia is exposed to external shocks, for instance from severe international trade tensions.
The recent election in October 2018, which resulted in challenging coalition 
building and a high number of parties in government, underlines the increasing 
level of political fragmentation in Latvia's unstable party system. This might 
reduce political leeway for the new government, but we currently expect broad 
policy continuity. In our view, many of Latvia's past governments have tended 
to be unstable, with relatively few serving a full term. That said, we have 
observed a high degree of cross-party consensus on the most important 
political items over the years, such as maintaining a business-friendly 
environment, delivering sound public finances, and retaining strong relations 
with EU and NATO partners. We believe the new government will likely 
prioritize addressing social inequalities, strengthening defense, and energy 
independence. The administration will also focus on implementing the 
recommendations of the Council of Europe's Moneyval report regarding AML 
measures, in order to establish a more resilient policy framework and limit 
further reputational risks to the Latvian financial system.

Overall, we consider political institutions and policymaking in Latvia as 
effective, which has supported our sovereign ratings in the past. The country 
has proven successful in addressing previous financial and economic 
challenges, including managing a severe economic and financial contraction in 
the aftermath of the 2008 financial crisis. Latvia has had to make significant 
adjustments to public finances and the economy to address the previously 
accumulated external, financial, and economic imbalances, as was the case for 
other Baltic states as well.

We expect economic growth in Latvia will abate to 3% on average over the 
coming years as the current business cycle matures. The liquidation of ABLV 
Bank, formerly the fourth-biggest bank in Latvia, as well as the significant 
outflow of NRDs from the banking sector did not materially weigh on headline 
economic growth in 2018. Instead, construction emerged as a key impetus of 
economic development last year. Activity in this sector increased by over 22% 
due to a surge in private construction and the rising absorption of EU funds. 
But the sector's strong growth was also due in part to low levels of 
construction activity in previous years. We consider construction activity 
will remain elevated over the coming years, given that EU funds will continue 
to flow in, with their peak expected in 2020-2021. At the same time, 
private-sector construction has not resulted in a credit increase, since 
private-sector agents have remained risk-adverse following the crisis, and the 
corporate sector has been able to fund investments from own liquidity. 
Supply-side constraints will prevent a significant misallocation of capital. 

That said, pronounced growth in construction is unlikely to last beyond 2022, 
when inflows relating to the current EU funding cycle will have abated. While 
Latvia currently benefits from EU fund inflows, the end of the funding period 
will have an extenuating effect on economic growth. The EU's current 
multiannual financing framework (MFF) will last until 2020, with its funds 
being generally available for three years after it has been concluded. A 
general reduction of funds to Latvia is also likely for the next MFF cycle, 
due to the planned exit of the U.K. as a strong net contributor to the EU 
budget, Latvia's income levels converging toward the EU average, and potential 
amendments to the allocation formula for distribution (e.g., a greater focus 
on youth unemployment).

Given the strong wage dynamic, with real wages rising about 6%-7% year on 
year, we expect that consumption will begin more markedly contributing to 
growth. Yet strong wage growth in recent years also highlights long-term 
structural issues of the Latvian economy. Some of the wage growth is from 
necessary income convergence, given that Latvian wages are still at only about 
30% of the EU average. However, a tightening labor market has significantly 
contributed to rising income, and we believe it will become a primary 
constraint to overall economic development, if unchecked. Given the country's 
adverse demographic profile, reflecting the demographic gap in the 1990s, low 
fertility rates, and outward migration, the working age population has already 
started to decline. We expect that employment levels will stagnate after a 
surprising increase in 2018. In our view, it will be difficult for employment 
and population figures to rebound unless there is a substantial reversal in 
net migration. Strong wage growth has also exceeded productivity increases, 
highlighting the continuous need for significant productivity-enhancing 
investments to retain external competitiveness. Overall, attraction of jobs in 
higher value-added sectors, such as information and communication technology 
and business services, will remain of prime importance for the Latvian 
economy, and we have noted favorable developments in this regard for 2018.

Further risks to Latvia's economic outlook relate to the external environment, 
even though the Latvian economy is much more domestically focused than its 
Baltic peers. Exports account for only 60% of GDP in Latvia, whereas in 
Estonia and Lithuania the figure is close to 80%. Yet, the Latvian economy 
would not be resilient to deterioration of the external environment. Over 70% 
of Latvian goods exports are currently to the EU, of which 5% go to the U.K., 
indicating a strong potential economic impact of weaker eurozone growth and a 
disorderly Brexit. Moreover, about 4% of exports go to the U.S. and could be 
hampered by rising global trade tensions. Finally, a further tightening of 
sanctions on Russia would also weigh on Latvian exports, given that 15% are 
headed to Commonwealth of Independent States countries, mostly Russia.

Flexibility and Performance Profile: External vulnerabilities have reduced 
with the NRD wind-down, but risks of AML breaches surfacing remain 
  • Following ABLV Bank's liquidation, NRD positions in the Latvian financial system have declined, effectively reducing the country's short-term external debt.
  • Although we have no indication thereof, surfacing of new AML allegations could still bear heavy reputational risks for the Latvian financial sector and weigh on the real economy.
  • Latvian public finances remain strong.
The significant outflow of NRDs in 2018 did not result in any distress to the 
country's economy, financial sector, or public finances. We expect no further 
fallout from the unwinding of the positions. We estimate the country's 
short-term external debt will decline to below 80% of current account receipts 
toward the end of our forecast horizon in 2022--a significant reduction from 
120% at the beginning of 2018. At its peak in 2014-2015, the stock of NRDs in 
the Latvian banking system amounted to almost €13 billion, above 50% of GDP. 
In our view, NRDs tend to be more volatile than resident deposits, bearing the 
potential for economic and financial distress for recipient countries in the 
event of sudden large outflows. Such risks were mitigated in Latvia by three 
major factors: a clear financial separation within the Latvian banking sector 
between domestically focused banks and banks predominantly serving nonresident 
clients; the higher liquidity and capital requirements for NRD-focused banks; 
and the nature of investments by these institutions, which were predominantly 
external and very liquid. These factors effectively shielded the domestic 
banking sector during the reduction of NRD positions in Latvia's financial 
system.

The reduction of NRDs occurred in the wake of the payment moratorium of ABLV 
Bank, after the U.S. Department of the Treasury's Financial Crimes Enforcement 
Network (FinCEN) named it an institution of primary money-laundering concern. 
Although we have no indication thereof, surfacing of additional breaches could 
bear significant reputational risks for the entire banking sector, including 
domestically focused banks. Such a scenario would likely require further 
government and regulatory intervention, but Latvia does not stand out among 
other Baltic countries in this regard.

On the balance of payment side, we expect widening current account deficits 
(CAD) over the coming years on the back strong domestic demand, particularly 
pertaining to construction activity. In our view, these CADs will be fully 
covered by both inflows of funds from the EU budget for various investment 
projects through the capital account and net foreign direct investment 
inflows, keeping the country's net external debt contained.

Latvia's strong fiscal performance continues to support the ratings. Public 
finances benefited from several tailwinds in 2018 as general government 
revenue increased by more than 13%. Public income receipts surged on high 
economic growth and favorable developments in the labor market, particularly 
benefitting the social security funds. Furthermore, tax revenue growth 
exceeded economic growth because of the ongoing implementation of the new tax 
code, mostly regarding changes to personal income tax and corporate income 
tax. That said, expenditure--mostly relating to rising capital expenditure, 
social support, and remuneration--has followed pace and will continue to 
remain high. We expect general government deficits of slightly above 1% of GDP 
on average over the coming years. Given that the current business cycle has 
likely just passed its peak, but economic growth and EU fund inflows in Latvia 
are robust, we consider the government's fiscal position slightly procyclical. 
The narrow size of the Latvian economy and the absence of independent monetary 
policy highlight the importance of ample fiscal buffers for the country to 
manage aggregate demand. In the medium to long term, rising pension and health 
costs will likely put pressure on public expenditure if left unaddressed.

The government maintains a generally strong fiscal position, with net debt at 
slightly above 31% of GDP--one of the lowest ratios in the EU. We expect gross 
debt will remain closer to 37% in the next two to three years, due to the 
government's prefunding of maturities. Benefitting from the ultra-low interest 
rates in the eurozone, Latvia has reduced its interest bill over the past 
years as a share of government revenue, but also in absolute terms. At the 
same time, the authorities have actively pursued a strategy of prolonging the 
overall maturity profile by issuing several bonds with 30-year maturities.

After the discontinuation of banking operations of formerly NRD-focused banks, 
the Latvian financial sector is now dominated by large, pan-Scandinavian 
financial institutions. This limits the government's contingent liabilities 
relating to the banking sector. Like other Baltic financial markets, 
concentrations remains high, particularly after the merger between DNB and 
Nordea across the three Baltic states to form Luminor Bank, and Danske Bank's 
exit from the Baltic banking market. Formal banks remain profitable, well 
capitalized, funded by domestic deposits, and enjoy high asset quality in a 
European context. That said, we will continue to monitor the operations of 
formerly NRD-focused banks, many of which have shifted their business profile, 
may discontinue their formal banking license, and are now also lending to the 
real economy.  

As a eurozone member, Latvia benefits from the monetary union's highly 
developed capital market and the credibility of ECB monetary policy. That 
said, we expect ECB policy to align more closely with the cyclical position of 
larger monetary union members than with smaller ones, such as Latvia. For 
example, Latvia's rapid pace of nominal wage growth has outpaced the eurozone 
average in recent years, also bearing inflationary implications--we forecast 
that prices in Latvia will rise by above 2.5% annually on average over 
2019-2022, above the ECB target.

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