Analytics, EU – Baltic States, Financial Services, Investments, Latvia, Rating

In a related rating action, Moody’s affirmed Latvia’s (P) ''Prime-2'' short-term rating.

The key drivers of the upgrade of Latvia’s government bond rating are the following:

(1) Latvia’s resilient and balanced economic recovery combined with the country’s positive medium-term growth prospects;

(2) The improvement in Latvia’s fiscal position, as the general government financial deficit-to-GDP ratio remains low, and as the general government debt-to-GDP ratio is expected to fall sharply in 2015;

(3) The adoption of the euro on 1 January 2014 which has reduced Latvia’s susceptibility to event risk, by (i) providing its banking system with access to liquidity and institutional support from the European Central Bank (ECB), as well as by (ii) lowering the ratio of foreign-currency government debt relative to total general government debt.

Latvia’s local-currency country risk ceiling, its foreign-currency bond ceiling, and its foreign-currency bank deposit ceiling have been raised to ''A1'' from ''A3'', ''A3'' and ''Baa2'', respectively. These upgrades reflect Latvia’s lower susceptibility to event risk as a result of its euro area membership. Latvia’s short-term foreign-currency bond and deposit ceilings have been raised to ''Prime-1'' from ''Prime-2''.

The first driver supporting the upgrade is Latvia’s economic resiliency as reflected in the economy’s robust growth. Real GDP growth averaged 4.9% during 2011 to 2013 and is expected to expand by 3.6% and 3.8% in 2014 and 2015, respectively, outperforming its European Union (EU) peers. Whereas after the global crisis, growth was initially driven by the export sector, it has become increasingly broad-based since then, with private consumption becoming an important contributor to the economic expansion since 2012 amid falling unemployment and rising wages.

Moody’s expects the economy to remain resilient as consumer and business confidence bolsters domestic demand, and as the ongoing economic recovery in the EU supports Latvia’s exports.

The second driver supporting the upgrade is the increasing resilience of the government’s balance sheet. With cross-party support for fiscal prudence, the authorities have remained committed to fiscal consolidation. Moody’s expects the general government deficit to be contained at around 1% of GDP in both 2014 and 2015, with primary surpluses to be maintained over the forecast horizon.

Latvia’s general government debt-to-GDP ratio is expected to fall from a peak of 44.5% in 2010 to 33.4% in 2015, following the repayment of a Eurobond and loans from the World Bank and EU during 2014 and 2015.

The third driver supporting the upgrade is a reduction in Latvia’s susceptibility to event risk following its entry into the euro area on January 1 2014. Non-resident deposits (NRDs) make up around 50% of total deposits in the banking system. As a result, the access gained to the ECB provides a source of emergency liquidity in the event of NRD outflows. Moreover, Latvia’s financial system is heavily euroized and euro adoption has reduced a significant amount of foreign-exchange risk for domestic banks. The adoption of the euro has also reduced the proportion of general government foreign-currency debt to total public debt ratio from around 85% to 24%, as the bulk of the government’s debt is denominated in euros, Moody's points out.

The stable outlook on Latvia’s ''Baa1'' government bond rating balances the government's improved fiscal metrics and reduced external vulnerabilities, following euro area entry, against the small scale and openness of the economy.

Upward pressure on Latvia’s rating could arise if the economy continues to grow strongly, and the government makes further progress in improving its fiscal flexibility and its shock-absorption capacity, reflected in a firm downward trend in the public debt-to-GDP ratio.

Conversely, the stable outlook on Latvia's rating would likely be changed to negative if there was a significant change in the government's fiscal policies and/or if economic growth was more limited than Moody’s anticipates. In addition, downward pressure could arise from a flagging commitment on the part of foreign bank owners that could raise the government’s exposure to bank contingent liabilities, the ratings agency points out.