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DBRS Confirms Republic of Estonia at AA (low), Stable Trend

BC, Tallinn, 17.12.2018.Print version
DBRS Ratings Limited confirmed the Republic of Estonia’s Long-Term Foreign and Local Currency – Issuer Ratings at AA (low) and its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The rating trends are Stable, DBRS informed BC.

Key rating considerations

The AA (low) ratings and Stable trends are underpinned by Estonia’s membership in the European Union (EU) and the Euro area, its stable macroeconomic policy framework, and its strong sovereign balance sheet. Estonia is a net recipient of EU structural funds, and the economy is supported by the free movement of goods and services offered by the single market. Public finances have been supported by effective fiscal policy and low public debt. The European Commission (EC) expects general government gross debt of only 8.0% of GDP in 2018, the lowest public debt burden in the eurozone. Debt appears even more negligible once offset by the Treasury’s 4.5% of GDP in liquid savings.

DBRS sees no evidence of spillovers to the Estonian financial system from the findings and conclusions of the investigations into Danske Bank’s Estonian branch. To further strengthen its regulatory authority, the Estonian government recently approved a draft law which establishes stricter sanctions in the financial system, introduces reverse burden of proof on suspicious assets, and strengthens regulation of virtual currencies.

The ratings are nevertheless constrained by structural challenges. Estonia’s small and open economy is vulnerable to external shocks and rising labour costs could weaken export price competitiveness. Moreover, convergence of Estonian income levels with the EU has slowed over the last decade. Income per capita in Estonia adjusted for purchasing power parity remains around three-quarters of the Euro area average.


Rating drivers

DBRS considers Estonia well-positioned at its current rating level. One or a combination of the following factors could lead to upward pressure on the ratings: (1) Increased evidence of a persistent reduction in economic volatility inherent to Estonia’s small and open economy; (2) Successful implementation of measures that improve income and productivity.

One or a combination of the following factors could lead to downward pressure on the ratings: (1) An external shock, possibly from financial instability among key Nordic partners, that causes sudden capital outflow from Estonia and material macroeconomic underperformance; (2) A return of excessive credit growth, particularly in the housing market, that leads to private sector overleverage and financial sector instability; (3) An unexpected relaxing of fiscal discipline that significantly weakens Estonia’s public debt dynamics.


Rating rationale

Strong Economic Output Has Not Been Accompanied by Domestic or External Imbalances

The Estonian economy gained momentum in recent years. After 3.5% growth in 2016, the economy expanded by 4.9% last year, and is currently operating above trend with a positive output gap. The strong economic outcome stems in part from favourable external conditions, but principally from robust domestic demand. The labour market has proven more resilient than previously thought and investment grew by 12.5% in real terms in 2017 – linked to the EU funding cycle and large infrastructure projects. As the fading of these factors slows investment growth, economic growth is expected to gradually decline in the coming years. The EC expects GDP growth of 3.5% in 2018 and 2.8% in 2019. Despite the significant investment activity relating to construction, DBRS sees little evidence of excessive private sector leverage, housing market imbalances, or saving-investment misalignments – features of the pre-crisis years.

Inflation is higher than the EU average, reaching 3.4% yoy in November, and average monthly gross wages expanded by 7.5% as of the third quarter of 2018. DBRS expects inflationary pressures to ease as base effects from tax measures and higher food and energy prices fade. However, strong wage growth appears persistent and reflects tight and structurally constrained labour markets. Though net migration has turned positive and the labour participation rate is at an all-time high due to the strong growth environment and activation policies, Estonia has a shrinking working age population. This is due to its ageing demographics in a context of skills and regional labour mismatches.

Estonia Has One of the Strongest Public Sector Balance Sheets Among Eurozone Members

The budget position has roughly remained in headline and structural balance since 2010. The small 0.3% and 0.4% deficits in 2016 and 2017 are expected to reverse this year due to stronger than expected performance in tax revenues. Notwithstanding tax cut measures that took effect this year, income receipts and consumption tax revenues have overperformed due to rapid employment and wage growth, and strong consumption and construction activity. Even as social spending programs are expected to increase public expenditures in the coming years, the government is expected to post 0.5% of GDP fiscal surpluses in 2018 and 2019.

Estonia’s low gross government debt is an outlier among its EU partners. The country’s conservative fiscal policy reduces the need to finance deficits, debt is expected to decline to 7.5% of GDP by 2020. Yet, given its small and open nature, the Estonian economy is particularly vulnerable to adverse external scenarios. The government provisions against shocks by maintaining a high level of liquid savings. As of the third quarter of 2018, the Liquidity Reserve, a financial buffer for daily cash-flow management, was €725 million and the crisis-related provisioning Stabilization Reserve Fund reached €412 million. Combined, the funds equal 4.5% of GDP and net of local government lending both exceed the State Treasury’s debt portfolio.


Estonia’s External Position Appears Stable, Yet Wage Growth May Weigh on External Competitiveness

Exports account for roughly four-fifths of Estonia’s GDP and service-sector exports have been resilient. The current account has been mostly in surplus since 2009 and is projected to reach 3.0% of GDP in 2018. Sustained current account surpluses have improved Estonia’s external position, evident by lower external debt and a narrower net liability international investment position, which improved from -80.0% of GDP in 2009 to -29.4% as of June 2018. Much of the external debt is owed by Estonian subsidiaries to their parent companies that have been the source of substantial inward direct investment over the last decade. External deleveraging mitigates risks of sudden capital withdrawals and helps reduce vulnerabilities to external shocks.

Labour costs have risen steadily since 2010 and over time could lead to some erosion of external competitiveness. Although export volumes grew by 6.5% y-o-y in the second quarter of 2018, the growth rate of unit labour costs is outpacing labour productivity. From the third quarter 2012 to the third quarter 2018, an index of unit labour costs increased by 31% compared against the 12% growth of output per worker. The rising cost of labour can contribute to tightening profit margins and weakening external competitiveness. A limited period of moderate or high wage growth may have benefits, as it creates a disincentive for outward migration and improves income convergence with the EU.

Financial Sector Risks from Nordic Parent Banks or Domestic Real Estate Are Contained


Risks to financial stability associated with spillovers from Nordic economies and parent banks appear well managed. Ninety-percent of the Estonian banking sector is foreign owned, and the liquidity and funding position of the Estonian financial sector is directly and indirectly affected by the performance of Nordic economies. While subsidiary banks in Estonia only rely on roughly one-fifth of their funding from parent banks, an economic slowdown in the Nordic region could reduce capital flows into Estonia and affect the income of Estonian exporters and their ability to service loans. These risks are mitigated by the improved economic conditions of Nordic countries, and strong asset quality, deposit funding, and capitalisation of banks operating in Estonia.

Likewise, DBRS sees no evidence of spillovers to the Estonian financial system from the findings and conclusions of the investigations into Danske Bank’s Estonian branch. Non-resident activity in the branch closed in 2015, limiting any contagion effects to other domestically oriented Nordic banks. Non-resident deposits in the financial system now account for less than 10% of the total, down from 20% in 2015. The Estonian government recently approved a draft law which establishes stricter sanctions in the financial system, introduces reverse burden of proof on suspicious assets, and strengthens regulation of virtual currencies.

Credit growth and the domestic real estate sector are expanding at a moderate pace. Lending to households and the non-financial sector increased 13.7% in the three years to June 2018. Real estate prices advanced by 14.6% over the same period. With household debt of 39% of GDP and non-financial corporate debt of 129% of GDP as of the second quarter of 2018, private sector debt ratios have declined to pre-crisis levels. Private sector savings rates are also at historical highs. If the lending environment turns excessive, the Bank of Estonia would likely raise capital buffer rates as its principal macro-prudential tool. Given strict loan-to-value and debt-to-income limits for obtaining mortgages, there is no evidence that banks have eased lending standards.

DBRS Expects Policy Continuity Following the March 2019 Parliamentary Election

There is broad political consensus in Estonia around key policy issues, including sound fiscal prudence, European integration, and reforms to address the deteriorating demographic trends. Regardless of the outcome of the parliamentary election in early 2019, DBRS expects Estonian public institutions to remain strong and predictable. Estonia is an exemplary performer, especially among its Baltic peers, on the World Bank Governance Indicators. Regulatory quality ranks in the 93rd percentile.

Concerns in the Baltic region about Russian policy intensified following Russia’s annexation of Crimea in 2014. The more recent Russia-Ukraine confrontation in the Sea of Azov could also signal an increase of regional instability. Any escalation in tensions along the Estonian-Russian border or evidence of Russian meddling in the election could adversely affect political stability and economic activity. Geopolitical risks – associated with the geographical proximity to Russia and the sizable ethnic Russian minority in Estonia – are offset by NATO’s Enhanced Forward Presence. It was agreed in the 2016 Warsaw Summit to increase the presence of NATO military personnel in Poland and the three Baltic countries.



Rating committee summary

The DBRS Sovereign Scorecard generates a result in the AA to A (high) range. The main points discussed during the rating committee include the economy’s size and volatility, changes to fiscal policy, wage growth dynamics, and external risks.


Key indicators

Fiscal Balance (% GDP): -0.4 (2017); 0.5 (2018F); 0.5 (2019F)
Gross Debt (% GDP): 8.7 (2017); 8.0 (2018F); 7.6 (2019F)
Nominal GDP (EUR billions): 23.6 (2017); 25.5 (2018F); 27.1 (2019F)
GDP per Capita (EUR): 17,950 (2017); 19,310 (2018F); 20,544 (2019F)
Real GDP growth (%): 4.9 (2017); 3.5 (2018F); 2.8 (2019F)
Consumer Price Inflation (%): 3.7 (2017); 3.0 (2018F); 2.5 (2019F)
Domestic Credit (% GDP): 88.0 (2017); 83.4% (Jun-2018)
Current Account (% GDP): 2.9 (2017); 3.0 (2018F); 3.5 (2019F)
International Investment Position (% GDP): -32.3 (2017); -29.4 (Jun-2018)
Gross External Debt (% GDP): 84.9 (2017); 81.0% (Jun-2018)
Governance Indicator (percentile rank): 82.7 (2016); 83.7 (2017)
Human Development Index: 0.87 (2016); 0.87 (2017).


Euro area risk category: low






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