Analytics, Economics, Financial Services, Latvia, Rating

Key rating considerations

The Positive trend reflects DBRS Morningstar's view that credit fundamentals in Latvia appear to be improving. The liquidation of ABLV Bank AS last year, the closure of PNB Banka this year, and the significant decrease in non-resident deposits (NRDs) in the financial system have not weighed on financial stability, nor have these developments affected Latvia's economic or fiscal performance. Furthermore, tax reform attempts to address some of Latvia's structural challenges. Even in a context of frequently changing governments, persistent geopolitical risks, and structural shifts in the banking sector, the country's low government debt ratio and its sustained strong economic and fiscal results demonstrate effective macroeconomic management.

The ratings are underpinned by Latvia's consensus around stable macroeconomic policy-making and institutional benefits from membership in the European Union (EU) and the euro area. In contrast, the ratings are constrained by structural challenges. These include vulnerabilities to external shocks from the country's small and open economy, lower income and productivity levels compared to EU peers, and remaining – albeit diminishing –financial sector risks stemming from banks that service foreign clients. Latvia's financial system could face adverse consequences if Moneyval, the Council of Europe's anti money laundering body, or the Financial Action task Force (FATF) decides insufficient progress has been made on executing its recommendations.

Rating drivers

DBRS Morningstar could upgrade Latvia's ratings if there is clear evidence that the authorities continue to strengthen the financial system, specifically by executing on the action plan to address Moneyval recommendations on reducing risks from the flow of cross-border funds for illicit activity. DBRS Morningstar is also looking for continued fiscal discipline in the context of the ongoing tax reform.

Conversely, the trend could return to Stable or downward ratings pressure could emerge if momentum to reduce financial sector vulnerabilities is reversed, or if additional cases of illicit activity in the banking sector cause reputational or operational damage to domestically focused banks. The ratings could also face downward pressure if there is a marked deterioration in Latvia's public debt dynamics. This could result from a severe external shock that causes material macroeconomic underperformance or a reversal of the Latvian authorities' prudent fiscal management.

Rating rationale

Latvia has Increased Regulatory Efforts to Reduce NRDs and High-Risk Transactions – A Key Credit Positive

The fallout to the Latvian banking sector from the ABLV self-liquidation last year and the closure of PNB Banka this year has been contained and has accelerated the decline in bank deposits from non-residents. The publication in 2018 of the US Treasury FinCEN report resulted in ABLV's self-liquidation. Another NRD bank, PNB Banka, closed in 2019 due to capital shortages. Authorities have appropriately managed these closures and the deposit guarantee scheme has operated effectively. As of September 2019, foreign client deposits shrank to €3.2 billion (19.5% of total deposits), down from €8.1 billion (39.4% of the total) in January 2018 and €12.4 billion (53.4% of the total) in December 2015. Latvian banks continue to reduce the amount of high-risk deposits and replace them with customer deposits from EU jurisdictions. The decline in NRDs has reduced Latvia's short-term external debt without undermining the confidence of domestic depositors, the financial system, the economy, or the country's fiscal position.

Authorities passed reforms in recent years meant to change the business model of banks servicing foreign clients. In May 2018, the amendments to the Law on Prevention of Money Laundering and Terrorism Financing (ML/FT) went into force, and as of July 2018 banks can no longer perform any operations with high risk client accounts. This bans cooperation between banks and shell companies that have no real economic activity and are not required to file annual financial statements in their jurisdictions. The domestic financial market is disconnected from banks servicing foreign clients. Banks servicing foreign clients account for only 6% of total domestic lending. The bulk of domestic financial services are delivered by the subsidiaries of large Nordic banks, whose financial performance and capitalization levels are strong.

In July 2018, Moneyval assessed Latvia's ability to prevent cross-border flow of funds for criminal purposes as low. Moneyval identified several recommendations to strengthen supervision, transparency, judicial oversight, and international cooperation to monitor and prosecute illicit financial behaviour. The Latvian government in October 2018 approved the action plan measures necessary for the implementation of Moneyval's recommendations. The FATF and Moneyval will soon decide whether enough progress has been made to keep Latvia off the 'grey-list' of countries at high-risk of ML/TF. DBRS Morningstar considers that this form of censure, were it to occur, could inflict reputational damage to the banking sector and have negative consequences to financial intermediation and economic activity.

Tax and Pension Reforms are Positive Developments for Latvia, and the Government Debt Ratio Remains Low

Fiscal deficits are expected to remain small and manageable through 2020, when the implementation period of the 2017 tax reform ends. Following a small fiscal surplus reported in 2016, the headline deficit widened to 0.5% of GDP in 2017 and 0.7% in 2018, driven by increases in defence spending, social payments, and public sector wages. Latvia's headline fiscal position is perhaps moderately procyclical given strong economic results and the economy's positive output gap. However, the 2020 Budget expects headline deficits within 0.5% of GDP and small primary surpluses throughout the forecast period as a result of budgeted expenditure restraint.

DBRS Morningstar considers recent tax reform to be integral to improving Latvia's economic growth prospects. The reform improves corporate competitiveness by lowering corporate taxes and allowing corporates to defer income tax until profits are distributed. It also lowers the tax burden on labour, increasing labour market flexibility, and makes personal income tax more progressive. These measures are partially offset by increases in consumption taxes and social contributions. Likewise, several rounds of pension reform that gradually increases the retirement age and mandatory contributions have positioned Latvia well to address fiscal challenges arising from an aging population. Age-related spending in Latvia is among the lowest in the EU.

General government gross debt is expected to remain around 37% over the forecast period, among the lowest in Europe. Favourable debt features reflect strong growth of nominal GDP, persistent primary surpluses, and low interest expenditure – expected below 1.0% of GDP for the next few years. DBRS Morningstar expects the government to continue to take advantage of high demand for its Eurobonds and low interest rates to prefund its redemptions.

Weaker External Demand is Expected to Moderate Latvia's Recent Strong Economic Growth Performance

Robust domestic demand has encouraged the strong economic performance in recent years. The economy expanded by 3.8% in 2017 and 4.6% in 2018 due to strong private sector investment and absorption of the European structural and investment funds. Furthermore, the strong labour market has activated a previously side-lined population and reduced the unemployment rate close to the lowest level since before the crisis. Strong employment and wage growth have supported the steady increase in household consumption.

DBRS Morningstar expects some economic deceleration in the coming years from a weaker external environment and as investment growth slows. EU-funded projects will continue to support investment, though at less impressive rates seen in 2017-18. External demand is also expected to weaken and slow export growth. Latvia's export performance and its economy are inescapably linked to the economic performance of key eurozone trade partners, and weaker than expected euro area results are likely to lower growth projections across Europe. The European Commission forecasts the Latvian economy to grow by 3.1% in 2019 and 2.5% in 2020, slightly below potential growth calculations.

DBRS Morningstar Expects Macroeconomic Policy Continuity from the 5-Party Coalition Government

The October 2018 parliamentary election resulted in another fragmented outcome. Arturs Krišjānis Kariņš of the New Unity party was eventually chosen as Prime Minister to lead a coalition of five disparate parties. Despite the fractured nature of Latvian politics, frequent government turnover, and lingering geopolitical tensions, Latvia's political environment appears stable and policy-making generally effective. Latvia has a long history since its independence of government reshuffling, including 15 Prime Ministers since 1991. It nonetheless performs above the regional average on World Bank Governance rankings. The current coalition government has vowed to maintain macroeconomic stability, manage fiscal policy prudently, continue to pursue key reforms, and maintain broad consensus around EU membership.

Euro area risk category: low