Analytics, Economics, Financial Services, Latvia, Rating
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Thursday, 18.04.2024, 12:32
DBRS Morningstar Confirms Republic of Latvia at A (low), Positive Trend
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