IHS Global Insight Upgrades Latvian Sovereign to Investment Grade, Outlook Positive18 March 2011 -- IHS Global Insight Daily Analysis
IHS Global Insight Perspective
IHS Global Insight has upgraded Latvia’s Sovereign Risk Rating by one notch to 40, the lowest investment grade. The rating outlook is Positive, reflecting our expectation that Latvia’s government will remain on the austerity track.
Latvia is still not out of the woods yet, as the trade gap remains too high. However, the recent recovery, combined with the shrinking fiscal deficit and improving solvency, signals that the country is on the way to a sustainable growth path.
A sustained recovery will support fiscal consolidation. The medium-term outlook is one of acceleration of Latvia’s growth momentum as fiscal-austerity effects fade. Upon evidence of further deficit reduction, the sovereign rating could be upgraded further within the next 12 months.
There have been a number of positive rating actions for Latvia from almost all major agencies, as well as from IHS Global Insight, during the last 12 months. Our rating is currently on par with two other major ratings institutions, while another has the country at a higher risk rating.
IHS Global Insight has upgraded Latvia’s Sovereign Risk Rating by one notch to 40, which is equivalent to BBB- on the generic scale. The rating outlook, meanwhile, has been switched to Positive from Stable. The latter had been upgraded from Negative already in April 2010. Our decision follows shortly after a similar step by the ratings agency Fitch.
The decision reflects Latvia’s slow but steady recent recovery, the improving fiscal situation, de-leveraging of the private sector, and receding external liquidity pressures. Moreover, a major hurdle was passed with the parliamentary election in October 2010, which was essentially a stamp of approval for the government's fiscal rigour.
Following the savage recession between 2008 and 2009, during which GDP shrank by almost a third, the second-largest economy of the Baltic trio has embarked on a recovery in 2010. Although GDP still inched down once more that year, Latvia’s industry had already been recovering since late 2009. The recovery has been driven by exports, while the rest of the economy, including almost all sectors focused on domestic demand, has still struggled to get back on its feet. The situation changed gradually for the better during 2010, with consumer spending stabilising at a low level.
As a result of the recession, but caused mainly by the need to cut costs under the pressure of an overvalued currency, Latvia’s corporate sector slashed wages and reduced the job count aggressively. Unemployment quickly bounced to around 20% by early 2010. Although sagging modestly from that peak over the course of 2010, unemployment has remained very high and a key drag on growth. This situation will hardly change, even in the long term, and weakens Latvia’s economic capacities and ability to service the still-sizeable debt load. At more than 300% of adjusted total foreign-exchange earnings, Latvia’s gross foreign debt is still extremely high. The key solvency ratio is more than twice as high as in Lithuania and Estonia, respectively. However, with the scale of adjustments in the recent past in mind, and given that Latvia’s private sector is still unloading the debt burden, its economy should be able to reduce the solvency ratio to more manageable levels during the next five years as exports remain on the recovery track.
While undoubtedly necessary, fiscal austerity was to a large extent responsible for the weakness of private demand, as consolidation was carried out significantly by tax hikes and public-sector wage cuts. Indeed, the public sector accumulated debt equivalent to almost 50% of GDP in 2010. The bulk of austerity measures have been passed with the implementation of the 2011 budget, and the drag on growth from the fiscal side will soften in 2012 and beyond. Clearly, this will enhance Latvia’s chances to maintain a steady, and eventually more broad-based, recovery in the medium term.
Risks for a sharp devaluation of the Latvian lats
—which is pegged to the euro and is allowed to float within a narrow trading band of plus or minus 1% around the central parity—have become fairly remote over the last 18 months. Although a devaluation was regarded as inevitable by many observers two years ago, Latvia has apparently stabilised its external liquidity position and replenished the stock of foreign reserves, which equalled more than six months’ worth of imports at the end of 2010.
Outlook and Implications
Despite the recent recovery and improvements of key solvency and liquidity indicators, Latvia is not out of the woods yet. There are still lingering doubts about Latvia’s external balances, as the trade deficit remains too high. The goods trade deficit reached 9.3% of GDP in 2010, while the gap in the fourth quarter alone equalled 11.4% of GDP. Although being mitigated by a services surplus at almost equal size, this is too high for a small open economy and Latvia’s economic structure. Indeed, Latvia’s current account turned negative for the first time in two years in the last quarter of 2010, and even a modest recovery of domestic demand will give imports a spur in 2011 and further ahead. Latvia needs to improve the competitiveness of its export sector still further in order to make the recovery sustainable in the longer term.
Reducing the fiscal deficit and pushing ahead with public-sector reform with bring Latvia closer to a sustainable growth path. A lower deficit will keep imports in check, while the tax burden needs to be lowered to improve Latvia’s competitiveness. If the government remains on the austerity track and the deficit is apparently reduced further, this could warrant a further upgrade to the rating. We think that is likely, which is why we have switched the rating outlook to Positive. A sustained recovery will support fiscal consolidation. Although the latest economic results have produced a mixed picture, the outlook for 2011 and beyond is still for an acceleration of Latvia’s growth momentum. Exports will remain robust, and domestic demand will join the fray as the impact of fiscal austerity is fading.
IHS Global Insight Upgrades Latvian Rating to Investment