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

DBRS Ratings Limited (DBRS) confirmed the Republic of Estonia’s Long-Term Foreign and Local Currency – Issuer Ratings at AA (low). At the same time, DBRS confirmed the Republic of Estonia’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trends on all ratings are Stable.

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 8.5% of GDP in 2019, 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.

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 would consider placing upward pressure on the ratings if there is (1) increased evidence of a persistent reduction in economic volatility inherent to Estonia’s small and open economy; or (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 stemming from the Nordic banking sector, that causes sudden capital outflow from Estonia and material macroeconomic underperformance; (2) A return of excessive credit growth that leads to private sector over-indebtedness and financial sector instability; (3) An unexpected relaxing of fiscal discipline that significantly weakens Estonia’s public debt position.

RATING RATIONALE

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

Growth of the Estonian economy has been strong in recent years. The EC measured growth of 3.9% in 2018, another year of above-trend performance. The strong economic outcome stems principally from robust domestic demand. Healthy construction supports investment, and high employment and wage growth drive private consumption. Furthermore, favourable commodity prices have increased exports across various sectors.

Despite the EC’s calculation of a 3.0% positive output gap, DBRS sees little evidence of excessive private sector leverage, housing market imbalances, or saving-investment misalignments – features of the pre-crisis years. Economic growth is expected to gradually decline in the coming years as the labour market reaches full employment and investment levels moderate from the 2017 peak. The EC forecasts growth of 2.8% this year and 2.4% in 2020. Under these assumptions, the positive output gap narrows to around 2.0% by 2020.

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

Exports account for roughly three quarters of Estonia’s GDP and service-sector exports have been resilient. The current account has been mostly in surplus since 2009 and reached 1.7% 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 -26.7% in 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 4.3% 2018, the growth rate of unit labour costs is outpacing labour productivity. From 2012 to 2018, an index of unit labour costs increased by 27% compared against the 11% growth of output per worker. The rising cost of labour can contribute to tightening profit margins and weakening external competitiveness. However, a limited period of moderate or high wage growth may have benefits. It can create a disincentive for outward migration and improves income convergence with the EU.

While Fiscal Policy has been More Expansionary in Recent Years than Historical Averages, Debt Remains Low

The average budget position in the fifteen years until 2015 was broadly in balance. Since then, Estonia has recorded small, though incrementally widening, deficits. This includes the -0.6% of GDP budget result in 2018. In its previous report, DBRS was anticipating a 0.5% surplus last year. The weaker outcome resulted from unexpected growth in current spending and investment. Revenue performance has been broadly in line with budgetary expectations, but receipts do not offset the structural increase in social spending. The government, in its 2019 Stability Programme, calculates a 1.4% structural deficit for 2018, only to decline to 1.0% this year. It is worth noting that the EC’s structural deficit calculations for 2018 and 2019 are much higher, at 2.2% and 1.7%.

Estonia’s low gross government debt is an outlier among its EU partners. The country’s historically conservative fiscal policy reduces the need to finance deficits. Debt is expected to remain around 8.5% of GDP. Despite the low debt, the Estonian economy is particularly vulnerable to adverse external scenarios, given its small and open nature. The government provisions against shocks by maintaining a high level of liquid savings. As of 2018, the Liquidity Reserve, a financial buffer for daily cash-flow management, was €677 million and the crisis-related provisioning Stabilization Reserve Fund reached €412 million. Combined, the funds equalled 4.2% of GDP. Net of local government lending, the funds exceed the State Treasury’s debt portfolio.

Financial Sector Risks from Nordic Parent Banks or Domestic Real Estate Appear 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 accounted for 9.5% of the total in 2018, down from 19.5% in 2015. In late 2018, the Estonian government presented to the Parliament 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. That law has not yet been approved.

Credit growth and the domestic real estate sector are expanding at a moderate pace. Lending to households and the non-financial sector increased 5.1% yoy in 2018, while real estate prices advanced by 5.7%. Even with healthy credit growth, private sector debt ratios have declined to pre-crisis levels. Household debt was 39% of GDP in 2018 and non-financial corporate debt was 130% of GDP. 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.

Following the Parliamentary Election, DBRS Expects Continuity Around Key Policy Issues

Despite losing one seat in the March 2019 parliamentary election, Prime Minister Jüri Ratas and his Centre party (26 seats in the 101-seat legislature) formed a three-party coalition with Pro Patria (12 seats) and the Conservative People’s Party (EKRE, 19 seats). The controversial EKRE, self-identified as a national-conservative party, showed the most improvement by picking up twelve additional seats from its showing in the 2015 election. For the first time, a far-right party enters Estonian government. The Reform Party (34 seats) performed best in the recent election but was unable to form a minority coalition with the Social Democratic Party (10 seats).

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. 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.

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 banking sector, changes to fiscal policy, wage growth dynamics, and external risks.

KEY INDICATORS

Fiscal Balance (% GDP): -0.6 (2018); -0.3 (2019F); -0.5 (2020F)
Gross Debt (% GDP): 8.4 (2018); 8.5 (2019F); 8.5 (2020F)
Nominal GDP (EUR billions): 25.7 (2018); 27.2 (2019F); 28.6 (2020F)
GDP per Capita (EUR): 19,310 (2018); 20,544 (2019F); 21,680 (2020F)
Real GDP growth (%): 3.9 (2018); 2.8 (2019F); 2.4 (2020F)
Consumer Price Inflation (%): 3.4 (2018); 2.4 (2019F); 2.2 (2020F)
Domestic Credit (% GDP): 85.7 (2017); 81.5 (2018)
Current Account (% GDP): 1.7 (2018); 1.4 (2019F); 1.4 (2020F)
International Investment Position (% GDP): -31.4 (2017); -26.7 (2018)
Gross External Debt (% GDP): 82.7 (2017); 77.4 (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

Notes:

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal, debt, GDP and Current account indicators taken from EC Spring Forecast 2019. Domestic credit and external debt from Bank of Estonia. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministry of Finance, Bank of Estonia, Statistical Office of Estonia, European Commission, Statistical office of the European Communities, International Monetary Fund, World Bank, United Nations Development Programme, Haver Analytics, and DBRS. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 14, 2017
Last Rating Date: December 14, 2018

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