Standard & Poor’s Ratings Services said today it lowered its long-term sovereign rating on the Republic of Latvia to ‘BBB+’ from ‘A-‘ due to the increasing risk of a hard landing and persistent external imbalances. The short-term sovereign credit rating was affirmed at ‘A-2’. The outlook is negative. At the same time, Standard & Poor’s also lowered its transfer and convertibility assessment on
“The downgrade reflects the expectation that the Latvian government’s recently adopted anti-inflation plan will only slowly reverse rapid growth in the current account deficit and external debt, resulting in an adjustment process that is potentially more disruptive than a more comprehensive policy approach,” said Standard & Poor’s credit analyst Eileen Zhang.
The current account deficit is expected to peak at 40% of current account receipts (CARs) this year, with less than one-third funded by EU transfers and net equity inflows. As a result, external debt, net of liquid external assets, will rise to 140% of CARs, more than double its level at the end of 2005.
The Latvian economy grew 12% in 2006 in real terms, resulting in two consecutive years of double-digit expansion. Nevertheless, the strong growth reflects an overheating real estate sector rather than the broad-based investment necessary to underpin sustainable economic expansion. Net imports are expected to reach 21% of GDP this year, up from 14% in 2005, leaving domestic demand as the driving force for growth.
Although the general government is expected to balance its accounts in 2007 under its anti-inflation plan, it implies only a very mildly anti-cyclical stance, which is unlikely to have a sufficient dampening effect on domestic demand. The general government debt burden is currently less than 10% of GDP. The adjustment of the macroeconomic imbalances, however, may weaken future fiscal performance and lead to an increase in public debt and contingent liabilities emanating from a banking sector heavily exposed to the frothy residential real estate market.
With the Latvian lat fixed against the euro and recent investment only marginally enhancing export prospects, the high external deficit and debt may not improve substantially without considerable deceleration in economic expansion or competitiveness-enhancing structural reforms. Exchange rate pressures will be minimized when
“The negative outlook reflects the prospect of a downgrade if the economic imbalances continue to be addressed at a slow pace and the risk of a hard landing increases,” said Ms. Zhang. “If the overheating continues, external pressures may ultimately weaken public and private balance sheets, although the government’s currently strong balance sheet at present provides an important buffer.”
Conversely, the government could use its considerable fiscal flexibility and bring about further budgetary tightening, and effectively implement additional demand control measures in a timely and coordinated manner. This approach would facilitate an orderly unwinding of economic imbalances and could lead to the outlook being revised to stable.
