Latvia sees successful transition over the past decade

In its annual report on Latvia, Moody’s Investors Service said its A2 government bond rating and stable outlook recognize Latvia‘s successful transition over the past decade.

The bond rating and Moody’s assessment of a very low risk of a payments moratorium in the event of a government bond default serve as the basis for Latvia‘s foreign currency country ceiling for bonds of Aa1.

“The ratings are anchored by ongoing structural reforms within the context of EU integration,” said Moody’s Vice President Kenneth Orchard, author of the report. “They also take into account Latvia‘s susceptibility to external shocks.”

In September Moody’s changed the outlook on Latvia‘s government bond rating to stable from positive. Worsening economic imbalances driven by extraordinary, credit-fuelled growth have eroded the upside potential for the rating for the foreseeable future. In addition, the inflation picture has deteriorated dramatically since early 2007.

“It appears that Latvia is in a classic wage-price spiral,” said Orchard.

“Such a cycle can be difficult to break, especially in an environment of rapid economic growth.”

“On the other hand,” he said, “ERM2 participation paves the way for eventual membership in the European Monetary Union and provides some degree of comfort. The prospect of eventual entry into EMU is also a deterrent to destabilizing capital flows, even though euro adoption has moved into the distant future.”

Following rising tensions in the currency market earlier this year, the government took action to cool growth and to reduce inflation. The plan appears to be having important psychological effect, although it has yet to impact inflation directly.

“Demand for credit has noticeably cooled, and housing prices, while still rising on an annual basis, have started to decline,” said Orchard.

“Accordingly, Moody’s continues to believe that a “soft landing” is the most likely outcome, followed by moderate growth over the medium term.”

However, the downside risks to the macroeconomic outlook have increased, said Orchard. The combination of factors that drove growth ever higher for several years are now in the process of reversing, and could cause growth to slow more sharply than desired.

“History has shown that returning an economy to a sustainable path after a period of extremely rapid economic growth often leads to turbulence,” noted Orchard.