Latvia ratings downgraded; outlook remains negative

Capital Intelligence has downgraded Latvia’s long-term foreign currency rating to ‘BBB-‘ from ‘BBB+’ and its long-term local currency rating to ‘BBB’ from ‘A-‘. The agency has also lowered the sovereign’s short-term foreign and local currency ratings to ‘A3’ from ‘A2’. The outlook remains negative.
The downgrade reflects the expected deterioration in the public finances arising from a deep and possibly protracted economic downturn, as well as increasing risks to sovereign creditworthiness stemming from sizable contingent liabilities in the banking sector and substantial private sector external financing needs at a time of reduced global liquidity and heightened risk aversion.
Capital Intelligence placed Latvia’s ratings on negative outlook in November 2007 amid mounting concerns that the economy would experience a hard landing after several years of rapid, credit-fuelled growth. A year on, the economic adjustment process is being made more painful by the severity of the global financial crisis and the cost in terms of lost output, financial sector stress and fiscal expense is likely to be greater than originally expected.
Latvia’s economy contracted by 4.2% year-on-year in the third quarter of 2008 and is expected by Capital Intelligence to shrink further in 2009 before beginning a sluggish recovery in 2010. A lengthy downturn will weaken Latvia’s hitherto strong public finances, pushing up borrowing requirements and reducing fiscal flexibility.
Capital Intelligence expects the cyclical impact of the recession to be greater than implied by the government’s fiscal plans for 2008 and 2009 and the general government budgetary position is projected to deteriorate from near-balance in 2007 to deficits in excess of 4% of GDP in 2009 and 5% in 2010.
The ratio of government debt to GDP is projected to double from 9.5% to 19% over the same period.
These projections do not take into account the potential realisation of contingent liabilities in the financial system, although the risks to sovereign creditworthiness from banking sector distress have significantly increased following the government’s decision on November 8 to rescue Parex Bank, the country’s second largest bank by assets, after a run on its deposits. In addition to providing liquidity support, the government has agreed to guarantee the bank’s syndicated loans of EUR 775 mln, which fall due during the first half of 2009. The government has also indicated that it would be willing to provide state guarantees for interbank loans contracted by other Latvian banks.
The current dislocation in international financial markets has increased refinancing risk for banks, making it more likely that the government will be called on to meet maturing foreign loan obligations by issuing debt locally and drawing down official reserves. This would add to pressure on the public finances and further weaken Latvia’s international liquidity position, reducing the sovereign’s already limited capacity to absorb external shocks.
According to Capital Intelligence’s estimates, central bank foreign exchange reserves of EUR 4.1 bln at end-October cover just 27% of the country’s projected gross external financing requirement of EUR 15 bln – about 8 bln of which is related to the banking sector, including EUR 5 bln of non-resident deposits (around 30% of which are with Parex Bank). The combination of large external financing needs, relatively low official reserves and a fixed exchange rate has been a longstanding constraint on the sovereign’s ratings and leaves Latvia highly vulnerable to sudden stops or reversals in foreign capital (including deposit outflows), the risk of which is, at best, only partly mitigated by the foreign ownership of about 65% of the banking sector.
In light of the deterioration in global economic and financial conditions and the worsening domestic outlook, Capital Intelligence is of the opinion that Latvia needs to take steps to bolster confidence and strengthen its external liquidity buffer by securing financial assistance from the EU and international financial institutions. Failure to do so could potentially result in sovereign creditworthiness being seriously weakened should downside risks to the capital account materialise.