Analyst
Guolong Yu
yuguolong@Dagongcredit.com

Local currency/outlook BB/stable
Foreign currency/outlook BB/stable
Rating time October 2010
Sovereign Credit Rating

Rationale

Dagong assigns “BB” on both local and foreign currency of Republic of Latvia in it sovereign credit ratings, which are based on a comprehensive appraisal of current debt requirements, as well as the factors related to risks of debt.

Affected by the international financial crisis, the declining of government revenues and additional aid to financial sector increased government expenditure, and at the meantime caused a dramatic expansion of government deficit and debt-scale. As of the end of June 2010, the central government debt of Latvia amounted to 4.748 billion Lats, which is almost 38.91% of GDP. With the bailout spending on financial sector, the all level governments fiscal deficit reached 7% in 2009. The government will continue its tight fiscal policy, under the pressure of the additional conditions of the loan assistance from European Union and the International Monetary Fund. However, due to recovery of the domestic economy is still un-robust, fiscal income in the short term will be difficult to obtain substantial improvement. Meanwhile the unconstitutional judgment on the reduction of pension expenditures resulted in the fiscal expenditure increasing.  It is expected that the fiscal deficit will reach 8.6% of GDP in 2010, which will further increase both government financing requirements and debt burden.

The fundamental solvency of the government has been ensured to some extent by the aid fund from international organizations. However, as economic growth is difficult to recover to the pre-crisis levels, and the debt burden is continuing got deteriorated, the solvency of the government will be subject to certain constraints in the future, mainly in the following areas:

The convergent economic philosophy of various parties provides a good political environment for the rapid economic development in Latvia. However, the radical fiscal tightening policies have led to a rising social pressure. In this case, the upcoming parliamentary elections will increase the uncertainty of economic and fiscal policies of the next government;

Declining in labor cost improved the competitiveness of export products in the international market, and the economic rebound is on the way. However, the situation of the rapid credit-fueled economic growth will be hardly reproduced. The current export-led growth model is not solid due to a series of factors, such as the European sovereign debt crisis.  Besides, the domestic unemployment remains high rates and the future of economic recovery is blur;

Capital adequacy ratio of banking system has been increased significantly under the government intervention. However, due to the gradual increase of non-performing loans in private sector, the asset quality of banking system deteriorated substantially, which may further increase the financing requirements, and make the size of government debt continuing extended;.

Thanks to the intervention of European Union and the International Monetary Fund, Latvia maintains its fixed exchange rate system, pressures on currency depreciation has eased a lot. With the good trend of FDI inflow and the growing trade account surpluses, international reserves has been steadily recovered and the pressure on foreign currency debt repayment also got reduce The international aid funds revived investor’s confidence and reduced the cost of local currency financing for the government. With the well performed fiscal austerity, it is expected that the aid funds from EU and the International Monetary Fund will be allocated as planed shortly, and will help to ensure the government's foreign currency solvency.

Outlook

It is unlikely for Latvian to recover it economic growth to pre-crisis level. The previous real estate-driven growth model has been proved unsustainable and the future economic development depends on the possibility of investment being attracted into international trade sector to establish a new economic growth mode. Although the stability of financial sector has been restored, the previous high ratio of private credit in the economy could result in a continuing deterioration of asset quality and increase the pressure on the government debt burden. Given that Latvia government strengthens the implementation of fiscal austerity, it is likely for Latvia to obtain aids from IMF and EU constantly, which will be conducive to the restoration of official foreign exchange reserves and stability of Lats, and then to maintain the short-term government solvency. Therefore, Dagong keeps a stable outlook for Latvia government’s local and foreign credit ratings in the next 1-2 years.