Moody's affirms Latvia's A3 ratings, maintains stable outlook

Paris, April 29, 2022 -- Moody's Investors Service ("Moody's") has today affirmed the Government of Latvia's long-term issuer and senior unsecured ratings at A3 as well as its senior unsecured MTN rating at (P)A3. The outlook remains stable.

The affirmation of Latvia's A3 ratings balances the following key rating drivers:

1) The increase of geopolitical risks stemming from the Russian invasion of Ukraine (Caa2, review for downgrade) affecting Latvia, mitigated by NATO security guarantees and troop presence;

2) The progress made by Latvia towards enhancing its energy security in light of heightened geopolitical tensions;

3) Moody's expectation that Latvia's economic and fiscal strength will be largely resilient to the impact of spillover effects from the Russian invasion of Ukraine.

The stable outlook reflects Moody's expectation that the risk of a conventional military conflict directly impacting Latvia remains low and that the country's progress towards bolstering its energy security will reduce the impact of energy-related risks. It also reflects Moody's expectation that the permanent damage of the Russia-Ukraine conflict on the Latvia's economy will be relatively limited and that Latvia's fiscal metrics will remain stronger than most of its A3-rated peers.

Latvia's local currency ceiling at Aaa, six notches above the local currency rating and the foreign currency ceiling at Aaa and hence at the same level as the local currency ceiling, remain unchanged. For euro area countries, a six-notch gap between the local currency ceiling and the local currency rating as well as a zero notch gap between the local currency ceiling and foreign currency ceiling is typical, reflecting benefits from the euro area's strong common institutional, legal and regulatory framework, as well as liquidity support and other crisis management mechanisms. It also reflects our view of de minimis exit risk from the euro area.

RATINGS RATIONALE

RATIONALE FOR AFFIRMING THE A3 RATINGS AND MAINTAINING THE STABLE OUTLOOK

FIRST DRIVER: THE INCREASE OF GEOPOLITICAL RISKS STEMMING FROM THE RUSSIAN INVASION OF UKRAINE AFFECTING LATVIA, MITIGATED BY NATO SECURITY GUARANTEES AND TROOP PRESENCE

The Russian invasion of Ukraine and the increasingly protracted military conflict between the two countries have led to an increase in geopolitical risks affecting Latvia. On account of this, Moody's recently changed Latvia's score for political risk (one of the four sub-factors of Moody's assessment of a sovereign's susceptibility to event risk) to "ba" from "baa", which indicates that the escalation of geopolitical tensions, possibly leading up to an armed conflict, has the potential to negatively impact economic activity, fiscal outcomes and funding conditions for Latvia.

However, although geopolitical risks and the uncertainty around such risks have increased with the Russian invasion of Ukraine, Moody's deems the likelihood of the military conflict in Ukraine spilling over into a conventional military conflict with a direct and material impact on Latvia to be low. Such risks are notably mitigated by the fact that Latvia benefits from full NATO security guarantees under the alliance's mutual defense clause. NATO has also reinforced its international troop presence, which has been stationed in Latvia since 2017, in the Baltic states and other Central and Eastern European countries since the Russian invasion of Ukraine.

There is a higher probability that Latvia could be directly impacted by more unconventional or hybrid forms of attack, such as cyberattacks, disinformation campaigns, sabotage operations or efforts to foment civil unrest. However, such hybrid attacks are on their own also much less likely than conventional military attacks to have a material negative impact on Latvia's credit profile. Although there is no indication of inter-ethnic tensions in Latvia escalating into outright civil unrest since the start of the Russian invasion of Ukraine, the presence of an ethnic Russian minority which accounts for around 25% of the Latvian population, is an additional risk factor in the current context of heightened geopolitical tensions with Russia.

SECOND DRIVER: THE PROGRESS MADE BY LATVIA TOWARDS ENHANCING ITS ENERGY SECURITY IN LIGHT OF THE HEIGHTENED GEOPOLITICAL TENSIONS

The Russian invasion of Ukraine has also heightened risks around energy security for European countries that have historically been dependent on Russian natural gas, oil and coal for a large part of their overall energy supply. The protracted military conflict has heightened concerns that Russia could reduce energy deliveries to Europe in order to retaliate against sanctions or to gain political leverage, or that political pressure resulting in an accelerated phase-out of Russian energy imports could jeopardise the stability of the energy supply of many European countries. In an adverse scenario, this could lead to the rationing of energy in the most affected countries, potentially with a material negative impact on the economic and fiscal strength of these sovereigns.

Latvia has historically been highly reliant on natural gas for its overall energy supply, and almost wholly dependent on imports from Russia to meet its natural gas needs. However, the Baltic states have taken a number of significant steps since the 2014 conflict in Ukraine to diversify their potential sources of energy supply and bolster their energy security. More generally, Latvia's preparedness and proactive policymaking in the field of energy security also supports our assessment of the sovereign's institutions and governance strength, one of the four factors of Moody's assessment of a sovereign's creditworthiness and also a Governance consideration under our ESG framework. Most notably, Latvia is already able to import liquefied natural gas (LNG) from the Lithuanian LNG terminal established in the port of Klaipeda, which has the capacity to satisfy the three Baltic states' combined gas needs. Latvia also has large underground gas storage capacity which currently holds unseasonably high levels of reserves.

To further enhance the security of supply in order to meet the government's ambition of ending Russian gas imports by the end of 2022, the Latvian government is cooperating with the governments of Estonia (A1 stable) and Finland (Aa1 stable) in their efforts to procure a floating LNG terminal to be initially based at the Estonian port of Paldiski. The ability to make such a terminal operational by the target date of November this year is enhanced by the fact that much of the necessary infrastructure for mooring a floating terminal and connecting it with the onshore gas infrastructure at Paldiski has already been prepared over the past few years. Latvia's reliance on Russian oil has been reduced by the fact that the Lithuanian refinery which supplies much of Latvia's refined oil products has announced that it has stopped importing Russian crude oil as a consequence of the Russian invasion of Ukraine.

Although Latvia like many other European countries is recording very high rates of inflation largely driven by increasing energy prices, recent efforts towards ending the import of Russian hydrocarbons reduces the likelihood of energy-related risks having a material negative impact on the sovereign's credit profile.

THIRD DRIVER: MOODY'S EXPECTATION THAT LATVIA'S ECONOMIC AND FISCAL STRENGTH WILL BE LARGELY RESILIENT TO THE IMPACT OF THE SPILLOVER EFFECTS FROM THE RUSSIAN INVASION OF UKRAINE

The Russian invasion of Ukraine will have a significant, negative impact on the Latvian economy this year, due to a combination of a sharp fall in exports to and imports from Russia and Belarus combined with weakening economic confidence and a reduction in consumer purchasing power due to sharply rising energy prices. That said, in Moody's baseline scenario, we expect economic growth to be weak but positive at 1.3% of GDP this year and 2.3% in 2023. While a significant downward revision from our pre-invasion forecasts, the immediate economic impact of the military conflict is ultimately much less sharp than that of the coronavirus pandemic which caused the Latvian economy to contract by 3.8% of GDP in 2020.

Although Latvian exports to Russia and Belarus will be sharply and permanently reduced by the Russia-Ukraine conflict, the impact on the Latvian economy is ultimately muted by the fact that around a third of exports to Russia and Belarus are re-exports which make a much lower contribution to gross value added than goods and services exports produced in Latvia. The Latvian economy also has a demonstrated ability to quickly adapt and adjust to external shocks, including the imposition of EU-Russia sanctions in 2014, the coronavirus pandemic and the global financial crisis which had a severe initial impact on the economies of the Baltic states. As such, Moody's expects that most Latvian exporters, with the exception of rail cargo transport services, will be able to redirect the vast majority of exports to Russia and Belarus to other markets and source their production inputs such from other sources over the coming two to three years, limiting the risk of a lasting negative impact on Latvia's economic strength.

Weaker growth coupled with higher government spending on for instance measures to help consumers cope with rising energy prices, national defense and the accommodation of Ukrainian refugees will also lead to a deterioration of Latvia's public finances this year. Moody's currently forecasts a headline government deficit of 6.8% of GDP this year, still down slightly from a pandemic peak of 7.3% of GDP in 2021. This will in turn cause Latvia's government debt burden, to increase to 47.4% of GDP in 2022, from 44.8% of GDP in 2021. That said, Latvia's debt burden will remain clearly lower than the median of its A3 rated peers of around 56% of GDP in 2022. Latvia's debt affordability metrics are also clearly stronger than the median of its A3 peers, and as a euro area country it also benefits from the ability to issue domestic currency debt in a reserve currency, further mitigating risks to its fiscal strength or the government's access to funding.

ENVIRONMENTAL, SOCIAL AND GOVERNANCE CONSIDERATIONS

Latvia's ESG Credit Impact Score is neutral to low (CIS-2), reflecting low exposure to environmental risk and moderately negative exposure to social risks, as well as a very strong governance profile.

Latvia's overall E issuer profile score is neutral to low (E-2), reflecting low exposure to environmental risks across most categories.

We assess Latvia's S issuer profile score as moderately negative (S-3), reflecting low exposure to social risks across most categories, with the notable exception of demographics. The country's highly adverse demographic profile will continue to limit the labour supply and constrain the economy's potential growth rate over coming decades. That said, on current projections, increases in ageing-related fiscal costs are relatively contained.

Latvia receives a positive G issuer profile score of (G-1). Latvia's institutional environment continues to benefit from membership of the European Union and the euro area. Although money laundering-related scandals in the country's banking sector have raised questions about the quality of financial supervision, the government has made significant progress in tackling these issues over recent years.

The publication of this rating action deviates from the previously scheduled release dates in the EU sovereign calendar published on www.moodys.com. This action was prompted by the Russian invasion of Ukraine and the related increase in geopolitical risk.

GDP per capita (PPP basis, US$): 31,594 (2020 Actual) (also known as Per Capita Income)

Real GDP growth (% change): -3.8% (2020 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): -0.5% (2020 Actual)

Gen. Gov. Financial Balance/GDP: -4.5% (2020 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: 2.9% (2020 Actual) (also known as External Balance)

External debt/GDP: [not available]

Economic resiliency: a3

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 27 April 2022, a rating committee was called to discuss the rating of the Latvia, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutions and governance strength, have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer has become increasingly susceptible to event risks.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

A resolution of the Russia-Ukraine conflict that leads to a lasting reduction of geopolitical tensions and uncertainty affecting Latvia, coupled with an easing of longer term pressures on the economy's potential growth rate, stemming from population ageing and structural economic change, most likely supported by structural reforms, could put upward pressure on Latvia's rating.

Moody's considers a military attack on Latvia, which would imply a military confrontation also with NATO, as a very low risk, high impact scenario. In such a scenario, Latvia's rating would come under significant additional pressure, likely resulting in a multi-notch rating downgrade. Unconventional or hybrid attacks could also put downward pressure on the ratings if such events were to have a material and lasting negative impact on the fundamentals of Latvia's credit profile. The eruption of civil unrest could also have a negative credit impact if it jeopardises Latvia's political and institutional stability. However, the magnitude of the negative impact of such events is likely to be much more limited than that of a conventional military conflict directly affecting Latvia.

Negative pressure could also build on Latvia's ratings if the lasting damage to Latvia's economic strength resulting from the Russia-Ukraine conflict is more severe than Moody's expectations for a relatively limited permanent negative impact. If the change in the geopolitical environment and negative economic spillover effects from the Russia-Ukraine conflict were to lead to a significant and sustained increase in Latvia's debt burden and deterioration of its debt affordability metrics, this could also place negative pressure on the A3 rating.

The principal methodology used in these ratings was Sovereign Ratings Methodology published in November 2019 and available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1158631. Alternatively, please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

REGULATORY DISCLOSURES

For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004.

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.

These ratings are solicited. Please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website www.moodys.com.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1288235.

At least one ESG consideration was material to the credit rating action(s) announced and described above.

The Global Scale Credit Rating on this Credit Rating Announcement was issued by one of Moody's affiliates outside the UK and is endorsed by Moody's Investors Service Limited, One Canada Square, Canary Wharf, London E14 5FA under the law applicable to credit rating agencies in the UK. Further information on the UK endorsement status and on the Moody's office that issued the credit rating is available on www.moodys.com.

Petter Bryman
Asst Vice President - Analyst
Sovereign Risk Group
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Alejandro Olivo Villa
MD-Sovereign/Sub Sovereign
Sovereign Risk Group
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