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Rating Action:

Moody's upgrades Latvia's government bond ratings to A3; stable outlook

13 Feb 2015

London, 13 February 2015 -- Moody's Investors Service (Moody's) has today upgraded the government bond ratings of Latvia to A3 from Baa1. Latvia's (P)P-2 short-term rating has not changed. The outlook on the rating is stable.

The key drivers for today's rating action are:

1. The durable strength of the government's balance sheet;

2. Reduced banking sector risk.

The stable outlook on the rating incorporates Moody's assumption that policies that support these positive developments will remain on track. Moreover, it also recognises Latvia's ability to largely withstand shocks emanating from Russia's economic contraction and related geopolitical risks .

RATINGS RATIONALE

RATIONALE FOR UPGRADE OF LATVIA'S GOVERNMENT BOND RATING TO A3

FIRST DRIVER—Durable strength of the government's balance sheet

The resilience of the government's balance sheet is the first driver of Moody's decision to upgrade Latvia's rating to A3. Latvia has demonstrated a strong ability to consolidate the public finances in a short period of time, and the country's fiscal deficit is forecast to remain below 1.5% of GDP throughout the forecast period. Fiscal consolidation savings between 2008 and 2013 were frontloaded and amounted to approximately 18% of GDP, which has set the country's debt trajectory on a firmly declining path.

Moody's forecasts that general government debt-to-GDP will fall to 36% of GDP by the end of 2015 from 46.3% in 2010 and will continue declining for the foreseeable future. In addition, our analysis suggests that the debt-to-GDP level would remain below 50% even in the event of a reasonably severe shock to growth and interest rates.

It is noteworthy that the authorities have intensified work towards enhancing tax collection. For example, in December 2014, the government made company board members personally responsible should their company be found guilty of tax evasion. The government has pursued a number of high-profile corporate tax fraud cases and the number of companies on the Latvian Register of Enterprises increased by 10,000 in one year alone. Since the introduction of the euro, cash usage has fallen substantially, which also contributes to the reduction in the grey economy.

Although the effectiveness of measures aimed at the grey economy is always difficult to predict, in its February 2015 winter forecasts, the European Commission has incorporated some of these efforts into their government fiscal balance forecasts for this year due to the unusual degree of granularity and specificity of the government's plans. Looking further ahead, Latvian policymakers have also made good progress on implementing pension reform, which will mute the impact of an aging society on public finances.

Latvia established a good track record of rapid and decisive fiscal consolidation during its financial crisis late in the last decade. The government has continued to build on institutional improvements implemented in the last few years, with the passing of the Fiscal Discipline Law and the creation of a Fiscal Council increasing confidence in the durability of improvements to the public sector's balance sheet. The country's Fiscal Discipline Law is intended to minimise the pro-cyclicality of fiscal policy in future, and the Fiscal Council provides independent oversight of the budgeting process and the health of the public finances.

SECOND DRIVER—Reduced banking sector risk

A further reduction in banking sector risk is the second driver of Moody's decision to upgrade Latvia's rating to A3. Relative to other countries in the euro area, the sector is relatively small, with total banking sector assets being equivalent to around 123% of GDP. Profitability in the sector has continued to improve, in part reflecting improvements in asset quality, with non-performing loans continuing to fall.

The banking system is well capitalised, with overall banking sector capitalization standing at 20.6% in the third quarter of 2014, and household and non-financial corporate debt burdens continue to fall. The domestic loan to deposit ratio (excluding government) has also decreased sharply to 133% at the last quarter of 2014 from 288% over the corresponding period in 2008.

While non-resident deposits remain the largest source of vulnerability to the system, the share of non-resident deposits in the system has been stable. Moreover, the regulators have imposed substantial capital add-ons and liquidity requirements for banks whose business is concentrated in this area. The capital minima for banks operating in the non-resident segment of the banking system range from just over 10% to 20%, and the liquidity requirements are substantial.

The impact of the non-resident deposit-taking segment of the banking sector on the Latvian economy is mitigated by the fact that only 12% of total loans by the 13 banks defined as specialists in non-resident banking are granted to residents. In addition, the increase in foreign liabilities has been matched by a similar expansion in foreign assets which comprise more than 60% of the total assets for these banks. The resulting bifurcation of the banking sector into those focused on non-resident and resident activities should alleviate the risks to the domestic banking sector and economy, and therefore to the government's balance sheet, from stresses in the non-resident banking sector.

Banking supervision has been stepped up, especially in the non-resident deposit taking part of the banking sector, with onsite and offsite visits. Following the financial assistance provided in the crisis, the resources for supervisory institutions, in particular the financial regulator, have increased. Banking sector risk is also mitigated by the supervisory oversight that is provided by the ECB's Single Supervisory Mechanism (SSM), which became operational in the last quarter of 2014 and which also includes Latvia's largest non-resident deposit taking bank.

CREDIT PROFILE ALIGNED WITH A-RATED PEERS

In light of these drivers, as well as its very open and flexible economy, Latvia's sovereign credit profile is now comparable to that of countries in the A3 peer group. Latvia is much smaller than most, though not all, of these countries and has a relatively volatile growth and inflation track record. It also has a somewhat higher susceptibility to event risk than what is typical in the A3 rating category, predominantly due to geopolitical risks related to Russia.

However, the country is institutionally stronger than many A3-rated sovereigns. The country's swift, strong, and decisive response to the economic crisis in 2008-09, as well as its successful implementation of an internal devaluation and swift fiscal consolidation are evidence of the authorities' proactive policy stance.

Latvia's public finances are a notable source of strength for the sovereign relative to peers. Its debt-to-GDP ratio sits comfortably beside A3-rated peers, its debt-to-revenue ratio and financial balance are close to the lowest of all A3 countries and its debt affordability ratio (interest payments-to-revenue) is the lowest in the A3 rating category.

RATIONALE FOR STABLE OUTLOOK

The stable outlook on Latvia's A3 rating reflects Moody's view that upside and downside risks are evenly balanced. On the one hand, there is potential for the government to implement measures that would further improve the country's competitiveness and therefore its growth potential. According to the European Commission, improved management of state-owned enterprises, as well as education and healthcare reform would have a material impact on the overall economy. There is also potential for tax revenue to increase, which would further increase the resilience of the public finances.

On the other hand, further upward movement in the rating will likely be slow due to structural factors such as Latvia's small size and openness, which place a natural limit the country's resilience to external shocks. Some things—such as a high degree of wealth, a low debt burden, a highly competitive and diversified economy, and strong institutions—can counterbalance the risks that come with being a small and open economy. In Latvia's case, some of these mitigants are already in place—which explains why the rating is positioned at A3—but we expect further enhancement of these mitigants to be gradual.

The stable outlook is also a reflection of Latvia's ability to withstand shocks emanating from Russia. There are a number of different ways in which Latvia is exposed to political and economic developments in Russia. However, on balance, thus far the country has demonstrated resilience to this downside risk and there is mitigation in place were other risks to crystallise.

Latvia imports 100% of its natural gas from Russia. Although we think that it is unlikely that the country's gas supplies from Russia would be cut off, the country is equipped to manage such an event due to its infrastructure and also more recently improved infrastructure elsewhere in the Baltics. Latvia is the only Baltic country with a natural gas storage facility, and this facility's capacity is more than sufficient to meet the country's energy needs for at least a year. Energy security in the Baltics more generally has improved with the mobile liquefied natural gas (LNG) terminal in Lithuania, which became operational at the end of 2014.

Russia's economic performance has an impact on Latvia's economic growth. In part, these come through trade channels as Russia is the second- largest market for Latvian exports, according to International Monetary Fund data. The crisis in Russia has dampened Latvian economic growth to below potential, with real GDP growth falling to an estimated 2.4% in 2014, and we are forecasting a 2.2% expansion in 2015. This incorporates a double-digit contraction in exports to Russia, as the full impact of the ruble's depreciation and Russia's economic contraction is felt.

Going forward, though, the negative impact on the Latvian economy from developments in Russia is likely to be partially mitigated by the positive impact of weaker energy prices, rising household incomes, and the depreciation of the euro. Re-exports are a key component of trade with Russia, which also explains why the economic impact of adverse Russian economic circumstances is more muted than the export data suggest. In addition, Latvian exporters have proven their ability to diversify into new markets. In total, despite the decline in demand from Russia, during the first eleven months of 2014 goods exports grew by 2.2% year-on-year.

Given Latvia's NATO membership, we consider geopolitical event risk to be contained at a moderate level.

WHAT COULD CHANGE THE RATING UP/DOWN

Moody's would consider upgrading Latvia's government bond rating in case of (1) a faster-than-expected debt reduction; (2) increased potential economic growth, most likely through further competitiveness-enhancing structural economic reforms; (3) decisive moves to increase the size of the country's tax base.

Conversely, downward pressure on the rating could develop in the event of a substantial weakening of the government's balance sheet. A dramatic deterioration in the economic or security situation vis-à-vis Russia would also increase downward rating pressures.

COUNTRY CEILINGS

In a related decision, Latvia's long-term foreign-currency and local-currency bond and deposit ceilings have been raised to Aaa from Aa1. The short-term foreign currency bond and deposit ceilings remain unchanged at Prime-1 (P-1).

GDP per capita (PPP basis, US$): 22,832 (2013 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 4.2% (2013 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): -0.4% (2013 Actual)

Gen. Gov. Financial Balance/GDP: -0.9% (2013 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -2.3% (2013 Actual) (also known as External Balance)

External debt/GDP: [not available]

Level of economic development: Moderate level of economic resilience

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

On 13 February 2015, 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 institutional strength/framework, have materially increased. The issuer's fiscal or financial strength, including its debt profile, has materially increased. The issuer has become less susceptible to event risks. An analysis of this issuer, relative to its peers, indicates that a repositioning of its rating would be appropriate.

The principal methodology used in this rating was Sovereign Bond Ratings published in September 2013. Please see the Credit Policy 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 rating action, if applicable.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt 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 rating action on the support provider and in relation to each particular 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 rating action, and whose ratings may change as a result of this 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.

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

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Sarah Carlson
VP - Senior Credit Officer
Sovereign Risk Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Alastair Wilson
MD-Global Sovereign Risk
Sovereign Risk Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's upgrades Latvia's government bond ratings to A3; stable outlook
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