Standard & Poor’s Ratings Services has revised its foreign currency outlook on the Republic of Latvia to positive from stable. At the same time, all the ratings on Latvia were affirmed, including the ‘BBB+/A-2’ foreign currency and ‘A-/A-2’ local currency sovereign credit ratings. The local currency outlook on Latvia remains stable.
“The foreign currency outlook revision reflects Latvia ‘s very favourable position with regard to EMU accession, which could occur as early as 2007, although the central bank targets 2008,” says Standard & Poor’s credit analyst Moritz Kraemer.
“Becoming an EMU member will minimise the potential negative impact of balance-of-payments pressures and the country’s large net external debtor position, which constitutes the principal constraint on Latvia ‘s foreign currency ratings.”
The ratings on Latvia are supported by a track record of sound macroeconomic management and favourable fiscal indicators, and the authorities’ firm commitment to deepening market-based reforms. Strong investment activity, ongoing structural reforms, and impending EU accession support prospects for robust and well-balanced output growth of close to 6% over the medium term. General government debt is expected at 19% of GDP in 2004 and the public sector is in a net external creditor position. Moderate general government deficits between 2% and 3% of GDP will contribute to the stabilisation of the debt ratio in the medium term.
The ratings on Latvia remain constrained by weak external financial liquidity, low levels of economic development, and lingering governance problems. Most importantly, the current account deficit remains large, at an estimated 8.5% of GDP in 2003, although most of it is financed by net foreign direct investment. The gross external financial gap is still very high, at about 412% of official foreign exchange reserves in 2003. About one-half of this is due to a high level of non-resident deposits.
EMU accession prospects hinge on the expectation that the authorities’ commitment to prudent macroeconomic policies will persist. A gradual reduction of the fiscal deficit from 2004 onward will alleviate external imbalances. Once an EU member, Latvia will qualify for substantial official transfers, mitigating the weaknesses in its external accounts.
“As EMU accession draws nearer, and provided stability is maintained, the ratings could be raised,” says Kraemer.
Repegging the currency to the euro and entry into the European Exchange Rate Mechanism (ERM II) which is projected for January 2005 will be significant steps, putting Latvia firmly on track toward Emu membership. Policy slippage jeopardising eligibility to become a Eurozone member by 2008, however, could lead to a revision of the foreign currency outlook back to stable.