Rating agency S&P announced on Friday that it had downgraded the ratings of the three Baltic states Estonia, Latvia, and Lithuania, citing the effects of the war in Ukraine and geopolitical risks with Russia.
Estonia saw its sovereign debt rating raised from “AA-” to “A+”, while Latvia’s has been raised from “A+” to “A”, as has Lithuania’s, all with a stable outlook.
The downgrades reflect “our view that the impact of the war in Ukraine and the wider regional geopolitical risks” will affect the Baltic region’s “economic growth, public finances, and competitiveness over the medium term,” S&P said.
The ratings on Estonia continue to be supported by the established institutional setup and a track record of macroeconomic stability-oriented fiscal and economic policies, as well as its membership in the EU and NATO. S&P also notes positively Estonia’s still-low government and external debt.
The effects of protracted war between Russia and Ukraine and broader geopolitical risks will weigh on Estonia’s small and open economy over the medium term, with an impact on public finances, economic growth, and external competitiveness
S&P projects that the Estonian economy will contract for a third year in a row in 2024 as foreign demand has remained weak at least in the first half of the year. Recovering foreign demand toward the end of the year, and rising consumption as disinflation continues, are the preconditions for a recovery, which will accelerate from 2025. The agency expects the economy to expand on average by just under 3 percent in 2025-2027.
Estonia’s long recession, which stands out in a comparison with regional peers, reflects several specifics of its economy. Its wood-manufacturing sector in particular faced weak demand from its key Nordic export markets and supply chain disruptions to inputs that had previously been mainly sourced from Belarus. In addition, Estonia’s transport sector was affected by the disruption of eastward transit and the country’s oil shale energy sector suffered from weak price competitiveness. However, the information and communication technology (ICT) sector has shown strength.
Heightened defense spending will pressure the government’s budgetary position, pressures on Estonia’s external competitiveness could dampen exports, and perceived risks could chill foreign direct investment (FDI), delaying a return to pre-COVID economic growth dynamics
The stable outlook reflects S&P’s assumption that Russia’s war will not escalate into the territory of NATO members, including Estonia’s. The stable outlook also takes into account the medium-term risks to Estonia’s budgetary growth,
and balance of payments performance as a result of regional geopolitical developments and foreign investors’ perception of these factors. These risks are, however, balanced by a projected cyclical economic recovery on the back of stronger domestic and foreign demand and looser monetary policy, as well as by our assessment that the country’s prior generally prudent fiscal policy will be preserved, with the authorities taking sufficient policy measures to ultimately keep budget deficits in check.
The agency expects the unemployment rate to increase to 7.6 percent in 2024 from 6.5 percent in 2023. This is a still-moderate increase in the context of Estonia’s drawn-out recession and chiefly occurs in the most-affected sectors. The labor market cool-down will also help moderate wage growth.
Inflation is set to moderate further to 3.3% in 2024 but remain above the eurozone average through 2027.
The agency projects Estonia’s general government deficit at slightly above 3 percent of GDP in 2024, expanding
to 3.5 percent in 2025, and declining to under 3 percent in 2026-2027.
Estonia’s banking sector appears sound amid the difficult economic environment. It reports high liquidity, solid profitability metrics, one of the lowest average nonperforming loan ratios and one of the strongest capitalization levels in the EU.
According to S&P, it could lower the ratings if the fallout from Russia’s war proved more significant than the agency currently expects, or if the war escalated, weighing more heavily on Estonia’s public finances and economic growth, and presenting additional security risks.
The agency could raise the ratings if the risks from the conflict subside, underpinning an improvement in Estonia’s growth prospects, foreign investment flows, and budgetary position.
Source: BNS
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