November 10, 2017 / 9:04 PM / 9 days ago

Fitch Revises Estonia's Outlook to Positive; Affirms at 'A+'

(The following statement was released by the rating agency) Link to Fitch Ratings' Report: Estonia - Rating Action Report here LONDON, November 10 (Fitch) Fitch Ratings has revised the Outlook on Estonia's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to Positive from Stable and affirmed the IDRs at 'A+'. A full list of rating actions is at the end of this rating action commentary. KEY RATING DRIVERS The revision of the Outlook to Positive reflects the following key rating drivers and their relative weights: MEDIUM GDP growth in Estonia appears to have returned to a higher trajectory, in line with its long-term potential after years of underperformance since the global financial crisis. This improvement is the result of favourable external conditions, strong domestic consumption and investment, as well as sound fiscal policy management. We expect full-year growth to reach 4% in 2017 and 3% in 2018-2019, with upside risks to the forecasts given the strength of momentum registered in 1H17. Fitch has increased confidence that Estonia's strong policy framework, characterised by conservative fiscal policy and eurozone membership, will continue to reduce macroeconomic volatility and mitigate the economy's vulnerability to external shocks. Inflation has increased above peers in 2017, reflecting the impact of tax measures and higher energy and food prices. However, Fitch expects inflation to ease to 2.8% and 2.5% in 2018-2019, close to the 'A' median. The decline in inflation will be facilitated by a reduction in structural fiscal deficit targets for 2018-2019 and the stated objective to return to a balanced structural fiscal position in 2020. This will reduce the risk of excessive domestic demand pressures, given labour market structural constrains and the high cyclical position of the economy. Estonia has moved into a net external creditor position, with its net external debt falling from 5.6% of GDP in 2011 to -11.3% of GDP in 2017, well below the 'A' median of 6.6%. This reflects the accumulation of current account surpluses and lower private sector external debt, stemming in part from reduced parental funding for banks. Estonia's current account surplus is expected to remain in surplus, at 1.9% of GDP in 2017, as a wider trade deficit will be balanced by a stronger services surplus. Continued domestic demand growth will reduce the surplus in 2018-2019, but Estonia's net external creditor position is expected to strengthen further, mitigating vulnerability to external shocks derived from the small size and openness of the economy. Since joining the euro area in 2011, Estonia has delivered an average fiscal surplus of 0.2% of GDP, leading to lower debt and higher accumulation of assets despite years of low economic growth and adverse external conditions. General government debt is now the lowest among Fitch 'A' rated sovereigns, and one-fifth of the 'AA' median. Debt is likely to continue to decline, as a modest fiscal gap will be financed through the use of assets. The government's net financial assets are 43.5% of GDP. This includes liquid assets (currency and deposits) equal to 7% of GDP in 1H17. Estonia's 'A+' IDRs also reflect the following key rating drivers: Fitch expects the general government fiscal deficit to narrow to near balance, at 0.1% of GDP in 2017, as the central government balance and social security position mitigate a deterioration in local government finances. Adjusting its 2018-2021 budget strategy, the government has revised down its 2018 structural deficit target to 0.25% of GDP (nominal deficit of 0.1% of GDP). Fitch expects the combination of slower revenue growth (due to lower economic growth and collections from excise taxes) and some expenditure under-execution to result in a general government deficit of 0.4% in 2018. The modification of the State Budget Act earlier in 2017 allows the government to run structural deficits of up to 0.5% of GDP, in contrast to a structural balance requirement in the previous legislation, as long as these can be financed by previously accumulated surpluses. Under the 2018 budget proposal, the 2019 structural deficit should remain at 0.25% before returning to a structural balance in 2020 and reaching a 0.50% of GDP surplus in 2021. This reflects a tighter stance than the 2018-2021 fiscal strategy from April, which forecast 0.5% structural deficits in 2018-2020 and returning to balance only in 2021. The scale down of structural deficit targets reduces fiscal risks arising from weaker revenue performance and mitigates risks regarding potential overheating, as economic growth is currently running above trend. Historical growth volatility, as measured over a 10-year period, has been high relative to rating peers as a result of the plunge in output during the global financial crisis of 2008-2009; Fitch expects this measure of volatility to decline sharply by 2019 under the base case scenario. Estonia's income per head will likely converge to the 'A' median in 2019, but it is only around 60% of the 'AA' median and around 70% of the eurozone average (in purchasing parity terms). Productivity growth has improved since 2H16 and outpaced the rise in labour costs in 1H17, but upward pressure on unit labour costs are likely to persist due to rising wages, reflecting structural constraints in the labour market. The government's Work Capacity reform has increased labour supply and will temporarily increase the unemployment rate. Nevertheless, skills and regional mismatches could persist. Banks' asset quality and capitalisation are sound. Credit for housing (6.5% annual) could remain dynamic due to rising income and still favourable financing conditions, but the ratio of debt to income remained similar to 2016, at 74% in 2Q17. Real estate prices maintain an upward trend, but growth is volatile depending on the type of property (new vs old) coming to market. Estonia's financial system is dominated by foreign banks, and parent banks provide 22% of total funding requirements. SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO) Fitch's proprietary SRM assigns Estonia a score equivalent to a rating of 'A+' on the Long-Term FC IDR scale. In accordance with its rating criteria, Fitch's sovereign rating committee decided not to adopt the score indicated by the SRM as the starting point for its analysis because the SRM output has migrated from 'AA-' to 'A+', but in our view this is potentially a temporary deterioration. Assuming an SRM output of 'AA-', Fitch's sovereign rating committee adjusted the output to arrive at the final Long-Term IDR by applying its QO, relative to rated peers, as follows: - External finances: -1 notch, to reflect that although Estonia benefits from the euro's 'reserve currency flexibility', Fitch believes this status would offer Estonia only limited protection in a global or domestic financial crisis. In addition, due to its small size and openness, the Estonian economy is vulnerable to shocks to its main trading partners and specific sectors. Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM. RATING SENSITIVITIES The main factors that could, individually or collectively, lead to an upgrade are: - Stable economic growth with continued sound fiscal management. - A further narrowing of the gap in incomes per head between Estonia and the 'AA' median. The main factors that could, individually or collectively, lead to a stabilisation of the Outlook are: - Economic or financial shocks that adversely affect Estonia's macroeconomic and financial stability. KEY ASSUMPTIONS The global economy performs in line with Fitch's Global Economic Outlook. Fitch assumes that under severe financial stress, support for subsidiary banks would come first and foremost from their foreign parent banks. The full list of rating actions is as follows: Long-Term Foreign-Currency IDR affirmed at 'A+'; Outlook Revised to Positive from Stable Long-Term Local-Currency IDR affirmed at 'A+'; Outlook Revised to Positive from Stable Short-Term Foreign-Currency IDR affirmed at 'F1+' Short-Term Local-Currency IDR affirmed at 'F1+' Country Ceiling affirmed at 'AAA' Contact: Primary Analyst Erich Arispe Director +44 20 3530 1753 Fitch Rating Limited 30 North Colonnade London E14 5GN Secondary Analyst Kit Ling Yeung Associate Director +44 20 3530 1527 Committee Chairperson Stephen Schwartz Senior Director +852 2263 9938 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com. 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