Fitch's recent report, "Risks Rising in the Baltic States?" (available from its website at www.fitchratings.com) drew attention to indications that the Latvian economy is overheating. Latvia's current account deficit was the highest in the EU at 21% of GDP in 2006 while inflation in February 2007 was the second-highest in the bloc (after Bulgaria) at 6.6%. A renewed bout of weakness for the Latvian lats ("LVL") in the last fortnight serves as a reminder of the vulnerabilities outlined in Fitch's report. The LVL weakened to 0.7098LVL/EUR from its central parity of 0.702804LVL/EUR, necessitating central bank intervention to keep the currency within its +/- (minus)1% band and causing a sharp spike in local interbank interest rates.
In its credit analysis report on Latvia published in August 2006, Fitch stated that the absence of a strong fiscal policy stance to address overheating, achieve the Maastricht inflation criteria and re-establish a credible euro adoption timetable would put downward pressure on the ratings. Euro adoption before 2012 looks unlikely. Fitch notes that the Latvian government's proposal to achieve a balanced budget in 2007, compared to its earlier target of a 1.3% budget deficit, represents only a moderate fiscal tightening. In contrast, the Estonian government delivered a budget surplus of 3.8% in 2006, with real GDP growth some half a percentage point lower. Fitch takes a positive view of the proposed changes to real-estate taxation and the introduction of measures to control credit growth and is encouraged by proposals to restrict the rapid growth of public-sector wages, although details of this last measure remain uncertain.
Fitch notes that Latvia's low level of public debt (just 11% at end-2006) with repayment peaks of just EUR200m and EUR400m in 2008 and 2014 respectively partially mitigate the downward pressure that an abrupt slowdown in capital and financial flows could put on the ratings. However, with over three quarters of loans denominated in foreign currency, a "hard landing" could impair household borrowers' capacity to make repayments, putting strain on the Latvian banking system. The contingent liability that this represents for the sovereign is partially mitigated by the fact that over half of Latvia's banking system assets are foreign-owned. Nevertheless, this is a lower proportion than those in the other Baltic countries and the exposure of Latvia is therefore potentially higher. Moreover, the country's gross external debt burden has risen to over 100% of GDP, almost double the 'A' range median of 53%.
Fitch believes that a smooth macroeconomic adjustment is still possible for the Latvian economy but that the likelihood of this is now lower. Indications that such an adjustment is taking place could lead to the Outlook being revised back to Stable. Nevertheless, the absence of a firmer resolve to address overheating could potentially lead to a downgrade.
