Driven by the government's continued commitment to fiscal discipline, Latvia finally recovered its investment grade credit rating from the last major agency, Standard & Poor's, on May 2.
S&P raised its rating on Latvia by one notch to 'BBB-' from 'BB+' and assigned a stable outlook, to join Fitch Ratings and Moody's Investors Service in rating the country's debt investment grade. S&P said that it expects Riga's austerity drive and rebalancing of the economy towards exports since the economy nosedived in 2009 to see the country duck under the 3% budget deficit limit needed to join the Eurozone, which Latvia says it plans to do in 2014.
The upgrade comes despite confirmation by the finance ministry on April 27 that it plans to pull back on some revenue-based austerity measures as early as this year. Riga said it will propose a reduction in the VAT rate by July 1 this year, and a cut in the personal income tax rate from January 1, 2013. "The ratings on Latvia balance our view of the government's proven political commitment to fiscal discipline, the economy's considerable flexibility, and the material increase in exports as a share of GDP, against the constraints of large (albeit decreasing) external debt, relatively moderate GDP per capita, and a lack of monetary policy flexibility," S&P said in a statement.
The upgrade will encourage Latvia's Baltic peers and the likes of other Emerging European states like Poland who have been pushing in recent months for improved ratings on the back of fiscal consolidation drives and growing economies. However, the rating agencies have said that they require results rather than promises before they offer more positive appraisals. "Latvia is in a truly unique situation," Finance Minister Andris Vilks claimed, according to Leta. "At a time when economic activity in the European Union is decreasing and the ratings of the majority of member states are being reduced, the rating on our country is increased. Standard & Poor's welcomed Latvia's development potential thanks to the joint effort of the government and businessmen, as well as society's support to achieve a balanced economy.
"Latvia currently differs from the rest of the EU, since our economy is expected to grow faster than in other member states this year, therefore Latvia will become more interesting to foreign investors and international companies," Vilks added, somewhat bullishly, given analyst forecasts that Latvia will lag its Baltic peers with growth of below 2% this year.
Still, the markets applauded the move, with the yield on Latvia's dollar bond due in 2021 falling 5 basis points to 5.17% and credit default swaps also dropping on the news, reports Bloomberg.
Analysts argue the upgrade was overdue, and even predicted further improvements should be on the way, unless the European debt crisis provokes a meltdown in the EU economy. "We could raise the ratings if the private sector continues to deleverage externally and fiscal and inflationary performance are consistent with eurozone acceptance criteria," S&P said.
However, it also warned that the agency "could lower the ratings if the Latvian government were to relax its fiscal stance or if external financing became more difficult to access, perhaps due to parent banks rapidly reducing their exposure to Latvia."
S&P praised upcoming reform of budgetary legislation in Latvia for institutionalizing fiscal consolidation. "The government's planned fiscal discipline law will include requirements to balance the budget over the economic cycle and establish ceilings on nominal spending," S&P analysts pointed out. "The law will likely be implemented by mid-2012 and we believe it will anchor spending growth. We expect the government will meet its deficit target of below 3% of GDP for 2012 and continue to reduce budget deficits over the medium term."
The rating agency also credited more general political reform for adding momentum to its appraisal. "We believe recent electoral reforms - to make voting procedures in parliament more transparent, to limit political advertising, and to introduce state funding of political parties - will strengthen political accountability and improve the policy environment," it said in the statement. "We also believe that the government's proposed fiscal discipline legislation will improve fiscal policy over the medium term and reduce the risk of fiscal slippages."
However, S&P does not necessarily expect Latvia to join the Eurozone within its stated target of 2014 due to inflation - which was 1 percentage point above the 3.1% threshold for joining in March - despite the fact that such a move would mitigate significant risks. "As a result of the lats' peg to the euro," it said, "Latvian monetary policy is determined by external factors. Entry to the European Economic and Monetary Union (Eurozone) would eliminate the devaluation risk, but balance-of-payment risks would remain. We do not assume that Eurozone entry would necessarily occur within the two-year outlook horizon. Our view is that inflationary risks are significant, not so much because of how they might distort the economy but how they may thwart Latvia's ambition to join the Eurozone by 2014."
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