Standard & Poor's affirmed Latvia’s long- and short-term foreign and local currency sovereign credit ratings at 'A-/A-2', changing the outlook to positive from stable on the back of strong economic growth, the ratings company said on September 22.

The revised outlook reflects expectations that Latvia will link its current fast economic expansion with reforming the labour market in order to sustain higher income levels. The country’s fiscal prudence is also expected to continue despite tax reform and elections next year, S&P writes.

Latvia’s rating is supported by Latvia's “track record of effective policy making, prudent fiscal policy, and moderate and declining net government debt”, S&P noted. The ratings also benefit from strong economic growth, even if income convergence with most Eurozone peers is slow. 

Membership in the Eurozone, moderate current account deficits, and modest external indebtedness are also rating positives. The latter is offset, however, by the “large prevalence of short-term debt, which is a reflection of the potentially volatile non-resident deposit funding of part of the financial sector”. 

Latvia is expected to post GDP growth of 4% on average in 2017-2018, according to S&P. Growth should be driven by an acceleration of investment as EU fund absorption picks up. Private investment and consumption are also expected to be major factors in the accelerated economic expansion this year. Bank lending is expected to recover as well.

Growth is expected to slow down to 3% in 2019-2020 owing to the tightening of the labour market, which should prompt the government to carry out reforms, addressing skills mismatches, activating remaining labour supply potential, addressing regional disparities in the labour supply, and demand, or tackling the grey economy.

No major fiscal slippage is expected in 2017-2020, despite upcoming elections and the implementation of tax reform, according to S&P. The general government deficit is forecast to widen to 1.3% of GDP in the election year 2018. 

General government debt will gradually decline to below 30% of GDP by 2020, down from a peak of 35% in 2011.

Foreign demand for Latvian exports will remain firm, hinging on favourable economic conditions in its European trading partners, which should offset more modest demand from Russia. Latvia's traditionally substantial services surplus could be at risk over the longer term if Russian efforts to shift transit trade into its own ports gain traction, S&P warns.

The sizable, if shrinking, level of non-resident deposits (NRDs) in the domestic banking system remains an external vulnerability. NRDs amounted to slightly over 40% of all deposits in Latvian financial institutions in early 2017.