OREANDA-NEWS. Fitch Ratings has affirmed Latvia's Long-term foreign and local currency Issuer Default Ratings (IDR) at A-', with Stable Outlooks. The issue ratings on Latvia's senior unsecured foreign and local currency bonds have also been affirmed at 'A-'. The Country Ceiling has been affirmed at 'AAA' and the Short-term foreign currency IDR at 'F1'.

KEY RATING DRIVERS
Latvia's ratings are supported by the government's favourable fiscal finances, as well as the institutional strengths and policy framework that come with eurozone membership. The ratings are constrained by the country's weaker external finances and lower per capita income than 'A' rated peers.

Latvia's economy grew 2.7% in 2015, boosted by a strong domestic sector, despite a double digit contraction in net exports due to weaker external demand. For 2016, Fitch forecasts a modest slowdown in growth to 2.5% stemming from weaker investment growth and a slow recovery in net exports. Weak demand from important trading partners (e.g Russia and the other Baltic countries) will keep the net export contribution to GDP negative for another year, albeit at a lesser degree, while gross fixed capital formation will slow due to the start of a new EU funding cycle. Growth in 2016 will primarily be driven by household consumption, supported by solid real wage growth and rising employment.

Latvia's medium-term potential growth is estimated by the authorities at around 3%. Achieving this growth rate will aid the economy's gradual convergence towards the 'A' median income level. However, structural rigidities constrain the economy's potential, as evidenced by the high labour tax burden contributing to structural unemployment, and the presence of a large grey economy. There is also a moderate risk that challenges to economic competiveness could arise, should the current trend of strong wage growth above labour productivity continue.

Public finances are a support for Latvia's rating. In 2015 the general government deficit was 1.3% of GDP and the government debt ratio 36.4% of GDP, compared with the 'A' medians of 2.0% and 44.1%, respectively. For 2016, Fitch is forecasting for the fiscal deficit to narrow further to 1.0% of GDP, but for the debt ratio to rise to 39.7% of GDP on the back of government plans to pre-finance 2017 redemptions, including a USD1bn Eurobond in February 2017.

Latvia does not face any near-term fiscal risks, but meeting medium-term fiscal targets beyond 2016 could be challenging. Pressures to increase defence spending and social welfare will require additional revenue raising measures to those already in the 2016 Budget.

Latvia's ratings are supported by a stable and improving banking sector. The sector is well capitalised (Tier 1 capital adequacy ratio at 19.7%, 2015), and on-going private sector deleveraging has helped improve banks' balance sheets, with non-performing loans down to 5.4% (March 2016) from a peak of 19% in 2010. The high level of foreign ownership in the banking sector reduces the risk of financial sector liabilities migrating onto the sovereign balance sheet. Although the share of non-resident deposits in the sector is high (46.1% of GDP, 50% of total deposits, 1Q16), they have proved resilient against a significant external shock in the form of the recession in Russia.

Partially constraining Latvia's rating is its weaker external finances relative to the 'A' median. Compared with the median net creditor position (20.4% of GDP) of its 'A' peers, Latvia is a high net external debtor (22.6% of GDP). This ratio has been on a steady downward trajectory since 2009, and on the basis the banking sector continues to deleverage and the government keeps to its latest medium-term public debt strategy, this ratio will narrow further. For the first time since 2008, Latvia's sovereign turned into a net external creditor for around 9.7% of GDP, after reducing its liabilities following the repayment of a EUR1.2bn European Commission loan back in January 2015.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced. The main factors that could, individually or collectively, trigger positive rating action include:
- A sustainable improvement in external finances in conjunction with a reduction in external debt.
- A longer track record of strong and stable economic growth that fosters higher income per capita, without the re-emergence of macroeconomic imbalances.

The main risk factors that, individually or collectively, could trigger negative rating action are:
- Deterioration in Latvia's public debt dynamics, for example, from sustained fiscal slippage and/or economic underperformance.
- Deterioration in external finances, for example, associated with overheating of the domestic economy.

KEY ASSUMPTIONS
Fitch expects the global economy to perform broadly in line with assumptions set in its Global Economic Outlook (March 2016), in particular eurozone GDP growth, to reach 1.7% by 2017, up from 1.6% in 2015.