Moody s A3 / S&P A- / Fitch A- 1 Economy: Agriculture 3%, Industry 22%, Services 75%

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1 Latvia Summary Moody s A3 / S&P A- / Fitch A- 1 Economy: Agriculture 3%, Industry 22%, Services 75% Latvia adopted the euro and formally became part of the European Union (EU) in 2014, a remarkable achievement for the former Soviet Union republic, and in 2016 it became the latest Organization for Economic Co-operation and Development (OECD) member country. As part of its transformation, Latvia has made an impressive fiscal adjustment and other structural reforms, and the OECD has praised Latvia as a top reformer. In part due to the adjustment, Latvia has one of the fastest growth rates in Europe despite challenges. Even with its success, there are important vulnerabilities to note, such as its high level of external debt and a banking system with a high share of nonresident deposits, although this has declined since From a longer term perspective, Latvia faces demographic challenges and needs to continue structural reforms in order to remain competitive and further increase productivity. Economic Indicators F 2018F Population (Millions) GDP per Capita (USD) 14,951 15,693 13,615 14,062 15,404 17,243 Nominal GDP (USD Billions) Real GDP (%) Year-End CPI (%) Fiscal Balance (% of GDP) Interest (% of Revenues) FC Debt/Public Debt (%) Government Debt (% of GDP) Government Debt (% of Revenue) Current Account (% of GDP) FDI (% of GDP) External Debt (% of GDP) Foreign Reserves/External Debt (%) Foreign Reserves (Mo. of imports) Foreign Reserves (% of GDP) As of November 2017 Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Lazard, Haver Analytics, IM 207

2 Lazard Emerging Markets Debt Rating History Below is a history of the country s foreign and local currency ratings by the major agencies dating back to We have also included a chart of the country s hard currency external debt spread and the JP Morgan EMBI Global Diversified Index spread for comparison. Rating History Hard Currency A+ A A- BBB+ BBB Local Currency A+ A A- BBB+ BBB BBB- BBB- BB+ BB+ BB BB BB BB Moody s S&P Fitch Moody s S&P Fitch As of December 2017 Performance represents past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg, Fitch, Moody s, Standard and Poor s Bond Spreads Latvia 2010 EMBIGD 2017 As of December 2017 Performance represents past performance. Past performance is not a reliable indicator of future results. Source: JP Morgan 208

3 Latvia Strengths Eurozone Membership, Euro Adoption, and OECD Membership Latvia formally joined the eurozone and adopted the euro in 2014 after fulfilling all the Maastricht criteria, a remarkable achievement for the former Soviet republic. The adjustment undertaken by Latvia underscores a steadfast commitment to the EU, which it joined in Joining the EU was an important policy goal aimed at bringing economic benefits via better creditworthiness and the explicit support of the EU community. However, support among the Latvian population was not unanimous when it joined. In a survey commissioned by the European Commission, only 55% of Latvians believed having the euro was a good thing 2 and 2017 polls show that this has declined to 45%. 3 In addition to eurozone membership, Latvia became the latest OECD member country following accession talks in Relatively High Growth Despite a challenging regional environment and a slowdown in its growth rate, Latvia s economy is expected to perform well, growing at an expected 3.8% in 2017 and 3.9% in 2018, rates that are among the highest in the eurozone. 5 Despite this anticipated solid growth rate, the medium term growth outlook is challenging as the IMF revised project growth down from around 4% to 3% due to lower total factor productivity, low investment, and demographic drag. 6 Policy Continuity and Fiscal Balance Improvement Latvia s fiscal deficit has improved considerably from 6.4% of GDP in 2010 to an expected budget deficit of approximately 0.7% in 2017, which we expect to improve to breakeven in This is broadly in line with its Fiscal Discipline Law, which includes a provision that the budget deficit cannot be greater than 1% of GDP. Latvia s fiscal policy strategy for has two main objectives: (1) achieve a general government structural deficit in the long term of less than 0.5% of GDP, and (2) increase potential growth from 3% to 5%. In this context, fiscal policy will be more expansionary, with a target budget deficit of 1.6% of GDP in 2018, 1.2% in 2019 and -.5% by Business Friendly Environment Latvia has a business-friendly environment. In the latest World Bank Ease of Doing Business rankings, Latvia ranks 19 th worldwide out of 190 countries, placing it among the betterranked economies in Europe and even ahead of Germany. 9 In addition, Latvia ranks 54 out of 137 countries in the World Economic Forum s Global Competitiveness Index. The country also has one of the lowest corporate tax rate in EU at 15%, the thirdlowest after Bulgaria, Ireland, and Cyprus. 10 Proven Willingness to Adjust Latvia is highly regarded for its internal devaluation during the sudden stop crisis (a bust following a boom financed by foreign banks), an adjustment that enabled it to avert a disorderly exit from its currency board arrangement, and hence avoid a default. The country achieved this adjustment through a drastic cutback in wages 30% in nominal terms by 2010 and an economic contraction that peaked at 19% year-over-year in the second quarter of The IMF, among others, believed this would be practically impossible. However, Latvia s leaders and its electorate proved they were willing to pay enormous costs to remain in the EU, and this commitment to pay has left a strong positive impression on the market. Latvia s proven commitment to reforms and adjustments was also highlighted by the OECD, which noted Latvia as a top reformer in its 2017 Economic Survey

4 Lazard Emerging Markets Debt Weaknesses External Debt Position Latvia s gross external debt remains high at an estimated 135% of 2018 GDP, although this is a substantial improvement from its 2010 level of 168% of GDP. 12 This is a legacy of the crisis caused by excessive bank borrowing to finance a boom in non-tradeables. The largest portion of external debt, 50%, is owed to foreign banks (including nonresident deposits) while 25% is issued by corporate entities. The IMF expects that external debt will gradually decline to 122% of GDP by Nonresident Deposits The high level of nonresident bank deposits (NRDs) in the banking system, about 50% of total deposits in and of which 80% 13 are from Russian and the Commonwealth of Independent States countries, has raised enough concern that in 2016, the IMF issued a warning statement that the high level of NRDs creates a contingent. If these nonresident deposits are rapidly withdrawn, it could trigger a banking crisis in which the Latvian government would need to step in to cover the deposit guarantees for the remaining accounts. In addition, NRDs proved to be volatile during the crisis and threatened financial stability. The IMF estimates that NRDs account for half of all banking deposits, 14 and it is estimated that 14 of 20 Latvian banks have NRDs as their main source of deposits. 15 Nevertheless, the IMF noted that the Russia-Ukraine crisis has had little impact on the banking sector 16 and it has seen few signs of inflow volatility. 17 Latvian financial regulators require banks that specialize in NRDs to have more stringent capital and liquidity requirements, and liquidity stress tests suggest that all Latvian banks can withstand a 60% outflow of their NRDs without requiring other sources of financing. 18 NRDs peaked in 2016 and have since declined, with NRDs accounting for 41% of total deposits as of June Population Decline and High Levels of Inequality Latvia has experienced one of the sharpest population declines in the region due to emigration, a process that has affected the Baltics and Bulgaria, countries that share currency boards and tight fiscal policies. In the long run, this will reduce the supply of skilled labor, affect economic growth, and eventually challenge public debt dynamics. In addition, Latvia has a high level of poverty despite its GDP per capita. Its 2015 Gini coefficient, which measures income inequality, was 35.4, one of the highest among European countries. 20 The government is taking steps to address this issue, for instance, with a Solidarity Tax in which Latvians earning above 52,400 will pay an additional surcharge, although the Constitutional Court has declared it partly unconstitutional and is at risk of being abolished by Need for Structural Reforms to Maintain Competitiveness One implication of using the euro is that Latvia is no longer able to use currency devaluation to restore competitiveness. In the past, Latvia s competitiveness was a function of competitive wages and productivity growth. However, wages are on a rising trend and therefore an increase in actual productivity is needed to remain competitive in the near future. The IMF indicates that this requires the government to embark on structural reforms in order to improve infrastructure to attract FDI, provide better access to ports to facilitate transportation and connectivity, or improve the electricity sector. 22 In the medium term, structural reforms to improve productivity and competitiveness will be needed to increase its income level

5 Latvia Country Background Size Capital Population 64,589 KM 2 (125th) Riga 2.0 Million Religion Lutheran 19.6%, Orthodox 15.3%, Other 65.1% Median Age 43.3 Years Literacy Rate 99.9% Independence 4 May 1990 Political System Government Leadership Next Election 2019 Legislative Branch Parliamentary Republic President Raimonds Vejonis, Prime Minister Maris Kucinskis Unicameral Parliament Economy Agriculture 3.2%, Industry 21.9%, Services 74.9% Labor Force Agriculture 7.7%, Industry 24.1%, Services 68.1% Merchandise Exports Export Partners Currency As of November 2017 Source: CIA Foodstuffs, Wood and Wood Products, Metals, Machinery and Equipment, Textiles Lithuania 17.3%, Estonia 11.5%, Russia 11.4%, Germany 6.8%, Sweden 5.7%, United Kingdom 5.3%, Poland 5%, Denmark 4.4% Euro (EUR) 211

6 Lazard Emerging Markets Debt Country Timeline 1991 During the attempted anti-gorbachev coup in Moscow, Omon force again strikes in Riga, causing another six deaths. Supreme Council declares full independence EU summit in Copenhagen formally invites Latvia to join in Latvia admitted to NATO and is one of 10 new states to join the EU International Monetary Fund (IMF) approves 1.68bn rescue package to help Latvia ride out severe economic slump The Central Bank spends almost a billion euros in 2009 to support the lat currency, prevent devaluation and avoid a domino effect elsewhere in Eastern Europe Latvia joins the eurozone. Laimdota Straujuma becomes prime minister. Source: BBC 212

7 Latvia Notes 1 December Flash Eurobarometer 405: The euro Area, TNS Political & Social, European Commission, October 2014, accessed 26 October 2015, accessed 24 October accessed 5 November Republic of Latvia Investor Presentation August 2017, Republic%20of%20Latvia-August.pdf accessed 24 October Press-Release-Staff-Report accessed 24 October IMF WEO Data, October Republic of Latvia Investor Presentation August Republic%20of%20Latvia-August.pdf accessed 24 October Doing Business: Latvia, DoingBusiness.org, World Bank Group, accessed November 1st 2017, Republic of Latvia Investor Presentation August Republic%20of%20Latvia-August.pdf accessed 24 October accessed 24 October Republic of Latvia: 2017 Article IV Consultation, International Monetary Fund, IMF Country Report No. 17/194, July 2017 accessed on 24 October Republic-of-Latvia-2017-Article-IV-Consultation-Press-Release-Staff-Report Republic of Latvia: 2016 Article IV Consultation, International Monetary Fund, IMF Country Report No. 16/17, June 2016 accessed on 5 November Republic of Latvia: 2015 Article IV Consultation, International Monetary Fund, IMF Country Report No. 15/110, May 2015, accessed on October 26, 2015, 15 Reformed bank eyes London for first Latvian IPO in decade, Business Recorder, 26 October 2015, accessed on 26 October 2015, 16 Republic of Latvia: 2015 Article IV Consultation, International Monetary Fund, IMF Country Report No. 15/110, May 2015, accessed on 26 October 2015, 17 Republic of Latvia: 2016 Article IV Consultation, International Monetary Fund, IMF Country Report No. 16/17, June 2016 accessed on 5 November Statement by Audun Groenn (IMF Executive Director for Latvia) regarding Article IV consultation, International Monetary Fund, IMF Country Report No. 14/115, 2 May 2014, pubs/ft/scr/2014/cr14115.pdf accessed 24 October OECD Income Distribution Database (IDD): Gini, poverty, income, Methods and Concepts, Accessed on 24 October Latvian court rules tax on high salaries partly unconstitutional, accessed 24 October Latvia: IMF Article IV Consultation, International Monetary Fund, IMF Country Report No. 14/115, May 2014, 23 Republic of Latvia: 2016 Article IV Consultation, International Monetary Fund, IMF Country Report No. 16/17, June 2016 accessed on 5 November

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