Latvia SEB MERCHANT BANKING COUNTRY RISK ANALYSIS 18 June 2012

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1 Latvia SEB MERCHANT BANKING COUNTRY RISK ANALYSIS 18 June 1 Analyst: Per A. Hammarlund. Tel: +() per.hammarlund@seb.se Strengths Country Risk Factors: Latvia Weaknesses Recovering GDP growth High unemployment/low GDP per capita Strong fiscal discipline Inflexible monetary policy framework Strong FDI Shrinking population Small current account deficit Lingering banking sector weakness High external debt Relatively poor governance record Summary: Latvia has staged a remarkable recovery since the 8 crisis, growing by.9% y/y in Q1 1 and aiming to qualify by January 1 for euro entry in 1. Public finances have stabilised, unemployment has fallen, and the current account posted only a small deficit in 11, which was more than covered by net FDI of.% of GDP. The economy has so far been largely insulated from the euro-zone crisis due to low direct exposure to the peripherals. Yet, the risk of contagion from a potential full-scale bailout of Spain is rising, which could cause Latvia s growth to falter and banks asset quality to deteriorate. Country Risk Analysis The economy will likely continue to grow, albeit at a slower pace. Real GDP expanded by.% in 11 after three years of contraction. Given the sharp fall in GDP by a cumulative %in 8 through 1, the rebound is somewhat disappointing. Nevertheless, with the exception of government consumption, the expansion has been broad GDP Growth & Unemployment Real GDP [c.o.p quarters] Unemployment, Rate, Total based, with investment being the main driver of growth. Although growth accelerated to.9% y/y in the first quarter of 1, we see substantial downside risk to the outlook emanating from a worse than expected downturn in the euro zone. Export growth has important your attention is drawn to the statement on the back cover of this report which affects your rights.

2 SEB Merchant Banking Country Risk Analysis: Latvia 18 June 1 plunged to.7% in April 1 (the lowest since January 1) from 1.7% in February. We now see growth averaging around % in 1. Exports, investment, and private consumption growth in Latvia look likely to moderate in the second half of 1, due to economic weakness and uncertainty in the euro zone, as well as doubts about how fast China will grow. In addition, the decline in the population by a rate of around.8% per year weighs on the long-term GDP growth outlook. The outlook for inflation has moderated since the beginning of the year primarily because of moderating energy and commodity prices. Nevertheless, as a result of geopolitical risk in the Middle East and expected strong demand growth from the BRIC, we expect the fall in oil and commodity prices to be moderate. Inflation in Latvia looks likely to be lower than last year s.% (on expectations of low private consumption growth and a cut in the VAT), but with year-on-year inflation averaging almost % in the first five months of 1, the.%-.% target range could be out of range, thus jeopardising entry into the euro area by 1. The fiscal deficit looks unlikely to hinder Latvia from adopting the euro by 1. The government is targeting a budget deficit of.% in 1, which currently looks realistic against the background of the government s track record of fiscal discipline. In addition, the fiscal deficit in the first four months of 1 has been cut by 9% compared to the same period in the previous year. The government is planning to offset a cut in the VAT with increases in other taxes and by bringing forward an increase in the retirement age. However, the ultimate effect of these measures is uncertain. Nevertheless, the government has reiterated its commitment to meeting the criteria and will likely not shrink from taking unpopular measures to achieve this goal if the economy slows more than expected. The government debt level at less than % of GDP is well below the Maastricht criteria. LVL (millions) Inflation Harmonized Consumer Prices, Total [c.o.p 1 months] Harmonized Consumer Prices, Total [c.o.p 1 month] General Government Finances Budget balance, LVL (LHS) [ma ] Expenditure, total, LVL (RHS) [ma ] Revenue, total, LVL (RHS) [ma ] Government debt issuance has been successful in 1. The government issued US$1 billion worth of -year Eurobonds on February 1 at a yield of.7% according to Bloomberg. It has also issued -year local currency bonds. The yield on benchmark 1-year LVL (millions)

3 SEB Merchant Banking Country Risk Analysis: Latvia 18 June 1 government bonds rose to.7% in March 1, but has fallen back to.%, as of June 1, revealing good investor sentiment despite rising concerns in the euro zone. External debt remains high. Gross external debt was 17% in 11, a third of which was short-term debt (or US$11. billion), mostly owed to Swedish parent banks. With gross foreign exchange reserves at a low US$. billion in May 1, Latvia remains vulnerable to changes in investor sentiment, rising risk aversion, as well as potential banking sector weakness in Europe, in particular in Sweden. The banking sector will have a challenging year. Credit is falling by a rate of more than 1% y/y (in March and April 1), which will prevent non-performing loans (NPLs) currently almost 1% from falling. Other risks in the banking system are the high share of foreign currency denominated loans at 8% of the total, banks short-term external debt at % of GDP, and a very high loan/deposit ratio at more than %. A key mitigating factor is the high share of foreign bank ownership at %. Latvia s institutional strength and corruption record is relatively weak. Latvia ranks in the top th percentile in the World Bank s governance indicators, close to Lithuania, but well below Estonia in the 1 th percentile. The World Economic Forum s 11-1 Global Competitiveness Index ranks Latvia in a low th place out of 1 countries, although that is an improvement by places on the previous report. ** ** Latvia: Risk Profile Key figures 1 Population (mil). GDP/capita ($) 1, Real GDP (% chg) 1.7 Inflation (%).7 Curr.Acc. Balance (% of GDP) -1. Chart Key: The farther from the centre, the less risk. Macro balance Resilience Liquidity Reserves/imports (months) Budget balance (% of GDP) -. Government debt (% of GDP) 1. Absence of Event Risk Latvia Information Average EM External ratings: Fitch: BBB- / Stable Moody's: Baa / Positive S&P: BBB- / Stable Peers: Hungary Estonia Lithuania Graph: Resilience to shocks stem from a favourable business climate, strong political institutions, and prudent fiscal and monetary policies. Economic volatility weigh on macro balance and event risk.

4 SEB Merchant Banking Country Risk Analysis: Latvia 18 June 1 LVL (millions) Current Account Balance of GDP Net Foreign Direct Investment ( of GDP) Goods Current Transfers Income Services Balance (RHS) Index Real Effective Exchange Rate Merchandise Trade REER Index deflated by CPI, 1999=1 REER Index deflated by ULC, 1999=1 Exports, Total, FOB [c.o.p 1 months] Imports, Total, CIF [c.o.p 1 months] 1 Unit Labour Cost and Productivity 1 Wages Index LVL Real unit labour cost, Index, =1 Real labour productivity per hour worked, =1 Public Sector, LVL [ma ] Private Sector, LVL [ma ] 8 - Bank Loans Total loans, LVL (LHS) [c.o.p 1 months] Loan-deposit ratio, % (RHS) Bond Yield & CDS Spread Ireland, CDS, Year, USD Latvia, CDS, -Year, EUR Latvia, Govt Benchmarks, 1-Year, Yield Basis point

5 SEB Merchant Banking Country Risk Analysis: Latvia 18 June 1 LATVIA: ECONOMIC INDICATORS* Table I: Macroeconomic Real GDP Growth (%) GDP, nominal (US$; Bil.; SA) Population, total (Mil) GDP per capita at PPP ( US$) 1,8 1,19 1,17 1,9 1, 1,7 1,9 GDP, per capita, nominal (US$; SA) 1,79 11,99 1,77 1,77 1, 1,18 1,89 Labour productivity growth (%) Unemployment rate (%) Total fixed investment (% of GDP) National savings (% of GDP) Table II: Money & Prices Consumer price index (% y/y) Money supply, M, Growth (%) Private sector credit growth (%) Interest rate, short-term (%) Minimum bid rate ECB (%) Exchange rate, average (Lat per US$) Real exchange rate index vs US$ ('9=1) Share price index (% chg) Table III: Government Finances Gross government debt (% of GDP) Gen. government debt (% of revenue) Government budget balance (% of GDP) Government expenditure (% of GDP) Interest expendit (% of Govt revenue) Year Govt Bond Yield (%) Table IV: Balance of Payments (US$; Bil.) Current account (% of GDP; SA) Current account Merchandise trade balance Exports, goods, nominal Imports, goods, nominal Services trade balance Transfers, net Interest, profit, and dividends, net Capital account Foreign direct investment, net Foreign direct investment, inward Non-FDI net capital flow Table V: External Debt & Liquidity External debt, total (% of GDP) External debt, total (% of exports) External debt, total (US$; Bil.) External debt, short-term (US$; Bil.) External debt, government (US$; Bil.) External debt, private (US$; Bil.) Debt service requirement (% of exports) Debt service requirement (US$; Bil.) Reserves, excl. gold (US$; Bil.) Reserves (months of import cover) * Source: Oxford Economics, Global Economic Model, May 1, unless otherwise indicated.

6 SEB Merchant Banking Country Risk Analysis: Latvia 18 June 1 Disclaimer Confidentiality Notice The information in this document has been compiled by SEB Merchant Banking, a division within Skandinaviska Enskilda Banken AB (publ) ( SEB ). Opinions contained in this report represent the bank s present opinion only and are subject to change without notice. All information contained in this report has been compiled in good faith from sources believed to be reliable. However, no representation or warranty, expressed or implied, is made with respect to the completeness or accuracy of its contents and the information is not to be relied upon as authoritative. Anyone considering taking actions based upon the content of this document is urged to base his or her investment decisions upon such investigations as he or she deems necessary. This document is being provided as information only, and no specific actions are being solicited as a result of it; to the extent permitted by law, no liability whatsoever is accepted for any direct or consequential loss arising from use of this document or its contents. SEB is a public company incorporated in Stockholm, Sweden, with limited liability. It is a participant at major Nordic and other European Regulated Markets and Multilateral Trading Facilities (as well as some non-european equivalent markets) for trading in financial instruments, such as markets operated by NASDAQ OMX, NYSE Euronext, London Stock Exchange, Deutsche Börse, Swiss Exchanges, Turquoise and Chi-X. SEB is authorized and regulated by Finansinspektionen in Sweden; it is authorized and subject to limited regulation by the Financial Services Authority for the conduct of designated investment business in the UK, and is subject to the provisions of relevant regulators in all other jurisdictions where SEB conducts operations. SEB Merchant Banking. All rights reserved.