Analytics, Baltic, Financial Services, Rating

Latvia's long-term foreign currency rating has been downgraded to "BBB" from "BBB+", whilst Latvia's long-term local currency rating has been downgraded to "BBB+" from "A-".

"The downgrade of the Baltic states reflects the risk that the deterioration in the European economic and financial environment will impose a more costly macroeconomic adjustment in the Baltic countries, given their large bank-financed current account deficits," Edward Parker, head of emerging Europe sovereigns at Fitch, said in a statement.

All three Baltic economies are in the top ten of those with the largest gap between outstanding bank credit and bank deposits relative to both GDP and total bank credit. Fitch has long highlighted substantial current account deficits (CADs) and external financing requirements, rapid bank credit growth and rising external debt ratios as rating weaknesses in the Baltic states.

The further deterioration in global and especially European financial conditions and the likelihood of recession in the euro area have heightened the risks for economies with large external financing needs and reliance on bank financing.

Strong public finances are a key support to sovereign creditworthiness and provide headroom for governments to help cushion the slowdown.

At end-2007, government debt was just 2.7% of GDP in Estonia, 9.7% in Latvia and 17.3% in Lithuania.

Relatively strong institutions and flexible economies should also help the adjustment. Nonetheless, with limited policy tools available to manage the adjustment given fixed exchange rate regimes – which Fitch expects to remain in place – and the dominance of large foreign-owned banks, the risk of a prolonged and deep recession cannot be wholly discounted, increasing the potential for adverse economic and fiscal shocks, Fitch said.