Fitch Ratings has affirmed Estonia’s Long-term foreign and local currency Issuer Default Ratings (IDR) at ‘A+’. The Outlooks are Stable. The Country Ceiling has been affirmed at ‘AAA’ and the Short-term foreign currency IDR at ‘F1’.KEY RATING DRIVERSEstonia’s ratings are underpinned by a strong sovereign balance sheet with very low debt, high governance indicators compared with rating peers, and a sound economic policy framework.Public finances are a key rating strength. Estonia’s government debt to GDP ratio stood at 10.5% of GDP in 2Q14 – the lowest by far in the European Union. Around a quarter of the overall debt stock is accounted for by European Financial Stability Facility (EFSF) guarantees. Estonia is one of only six OECD countries with a public sector net asset position.The general government deficit was 0.3% of GDP in 2Q14. Fitch expects the deficit for 2014 as a whole to be 0.5% of GDP, and to remain broadly stable over the forecast horizon. The debt to GDP ratio is forecast to edge back to 10.3% by2016.Data revisions have improved the recent macroeconomic picture. Real GDP growth for 2013 is now estimated to have been 1.6% (up from 0.8% in the previous review). We expect GDP growth for 2014 to be around 2%, before picking up to 2.4% next year and 2.8% in 2016. Domestic demand will be the main driver of growth over the coming years.Falling import prices will lead to an improvement in the current account balance, with deficits of 0.8% of GDP forecast over the forecast horizon (compared with 1.4% in 2013). Estonia’s external debt sustainability has improved substantially over the past four years, thanks to falling banking sector reserve requirements following euro accession. Net external debt is estimated to be around -3.5% of GDP.Our projections imply that the process of convergence of Estonian incomes with the eurozone average will continue. Incomes per head are slightly lower than the ‘A’ peer group median, but less than half of the ‘AA’ median.As a small, open economy, Estonia is vulnerable to adverse shocks affecting its main trading partners. GDP and inflation are much more volatile compared with rating peers. Russia is currently Estonia’s third-largest trading partner. Consequently, a key risk to economic prospects is a further disruption in trade and investment flows between Russia and Western countries.Current demographic trends are another rating weakness. Both the total and the working-age population are shrinking. This creates pressures on wages in the short term. In the longer term, relatively larger decreases in the working-age population would raise the dependency ratio and exert downward pressure on potential growth, unless productivity improves.Estonian banks are well-capitalised. Asset quality has improved, with non-performing loans falling back to 1.3% of total loans in 2Q14, down from 2.1% a year earlier. The Estonian central bank recently announced limitations on housing loans to limit the risks from excessive household borrowing.RATING SENSITIVITIESThe Stable Outlook reflects Fitch’s assessment that upside and downside risks are currently broadly balanced. However, future developments that could, individually or collectively, result in a positive rating action include:-Economic growth picking up in line with the economy’s potential growth rate without creating or exacerbating significant imbalances.-A narrowing of the gap in incomes per head between Estonia and the ‘AA’ peer group median.Future developments that could, individually or collectively, lead to a negative rating action include:-Severe economic or financial shocks affecting Estonia’s main trading partners spilling over to the domestic economy.-Further sharp rises in wages unaccompanied by productivity improvements, leading to a deterioration of the economy’s competitiveness and a widening current account deficit.KEY ASSUMPTIONSFitch assumes the eurozone will avoid long-lasting deflation, such as that experienced by Japan from the 1990s. Fitch also assumes the gradual progress in deepening fiscal and financial integration at the eurozone level will continue; key macroeconomic imbalances within the currency union will be slowly unwound; and eurozone governments will tighten fiscal policy over the medium term.Fitch assumes that potential further escalations in geo-political tensions between Russia and Western countries do not affect Estonia over and above what is already assumed in our forecasts.
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