The outlook remains 'stable', according to Fitch, which had previously rated Estonia at AA-.

Debt to GDP ratio over double 2018's figure

The downgrade mostly relates to a deterioration in public finances, in a situation where general government debt is forecast to rise to 21.1 percent of GDP at the end of 2023 and remain on an upward path in the medium term, despite fiscal consolidation measures introduced in June, Fitch said.

The debt to GDP ratio is more than double the level when Fitch upgraded Estonia to AA- in 2018.

A loosening of the historically tight fiscal stance, aggravated by the war in Ukraine and the Covid pandemic, are related background developments.

Tax and VAT hikes

Discomfort over the debt trajectory at a time of rising financing costs saw the Reform-Eesti 200-SDE government, which entered office in April, introduce a package of consolidation measures to come into effect mostly from the start of 2024.

Fitch cites the most significant of these being the 2-percentage point VAT hike.

Rises in corporate income tax, gambling taxes and excise duties and the part-reversal of the child benefit increases are also significant.

Fitch forecasts 3.6 percent GDP growth for Estonia in 2023

Fitch forecasts a deficit of 3.6 percent of GDP this year, reflecting the strong performance over the first five months and expenditure restraint by the new government.

The deficit should then narrow to 2.6 percent in 2024 and 2 percent in 2025, due to the new revenue-raising measures, Fitch says.

Fitch forecasts debt: GDP to rise to 23.1 percent by year-end 2025 from 18.4 percent at year-end 2022 and the agency's debt dynamics show a continued gradual increase to 25.1 percent by the end of 2027.

Economy affected by Russia, Belarus sanctions and weak Nordic real estate sector

Real GDP growth has remained weak, Fitch notes, and the Estonian economy is being hit by the sanctions on Russia and Belarus, which have disrupted supply chains for some industries.

The weakness of the Nordic real estate sector, as a major market for Estonian manufacturing, has also made its effects known.

Growth should pick up later this year, Fitch says, as real wages return to positive values, although a likely rebuilding of household savings may slow this up.

All in all, Fitch says it expects the Estonian economy to contract by 1.6 percent this year.

In Fitch's opinion, it is too early to determine whether there has been structural damage to Estonia's competitiveness, partly due to the intertwined nature of the two shocks the economy is facing, Fitch says.

Inflation falling

Fitch notes that Inflation has fallen and was 9.2 percent in June, from a peak of 25.2 percent in August 2022, largely due to falling energy prices. Food prices are now the main source of inflation and should decline in line with lower commodity prices, although the pass-through has been slower than usual.

Fitch forecasts inflation to fall to around 5 percent at year-end and average 9.7 percent, above the 'A' median of 6.2 percent.

The planned tax hikes could add around 2 percentage points to inflation in 2024, when we forecast it to average 4.3 percent, Fitch reports.

Average inflation is expected to ease further, to 3.1 percent in 2025. The shock to inflation does not appear to have un-anchored long-term inflation expectations, Fitch says.

Strong banking sector

The largely foreign-owned banking sector is in a strong position, and is well capitalized, Fitch adds. Non-performing loans have stayed on a downward trend and were 0.8 percent at the close of April 2023.

Banks have not reported any impact from higher interest rates on the servicing of their mortgage portfolios, even though virtually all mortgages are floating rate, as they are stressed well above current interest rates at origination.

Strong ESG political stability, human rights scores

Estonia has an Environmental, social, and governance (ESG) Relevance Score of 5[+] for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, Fitch notes

Estonia has a high World Bank Governance Indicator (WBGI) ranking at 87th percentile, reflecting its long track record of stable and peaceful political transitions, well established rights for participation in political processes, strong institutional capacity, and effective rule of law and a low level of corruption, Fitch goes on.

According to Fitch, Estonia has an ESG Relevance Score of 4[+] in respect of Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As Estonia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

The full Fitch report is here.

Finance minister: Tax amendments should reduce budget deficit 

Commenting on the Fitch report, Finance Minister Mart Võrklaev said: "Fitch's decision to downgrade Estonia's rating means that financing the budget deficit via a loan may become more expensive than it had been."

"Assuming we don't want higher interest rate payments, we will need to work harder to reduce the deficit and slow up the growth of the debt burden," the minister went on, via a press release.

"For this reason we introduced a number of tax changes and we are actively looking for savings in the state sector as well.

"Negotiations for next year's state budget are about to commence, and the ministries have presented us with proposals for savings in their own areas of responsibility. We cannot submit any additional requests," Võrklaev concluded.

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