In its latest rating update, international credit rating agency Fitch affirmed Estonia's Long-Term Foreign-Currency Issuer Default Rating (IDR) to A+ with a stable outlook.
Estonia's A+ ratings reflect strong governance standards and institutions underpinned by EU and euro area membership, low – albeit rising – public debt and a net external creditor position, Fitch said in its report.
These are balanced by slightly lower income per capita relative to peers as well as the economy's small size, which exposes it to shocks, it added.
Estonia's economy has contracted for seven consecutive quarters in real terms, and is expected to continue declining in 2024 as well, "making Estonia the only Fitch-rated sovereign to post three consecutive years of negative growth over 2022-2024," it noted.
"This reflects a series of shocks to consumption, investment and net trade stemming from sanctions against Russia and Belarus, weakness of the Nordic construction and real estate sectors, appreciation of the euro against the Norwegian and Swedish currencies and the earlier distortion to domestic consumption from pillar two pension withdrawals," Fitch detailed. "Reported real GDP numbers may be understated due to a potential overestimation of GDP deflators."
While near-term prospects are weak, Estonia's economy is expected to start seeing a gradual recovery in the second half of this year before gaining traction in 2025, when the credit rating agency forecasts real GDP growth of 3.1 percent.
Growth in real wages and recovering sentiment should support private consumption, it continued, while funding costs and the economic recovery should lift investment, and the revival in export markets will support net trade.
"In Fitch's view, it is still too early to disentangle cyclical and structural effects on potential growth, but we believe risks to medium-term growth are mostly tilted to the downside," it noted.
Higher social transfer and public sector wages as well as weak revenues pushed the general government deficit to 2 percent of GDP in the first 11 months of 2023. As spending tends to peak in December, Fitch therefore estimates a deficit of 2.7 percent, below the revised target of 3.3 percent introduced by the government that took office last spring.
Although low relative to peers, this is the highest this deficit has been in over 20 years, excluding the COVID-19 pandemic-affected 2020, "and in Fitch's view reflects the structural loosening of a historically tight fiscal stance."
The agency expects the general budget deficit to narrow to 2.6 percent of GDP this year, however, reflecting hikes to the VAT, corporate income tax, gambling taxes and excise duties combined with a partial reversal of a previous increase in child benefits, balanced against revenue underperformance given the optimistic macro projections underpinning the budget.
"We expect a widening of the deficit to 3.5 percent in 2025," it continued. "Personal income tax will be increased by two percentage points in 2025, but an increase in the tax threshold means this will be net negative for the budget, and defense spending will be raised to 3 percent. Offsetting measures have yet to be legislated, and the largest, a yet undefined 'security tax,' is politically unpopular."
Fitch projects Estonia's debt-to-GDP ratio to increase from an estimated 20.4 percent at the end of 2023 to 24.6 percent at the end of 2025. It noted, however, that this remains very low relative to peers.
Inflation has also normalized, easing across all major subcomponents of the inflation basket, and is forecast to average 3.5 percent in 2024 and further fall to 2.4 percent in 2025, down from 9.1 percent overall last year, 18.6 percent in January 2023 and a peak of 24.8 percent in August 2022.
According to the credit rating agency, factors that could negatively impact Estonia's rating include a significant and persistent increase in general government debt to GDP, for example, or a structural deterioration in medium-term growth prospects reflecting clear evidence of a weakening in competitiveness.
On the other hand, factors that could positively impact the country's rating include a fiscal stance consistent with placing the debt-to-GDP ratio on a firm downward path over the medium term, potentially reflecting additional consolidation measures and stronger prospects for revenues, or higher medium-term growth supported by policies that don't lead to macro, fiscal and external imbalances.
Click here to read Fitch's latest report on Estonia in full.
Editor: Aili Vahtla