The A1 ratings takes into account geopolitical risk, which has increased since Russia's invasion of Ukraine (which itself Moody's rates at Ca, "stable") in 2022.

The affirmation of Estonia's A1 ratings is, Moody's says, supported by its very strong public finances, reflecting a long track-record of prudent fiscal management. Moody's expects this to continue, despite the modest rise in public debt, and the "robust" debt affordability.

Russia's war on Ukraine

Russia's invasion of Ukraine in 2022 has increased geopolitical risks for Estonia, and in Europe generally, Moody's says. This is particularly the case with the Eastern Flank nations, including Latvia (which Moody's has given an A3 "stable" rating), Lithuania, Poland (both A2 "stable") and Romania (Baa3, "stable").

In Moody's view these nations are particularly exposed. In addition to raising critical security questions, the war in Ukraine has had a significant impact on the European continent's economic activity and fiscal policy, accelerating inflation and prompting governments to implement support measures for households and corporates.

Estonia shares a land border with Russia, and its proximity to the war in this sense leads to a higher risk of adverse consequences in the event of an escalation, Moody's notes.

As with its Baltic neighbors, Estonia has a history of tense relations with Russia.

Against this backdrop, it is exposed to potential unconventional or hybrid forms of attack, such as cyberattacks, disinformation campaigns, sabotage operations or efforts to foment civil unrest, Moody's reports.

Around one quarter of Estonia's population is ethnically Russian which also raises the risk of heightened geopolitical tensions spilling over into increased domestic political risks, the agency says.

However, Moody's views the likelihood of the war in Ukraine spilling over into a conventional military conflict with a direct and material impact on Estonia to be low.

NATO and defense spending

Such risks are notably mitigated by the fact that Estonia benefits from full NATO security guarantees, under the alliance's mutual defense clause (Article 5).

NATO has also reinforced its international troop presence in Estonia and elsewhere in the region.

At the domestic level, the Estonian government's planned defense spending of 3.2 percent of GDP per annum for 2024 is well above NATO's 2 of GDP benchmark, which demonstrated Estonia's strong commitment to ensuring a high level of preparedness, Moody's says, and to bolstering its deterrence capacity to not only conventional threats, but also cyberattacks and hybrid warfare.

Moody's: Estonia's low levels of public debt noteworthy

Moody's also reports that Estonia's public finances are a key credit strength, reflecting low levels of public debt below 20 percent of GDP and very strong debt affordability.

Despite spending pressures stemming primarily from defense and security, Moody's says it expects Estonia's public finances to remain strong over the next three years as a comprehensive fiscal consolidation package is phased in and growth accelerates.

The A1 affirmation also considers Estonia's strong institutions and governance capacity, which helps to smooth external shocks to the small and open economy, the agency says.

Estonia benefits from a secure energy supply thanks to its forward-looking strategy and low dependence on foreign sources. Estonia's economic strength balances high income levels, a flexible economy and moderating trend growth, Moody's goes on.

At the same time, Estonia's small and open economy, with its attendant volatility, leaves it exposed to global developments, and a credit constraint.

Budget deficit

For 2023, Moody's estimates that the budget deficit reached 2.6 percent of GDP, taking into account the budget execution up to November. This corresponds to a wider deficit compared with the previous year (-1.0 percent of GDP) due to higher spending, including wage increases for public sector employees, higher defense spending and social benefits.

Previously, Estonia had narrowed its relatively wide pandemic-related deficit (-5.4 percent of GDP in 2020) rapidly, illustrating the sovereign's capacity to restore a sound budget position swiftly, the agency says.

Looking ahead, Moody's says it expects the deficit to reach 3.0 percent of GDP this year, and narrow to 2.4 percent of GDP in 2025, followed by a deficit of 2.0 percent of GDP in 2026.

This trajectory takes into account significant fiscal consolidation measures voted in the summer of 2023.

On the revenue side, Moody's incorporates in its new rating the impact of measures such as the hikes in VAT and corporate income tax rates, the hikes in excises and the gambling tax, as well as the uniform basic exemption on personal income tax.

In addition, Moody's notes the government's commitment to implement new consolidation measures in the 2025 budget.

The full Moody's report (login required) is available here.

Moody's Ratings is one of the "big three" credit agency scores, along with those from Standard & Poor's and Fitch Group.

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