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      FRIDAY, 04/10/2019 - Scope Ratings GmbH
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      Scope affirms Lithuania’s credit rating at A- and revises the Outlook to Positive

      Sustained economic and fiscal performance drive the Outlook change. Adverse demographics, low productivity growth and external vulnerabilities remain rating constraints.

      For the rating action annex, click here.

      Scope Ratings GmbH has today affirmed the Republic of Lithuania’s long-term issuer and senior unsecured ratings at A- in local- and foreign-currency and revised the Outlook to Positive, from Stable. The short-term issuer rating has been affirmed at S-1 in both local and foreign currency with a Stable Outlook.

      Rating drivers

      The revision of the Outlook on Lithuania’s A- long-term ratings to Positive reflects: i) sustained robust economic performance, reflecting proactive macroeconomic policies and high-absorption of EU structural funds; and ii) a prudent fiscal stance with declining debt levels, supported by the strengthening of the fiscal framework. The Positive Outlook indicates Scope assessment that upside potential to the ratings from better-than-expected economic and fiscal outcomes outweighs challenges rooted in the shrinking labour force, weak productivity gains and external vulnerabilities. The Outlook revision reflects improvements in the assessment of the ‘domestic economic risk’ and ‘public finance risk’ categories under Scope’s sovereign rating methodology.

      The first driver of the Positive Outlook is Lithuania’s sustained robust economic growth. Lithuania’s real growth has been faster than expected, averaging 3.8% in 2017-18 above its growth potential and remained strong at 4% YoY over the first half of 2019. This has been mainly a result of solid private sector demand supported by i) rising wage and employment levels, and the personal income tax (PIT) reform; ii) a high absorption rate of EU structural funds (at a cumulative 40.5% as of September 2019, the second highest such ratio among Central and Eastern European economies) and iii) still robust export performance. The PIT reform, which came into effect in January 2019, introduced progressive taxation, increased the tax-exempt income threshold, raised PIT rates and reduced social security contributions. The reform’s net negative budgetary impact is estimated by the European Commission (EC) at 1% of GDP in 2019, which could be offset by the combined effect from the government’s recent progress in enhancing tax compliance alongside higher tax revenues from stronger-than-expected economic performance.

      The second driver for the Outlook change reflects Lithuania’s prudent fiscal stance, supported by ongoing strengthening of its fiscal framework. Since 2018, Lithuania has required that all budgets of large municipalities be at least balanced in structural terms. Budget planning has improved and now includes expenditure ceilings and targets to be achieved over the next three years. The government plans to strengthen the medium-term budget framework and the monitoring of national fiscal rules, including incorporating expenditure justification and spending reviews from the 2021 budget on. Bolstered by recent strong economic performance, this has led to steady improvements in the headline budget balance from a deficit of 3.1% in 2012, to a surplus of 0.7% of GDP in 2018. According to the Stability Programme for 2018-22, the budgetary position is set to remain in a small surplus throughout the programme period, reflecting moderate growth forecast assumptions alongside the tax reform, despite higher social security spending and public sector wage increases. The EC expects Lithuania to remain compliant with the Stability and Growth Pact’s medium-term budgetary objective of a structural balance of -1% of GDP in both 2019 and 2020.

      The Positive Outlook is also underpinned by a falling government debt-to-GDP ratio, which remains well under the EU’s 60% reference value, at 34.1% as of Q1 2019. The moderate increase in the ratio projected for 2019 owes to plans to secure pre-financing at currently very low interest rates for debt redemption in upcoming years. The Stability Programme projects a gradual reduction in the ratio to 32.9% of GDP by 2022. Contingent liabilities arising from government guarantees and liabilities of government-controlled entities outside of the government sector are among the lowest in the EU, at 7.8% of GDP as of 2017.

      Lithuania has required the participation in second-pillar pension funds for persons under 40 since July 2019. According to the reform, employees will contribute 3% of their wages to the pension accumulation scheme, while an additional 1.5% of the country’s average wage level will be paid in by the government. This reform will support the pension scheme’s sustainability and somewhat improve the low level of pensions (Lithuania’s pre-retirement-income replacement ratio through pensions is the fifth lowest in the EU, at just 45% in 2016).

      Despite these credit strengths, Lithuania continues to face a number of medium- to long-term challenges. The IMF estimates a gradual reduction in Lithuania’s potential growth, from the current 3% to 1.4% under a baseline scenario (and to 2.4% under an optimistic scenario) by 2030, reflecting adverse demographic projections and weak productivity growth. The old-age dependency ratio (i.e. the population aged 65 and over as a percentage of those aged 15-64) is projected by the EC to increase from 29% in 2016 to 46.4% by 2030 – the highest such increase among EU countries – driven by population ageing and emigration. More recently though, net emigration has been moderating, from 28,000 persons per annum in 2017 to just 3,000 persons by 2018.

      Since 2013, productivity growth has significantly lagged behind growth in real wages. This is the result of low private expenditure on R&D (at 0.3% of GDP in 2017, well under the EU average of 1.4%) and higher wage growth owing to a tight labour market, with the employment rate at an all-time high of 73.3% as of Q1 2019, above the EU average of 69.2%. A prolongation of this trend could damage the international competitiveness of domestic producers. Acknowledging this, authorities have adopted measures to improve the education, and research and innovation systems, the efficiency of public investment projects and the performance of the healthcare system. Progress in implementing these reforms, however, has been limited to date as highlighted by the EC.

      Lithuania’s net international investment position has continued to improve, by around 14 percentage points over the last two years to -28% of GDP in Q1 2019. This was driven by current account surpluses reflecting strong services trade, and valuation changes. The country also managed to recover market share in world goods exports over the past five years. Regarding energy sources, Lithuania continues to reduce its reliance on Russia and diversify domestic sources through EU financial support: several short- to medium-term projects are underway, including the connection of the Baltic States’ and continental Europe’s electricity and gas networks and the construction of infrastructure for renewable energy.

      At the same time, Lithuania’s small, open economy remains vulnerable to external shocks and is reliant on external demand, reflected in a very large export sector (in goods and services) relative to the size of the economy, at 83% in 2018. With EU countries being the destination for around two-thirds of total exports, a deeper slowdown in the EU could adversely impact the country’s economic performance. Furthermore, the EU’s Mobility Package, aimed at reforming EU transport rules, proposes, among other things, the regular return of drivers to their home countries to offer rest and better working conditions. If approved without amendments, this would reduce the flexibility of drivers and have direct and indirect negative impacts, however, on Lithuania’s transport sector. Exports of transport services to the EU accounted for 12% of the country’s total exports in 2018.

      As external demand weakens and the labour market tightens, Lithuania’s growth is set to moderate to an average of 2.4% over 2020-21 from projected 3.7% in 2019. Growth will continue to benefit from the high take-up of EU funds: allocated funds to Lithuania for 2014-20 are among the highest in the EU relative to the size of the economy, at 18.7% of Lithuania’s 2018 GDP. EU funds contribute to, among other areas, strategic infrastructure projects. Still, looking ahead, the EC is proposing to reduce Lithuania’s EU fund allocation for 2021-27 by around 20% compared to that over 2014-20. This proposal accounts for the UK’s planned EU exit, and also reflects Lithuania’s ongoing income convergence to the EU average as well as proposed new criteria for EU fund allocations. Scope expects the EC’s proposal for the 2021-27 EU budget to be amended, however, in upcoming negotiations between the European Council and the European Parliament, which could result in a meaningful change in the fund allocation to Lithuania.

      Finally, Lithuania’s banking sector is exposed to concentration risks and spill-over from changes in market conditions and risks from high household debt in Sweden. Two Swedish banks, Swedbank – which is undergoing investigations by US, Swedish and Baltic regulators regarding large amounts of alleged “high-risk, non-resident” money that flowed through Swedbank’s Estonian branch – and SEB, account for 61% of bank assets in Lithuania; a further 24% of bank assets is held at Luminor Bank, an entity currently under restructuring and which arose from a merger between Norway’s DNB and Finland’s Nordea, with Blackstone set to acquire a majority share. These risks are mitigated by the high level of capitalisation and asset quality of Lithuania’s banking sector. As of Q1 2019, the system-wide tier 1 capital ratio in Lithuania was 19.5% of risk-weighted assets and the non-performing loan ratio was close to 2%, both better than the euro area average.

      Lithuania’s small share of non-resident deposits (3% of total deposits as of June 2019) curbs cross-border money-laundering risks. However, the materialisation of money-laundering risks in Latvia and Estonia still pose some indirect reputational and financial stability risks for Lithuania, given the structural similarities of banking system assets. Moreover, the swift expansion of fintech, while benefitting the quality of financial infrastructure, also brings new challenges for anti-money-laundering supervision.

      Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

      The rating committee reviewed Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals and assigned an indicative ‘A’ (‘a’) rating range for the Republic of Lithuania. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

      For Lithuania, the following relative credit strength is identified: i) debt sustainability. The following relative credit weaknesses are identified: i) growth potential of the economy; ii) macro-economic stability and sustainability; iii) vulnerability to short-term external shocks; iv) geopolitical risk; and v) financial imbalances and financial fragility.

      The combined relative credit strengths and weaknesses generate a one-notch downward adjustment and indicate a sovereign rating of A- for Lithuania.

      A rating committee has discussed and confirmed these results.

      Factoring of Environment, Social and Governance (ESG)

      Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, under which Lithuania has above-average performance among Central and Eastern European countries as assessed by the World Bank’s Worldwide Governance Indicators.

      According to the EC, Lithuania’s performance across key social dimensions is mixed. This is reflected in the country’s relatively low rates of unemployment, above-EU-average levels of poverty (although levels are declining), and relatively high regional disparities. The research and innovation system remains fragmented with only limited progress in improving policy coordination. The EC’s Digital Economy and Society Index 2019, which assesses EU members states’ digital competitiveness, ranks Lithuania as average at 14th. Lithuania ranks 40th among the 193 countries in the United Nations’ E-Government Survey 2018, which measures effectiveness in the delivery of public services via information and communication technologies. Lithuania plans to increase the share of renewable energy sources in its final energy consumption to 38% by 2025, supported by EU-financed installations for renewable energy with an overall budget of EUR 385mn.

      Outlook and rating-change drivers

      The Positive Outlook on Lithuania’s A- ratings reflects Scope’s view that risks to the ratings are tilted to the upside over the next 12 to 18 months.

      The ratings could be upgraded if, individually or collectively: i) the continued implementation of structural reforms, such as labour market, innovation and educational reforms, and infrastructural advancements, improves Lithuania’s growth potential; ii) the implementation of the budget framework reforms strengthens the fiscal rule and tax base; and/or iii) Lithuania’s external resilience is materially improved.

      Conversely, the Outlook could be returned to Stable if, individually or collectively: i) public finances deteriorate due to a loosening of the government’s commitment to fiscal discipline; ii) lower-than-expected absorption of EU funds and/or high wage-productivity disparities worsen Lithuania’s competitiveness and growth outlook; iii) financial stability concerns increase due to amplified risks in the banking sector; and/or iv) heightened geopolitical risks undermine Lithuania’s growth and investment outlook.

      Rating committee
      The main points discussed by the rating committee were: i) Lithuania’s growth outlook; ii) demographics, labour market and productivity developments; iii) amendments in the fiscal framework; iv) fiscal performance and debt sustainability; v) banking sector developments; vi) external sector developments; and vii) peers.

      Methodology
      The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
      Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.
      The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months.

      Solicitation, key sources and quality of information
      The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
      The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: Statistics Lithuania, Bank of Lithuania, Ministry of Finance of Lithuania, the European Commission, the European Central Bank (ECB), the Statistical Office of the European Communities (Eurostat), the IMF, the OECD, the BIS and Haver Analytics.
      Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
      Prior to the issuance of the rating, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

      Regulatory disclosures
      This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
      Lead analyst: Levon Kameryan, Analyst
      Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
      The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 27 October 2017.

      Potential conflicts
      Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

      Conditions of use / exclusion of liability
      © 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5, D-10785 Berlin.

      Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Directors: Torsten Hinrichs and Guillaume Jolivet.

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