By Nick Mann | 10 September 2012

Higher-than-expected tax revenues and lower interest and social welfare payments mean Latvia will record a smaller budget deficit than previously forecast this year, Fitch Ratings said on Friday.

The ratings agency had expected the Baltic state to post a deficit of 2.5% of gross domestic product. But the tax and welfare changes, combined with strong macroeconomic performance, means it now forecasts the deficit will be 2% this year before falling to 0.8% in 2014.

Latvia recorded 5.5% year-on-year growth in 2011, and growth has continued to outperform expectations so far in 2012. Fitch says stronger domestic consumption and investment, created by a fall in unemployment and more efficient use of European Union funds, means the Latvian economy is now likely to grow by 3.5% this year, compared with the previous forecast of 2.5%.

But the agency warns that Latvia’s economy remains vulnerable to weaker external demand, with exports of goods so far this year falling by over 20% compared with 2011.

Latvia also has a ‘heavy’ schedule of loans it needs to repay, mainly to the International Monetary Fund and European Commission. The government plans to raise $5bn on the international bond markets during 2013 and 2014 to pre-fund these repayments. Fitch said this approach was ‘ambitious but achievable’ for the triple B minus-rated country although it warns that it ‘could be put at risk by increases in market volatility’.

The high proportion of deposits in the country’s banking system by non-Latvian residents also represents a risk to the country’s stability if risk-averse depositors begin to withdraw their funds. But Fitch notes that Latvian banks remain profitable and solvent, with their capital ratio of 14.9% ‘far exceeding’ the 8% required by law.

‘Overall... the risks to creditworthiness have diminished since our review in late 2011. A continuation of positive fiscal and macroeconomic trends could lead to a positive rating action,’ it adds.