Moody's Investors Service, a ratings agency, on Friday downgraded Croatia's long-term issuer and senior unsecured debtratings to Ba2 from Ba1 and maintained the negative outlook, explaining that the main rationales for the downgrade are a large and increasing public debt and weak medium-term growth prospects.

The government's large and increasing debt burden stood at around 86% of GDP at year-end 2015 and Moody's expects it will increase to above 90% by 2018. This significantly exceeds the Ba1 peer group median of around 45% of GDP and is unlikely to reverse much before the end of the decade, this ratings agency reported.

Croatia is faced with continuing weak medium-term economic growth prospects, which derive from historically low investment and structural rigidities, including a low labour force participation rate, as well as bottlenecks in the absorption of EU funds.

"Despite having recently emerged from recession, Moody's believes that Croatia's potential growth is below 1%, which is low for a converging economy and below other catching-up economies."

The negative outlook reflects Moody's view that the balance of risks at the Ba2 level is tilted towards the downside. Moody's expects the new government to face significant challenges in implementing a demanding reform agenda. 

"Croatia's long-term and short-term foreign-currency bond ceilings were lowered to Baa3/P-3 from Baa1/P-2, the long-term foreign-currency deposit ceiling was lowered to Ba3 from Ba2. The short-term foreign-currency deposit ceiling remains unchanged at Not Prime (NP). At the same time, the local-currency bond and deposit country ceilings were lowered to Baa1 from A3."

"Croatia's government debt is substantial at an estimated 86.5% of GDP at year-end 2015. This significantly exceeds the 45% median of Ba1-rated countries. Under Moody's baseline scenario, the debt burden will increase to above 90% of GDP by 2018 and will only fall slowly thereafter. At the current level and trajectory, the government debt burden is more consistent with a Ba2 rating."

Croatia entered the global financial crisis with a modest debt burden of around 39% of GDP in 2008. However, debt has risen rapidly in the last seven years, due to low nominal growth, high budget deficits, the assumption of state-owned enterprise debts, as well as costs related to restructuring state enterprises.

High budget deficits during the crisis reflected both revenue shortfalls and expenditure overruns. The deficit averaged 6% of GDP in 2009-2014, compared to 3.4% of GDP in 2001-08.

Moody's believes that the process of fiscal consolidation will be slow and halting, and expects a fiscal deficit of around 3.9% of GDP this year, weaker than the 3% of GDP criteria required to exit the European Union's (EU) excessive deficit procedure. This trend, combined with the anticipated modest levels of real economic growth, will likely push the debt burden above the 90% of GDP threshold by 2018. 

"The economy grew 1.6% in 2015, emerging from a six-year recession that reduced real GDP by 12.5% between 2008 and 2014. However, the economic recovery was principally driven by one-off factors, such as an exceptionally strong tourist season and a recovery in private consumption boosted by low oil prices and a reduction in the personal income tax, both of which increased real disposable incomes."

In 2016, the agency expects growth of around 1.5%.

As for the rationale for negative outlook it "reflects Moody's view that the balance of risks at the Ba2 level are tilted towards the downside. Moody's expects the new government to face significant challenges in implementing its reform agenda, which is designed to arrest the debt increase and to improve growth prospects."

"In particular, Moody's notes that the current coalition in parliament between the Patriotic Coalition (led by the Croatian Democratic Union, HDZ) and the newly-formed party MOST (which translated as "Bridge") holds only a slim majority, especially following the latter's loss of four MPs. The wide range of political views within the coalition and the relative inexperience of MOST's MPs at the central government level increase the risk that the new government will be unable to sustain majority support in parliament for economic and fiscal reforms. While the new government has popular support for reforms as MOST campaigned on a pro-reform platform, some of the proposed reforms (such as the rationalization of the public administration) already face resistance from different parts of the coalition."

Now, all three leading ratings agencies -- Moody's, Fitch and Standards&Poor's -- keep Croatia's rating two notches below the investment level with a negative outcome.

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