The credit rating agency Standard & Poor's on Friday affirmed its 'BB' long-term and 'B' short-term foreign and local currency sovereign credit ratings on Croatia. The outlook remained negative.
The agency said in a statement that Croatia's six-year-long recession has ended, but growth in 2016 will be relatively weak and mainly dependent on external factors. "Public finances remain in poor shape and reform planning hasn't yet started because the government has not been finalized since the election in November 2015."
"We remain concerned about Croatia's public finances because the deficit has not been contained and general government debt as a share of GDP continues to increase. A period of uncertainty followed the November 2015 parliamentary election, since neither the Croatian Democratic Union (HDZ) nor the Social Democratic Party was able to secure a majority; and a third party, MOST, emerged. Following weeks of negotiations, a non-partisan prime minister designate, Tihomir Oreskovic, has been tasked with forming a new government, which will likely consist of the centre-right HDZ and MOST. As the new government takes shape, its reform priorities and the speed at which it addresses them will be crucial factors, in our view," S&P said.
"We continue to see a risk that the policy response and the momentum of reform could be insufficient to reverse the upward trajectory of debt. This, in turn, would cast further doubts on the ability of Croatia's political institutions to implement effective policies that would deliver sustainable public finances and promote balanced economic growth. Our affirmation of the ratings rests on the assumption that HDZ and MOST will form a coalition government by the end of January," it added.
"The ratings are constrained by Croatia's weak growth prospects and the public sector's dominant and inefficient role in the economy, due to a backlog of unimplemented structural and fiscal reforms. In addition, high and increasing public-sector debt, partly owing to loss-making state-owned enterprises, jeopardizes the long-term sustainability of Croatia's public finances. The ratings are supported by slightly decreasing external debt because of deleveraging in the financial sector, which somewhat offsets that of the public sector, which is mounting."
The agency believes that Croatia's institutional framework benefited from EU membership, particularly because of the EU's deficit monitoring function through its Excessive Deficit Procedure (EDP). "However, we have seen little progress in terms of fiscal consolidation in Croatia since the beginning of the EDP in 2013, and we think there's a high likelihood that Croatia will not meet its EDP deficit correction deadline in 2016."
Acknowledging that economic growth had picked up, S&P revised its 2015 growth forecast for Croatia to 0.9%, compared with 0.2% in July 2015. It said that Croatia's recovery last year was underpinned by a small rebound in consumption, supported by changes to the personal income tax system, low inflation, and rising employment.
"In addition, positive net exports--helped by continued recovery in the eurozone--and a strong tourism season supported growth. Nevertheless, we expect growth to remain relatively weak over 2016-2019 at an average of 1.4%, thereby lagging that of peers with similar income levels," the statement said. "However, we continue to see downside risks to our GDP forecast, for instance, if the recovery in the eurozone, Croatia's main trading partner, were to falter. At the same time, deleveraging pressures in all sectors persist and may increase the drag on investments," it added.
"Croatia's institutions have so far been unable to effectively respond to the mounting economic and fiscal challenges. After weeks of political uncertainty, a prime minister designate has been appointed and formation of the government is underway. We anticipate that the new government will be formed this month and will aim to address structural issues to improve Croatia's competitiveness while containing the fiscal deficit. In that regard, presenting a credible 2016 budget will be an important first step, in our view."
S&P does not expect Croatia will meet its target for EDP exit in 2016, but that the budget deficit could decline gradually toward the 3% EDP target beyond 2018. "In 2015, slow reform momentum regarding state-owned enterprises and pre-election measures--such as changes to personal income tax rates and debt relief for the very poor--will have likely left the deficit unchanged at over 5% of GDP, where it has been since 2009. Croatia's future consolidation path will depend on the new government's fiscal plans."
The agency estimates that net general government debt will increase to 83% by 2018. "Contingent liabilities, in particular, resulting from the vulnerable financial situation of state-owned enterprises, could increase this ratio, although much of Croatia's quasi government debt is included in general government debt under the European System of Accounts' 2010 framework. In addition, foreign currency debt currently represents 73% of general government debt, making Croatia sensitive to changes in global monetary conditions and sentiment, which could push up interest rates and result in higher debt-servicing costs."
"However, Croatia's external accounts are improving, and we expect the current account to remain in surplus at least until 2018. We estimate a current account surplus of 0.8% of GDP in 2015, aided by lower oil prices and stronger growth, particularly from tourism," the statement said.
"In September 2015, the government enacted legislation to enable borrowers to convert Swiss-franc-denominated mortgage loans into euro- or kuna-denominated loans. Conversion is mandatory for banks on the borrower's request. We expect this step will significantly hamper Croatian banks' profitability in the coming years, and banks have already reported losses of Croatian kuna (HRK) 7 billion (about €1 billion) to HRK8 billion in 2015. Nonperforming loans remain high at about 17% of total loans, but conversion of Swiss-franc-denominated mortgage loans into euro and kuna should help stabilize this ratio," the agency noted.
"The negative outlook continues to reflect our view that there is at least a one-in-three possibility that we could lower our ratings on Croatia in the next 6-12 months," S&P said.
"We could lower the ratings if government policies do not robustly counter Croatia's entrenched fiscal and economic hurdles after the new government is formed, which we expect will take place this month. In addition, we could lower the ratings if we considered that the Croatian National Bank's effectiveness or credibility was being undermined if increased euroization weakens its policy transmission mechanism. On the other hand, meaningful progress in addressing key structural economic and budgetary challenges could lead us to revise the outlook to stable, as would an increasingly substantial and sustained return to economic growth," the agency concluded.
Croatia's 'BB' foreign currency rating maintained by S&P is two notches below the investment level. The same rating, with a negative outlook, is maintained by Fitch agency, while Moody's keeps Croatia's rating one notch below the investment level, also with a negative outlook.