ZAGREB, September 22, 2018 - Standard&Poor's (S&P) has affirmed its 'BB+/B' long- and short-term local and foreign currency ratings on Croatia but it has revised its outlook on the country to positive from stable, owing to expectations that the country's economy will continue to grow and fiscal indicators will continue to improve.
"The positive outlook reflects our expectation that Croatia's economy will continue to expand and fiscal and debt metrics will strengthen further, while residual risks relating to Agrokor abate," the rating agency says.
S&P expects real GDP growth to reach 2.8% both in 2018 and 2019 and believes growth will stem from strong household consumption on the back of rising disposable incomes and exports, which continue to perform well, benefiting from another strong tourism season. "Although investment growth has been subdued recently, mainly due to decreased public investment and Agrokor-related capital expenditure (capex) reduction, we expect it will accelerate toward the end of the year and into 2019. "This will result from increasing withdrawals of EU funds and increasing public infrastructure investments (e.g. Pelješac bridge)...
"Importantly, the restructuring of Croatia's largest food retailer Agrokor has made significant progress, with the approval of the settlement deal by a large majority of the company's creditors reducing overall economic and political risks."
"However, tax changes will only partly offset the negative effect of labour shortages on Croatia's growth prospects. Unemployment is falling to below 10%, partly due to emigration but also due to a recent rise in employment. Thus, addressing labour shortages reported across many sectors, such as tourism and construction, is a key challenge, particularly as the remaining unemployment appears partly structural."
"In the long term, further educational and healthcare system reforms, rightsizing and improving efficiency of the state's role in the economy, and enhancing the business environment, could enable Croatia's real income to converge toward the EU average."
In 2017, Croatia posted the first general government surplus in its history, S&P says, adding that it expects another surplus of 0.2% of GDP in 2018. "According to budget execution thus far in 2018, revenue performance remains strong, particularly on value-added tax (VAT), supported by the consumption-driven economic upswing. Expenditures, especially on public sector wages, have remained contained."
S&P expects that in the period from 2018 to 2021, Croatia will return to posting small deficits, as accelerated pick-up of EU structural and cohesion funds push up capex, and further VAT cuts and social contribution scheme changes to inject funds into the health sector are implemented.
"The recent fiscal performance has enabled fast debt reduction, and we project general government debt net of liquid asset will decline to a still high 60% of GDP by 2021, from the 75% peak in 2015.
"According to the authorities, expected improved budget performance will likely be used to further reduce debt, which is prudent given the remaining structural weaknesses in Croatia's government debt profile. More specifically, over 70% of public debt is denominated in foreign currency and the domestic banking sector's government debt holdings amount to about 20% of assets."
"We note that, in addition to swift progress in debt reduction, the government has lengthened the maturity profile and the recent liability management exercise of Croatian road companies, further aiding interest cost reduction. We also note that our debt projections could be subject to upside risks, should economic growth exceed expectations and reform efforts accelerate, in particular those in the public administration and the healthcare sector."
"Although we believe that contingent fiscal risks are contained, some state guarantees could be activated and fall on the government's balance sheet. In particular, the resolution of the troubled Uljanik shipyard, which is currently in search of a strategic investor and could otherwise face bankruptcy, could cost the government up to 1% of GDP. The precise cost however depends on the final scenario, and the possible finalization of ships under construction," says S&P.
S&P also notes that, despite effects related to the debt-laden Agrokor food and retail conglomerate, domestic banks' asset quality continued to rebound in 2017-2018, supported by the ongoing economic recovery and material asset disposals. "We therefore expect a further decline in nonperforming loans going forward, from 11.4% of total loans reported at year-end 2017. Lending has begun to pick up and is especially driven by household loans supported by the strong sentiment."
S&P warns, however, that the political situation could hinder reform acceleration. It recalls that in May, former deputy prime minister and minister of economy Martina Dalić resigned due to alleged conflicts of interest in the Agrokor restructuring.
The Croatian Democratic Union (HDZ)-led government now has only a very slim majority following the loss of support from several members of parliament, the agency notes. "That said, appetite for early elections across the political spectrum seems lower than in previous years, and the government could potentially rely on some independents to increase support for structural policy measures before the start of the regular electoral cycle, with parliamentary elections due in 2020."
S&P says its ratings on Croatia reflect its view of the country's sound external position, with external indebtedness reducing on the back of persistent current account surpluses. Additionally, supporting the ratings are recent strong fiscal consolidation efforts, with the government likely to close another year with a headline fiscal surplus, it says. "Although this has enabled fast debt reduction, a high level of government indebtedness still constrains the ratings.
"The ratings also take into account Croatia's below-average income levels compared with that of European peers, past political volatility hampering structural reform efforts, and the country's stability-inducing but less flexible monetary arrangements."
The agency notes that it could raise its ratings on Croatia if it maintains fiscal prudency, supported by expenditure control and revenue enhancing measures, reducing public debt. Further growth-enhancing structural reforms, enabling faster convergence with the EU average income levels, would also be beneficial for the ratings, says the agency. However, it also notes that it could revise its outlook back to stable if reform progress stalled and fiscal consolidation reversed.
In addition, the ratings could come under pressure if sizable contingent liabilities, for example from distressed sectors of the economy, fell on the government's balance sheet, or caused a drag on the economy, S&P says.
Since the beginning of this year, the world's three leading rating agencies have revised upward either their ratings or their outlook on Croatia. S&P and Fitch now keep Croatia's rating one notch below the investment level, while Moody's keeps it two notches below the investment level. S&P and Fitch have a positive outlook on Croatia, while Moody's outlook on Croatia is stable.
