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Fitch affirms Croatia at 'BB+', outlook positive

Fitch affirms Croatia at 'BB+', outlook positive Author: Radomir Ralev

ZAGREB (Croatia), December 10 (SeeNews) - Fitch Ratings said it has affirmed Croatia's long-term foreign- and local-currency issuer default ratings (IDRs) to 'BB+', with a positive outlook.

Croatia's ratings balance strong structural features, including human development and governance indicators and high gross domestic product (GDP) per capita, with weak growth potential, high public sector debt and external vulnerabilities, the ratings agency said in a statement late on Friday.

Fitch also said:

"Croatia's ratings balance strong structural features, including human development and governance indicators and high GDP per capita, with weak growth potential, high public sector debt and external vulnerabilities (heightened by still high net external debt).

The Positive Outlook reflects Fitch's expectation that the combination of persistent primary budget surpluses, low interest and healthy GDP growth will contribute to a continued marked reduction in gross general government debt. In addition, continuing current account surpluses, supplemented by net equity FDI and EU capital inflows, will lead to a decline in Croatia's net external debt.

Fitch expects Croatia to outperform its budget target for the third consecutive year in 2018, with a deficit forecast of 0.2% of GDP, compared with the government's deficit target of 0.5%. Croatia's fiscal performance continues to benefit from strong revenue growth and expenditure restraint. This outperformance is despite the materialisation of contingent liabilities stemming from troubled shipyard company Uljanic, which we expect to amount to approximately 0.6% of GDP for this year.

Fitch forecasts the general government budget will remain broadly balanced in 2019-20, against the small deficits projected by the authorities. Positive fiscal dynamics are underpinned by favourable nominal growth, the government's commitment to meeting its expenditure rules as well as the incentive of joining the eurozone. The government outperformed its budget balance targets by 2.1% of GDP in 2017 and by 1.5% of GDP in 2016.

We forecast general government debt/GDP to fall to 74.1% of GDP at end-2018, down from 84% at end-2014, and to 68.3% by 2020 and 61.9% by 2023 on the back of primary surpluses. This would still be well above the historical 'BB' median of 38.3% of GDP. Downside risks to debt dynamics are contained by government cash deposits of around 6.5% of GDP (3Q), low explicit contingent liabilities (around 1.8% of GDP, excluding Uljanic) and 'second pillar' pension fund holding of government debt of around 17.5% of GDP. 

External deleveraging continues at a rapid pace, supported by surpluses in the balance of payments. Although still well above the current 'BB' range-median of 9.5%, Croatia's net external debt is expected to fall to 20.7% of GDP by end-2018, the lowest ratio in 15 years and over 40pp below 2013 levels. Fitch forecasts the current account to post an average surplus of 2.3% of GDP in 2018-20, as services exports (led by tourism) and current transfers remain robust, offsetting a slowdown in tradable exports. This will support a build-up of foreign reserves and further strengthen the sovereign's net external creditor position, helping to limit external vulnerabilities.

The economy is set to maintain a moderate rate of expansion, averaging 2.5% in 2018-20 (versus current BB median of 4.2%), supported by private consumption growth and price/exchange rate stability. 3Q18 GDP growth was 0.6% qoq, only slightly below 1H levels. As in previous years, the main driver of growth remains domestic demand, aided by robust labour dynamics (employment is expected to expand by around 2% this year) and tax incentives for investment and consumption. 

Medium-term economic prospects are limited by adverse demographic trends and structural weaknesses, with potential growth estimated at around 2%. The main downside risks include a sharper-than-expected slowdown in GDP growth in key European markets and/or a slowdown in tourist inflows given the importance of the sector for growth, employment and external finances. 

Labour market dynamics are putting some upward pressure on wages but the effect on prices has been muted, with core inflation averaging 0.6% in the first 10 months of 2018. An upcoming tax reform to reduce VAT rates in key consumer items such as food will further reduce upward price pressures. Fitch now expects consumer price inflation to average only 1.4% in 2019-20, limiting any risks of price competitiveness loss. 

The banking sector remains stable with ample liquidity and capital levels well above the regulatory minimum (22.6% 3Q18). Unlike the Agrokor fallout in 2017, banks have felt no impact from the troubles at Uljanic. Profitability is set to increase only modestly, as aggregate credit demand remains muted (household credit is rising but corporates are still deleveraging). The rapid fall of the NPL ratio in previous years has slowed (it stood at 10.26% in September 2018), in part due to new classification methods but also as bulk buyers of NPL portfolios have reduced purchases. 

Croatia is putting reforms in place that Fitch believes will help anchor monetary and macroeconomic policy coherence and credibility ahead of formally applying to join ERM2. Croatia could aim to join the ERM2 in 2020. An important step has been the approval of a new Fiscal Responsibility Act that address many institutional weaknesses highlighted by the European Commission, including setting numerical rules for debt and deficit targets, enhancing medium-term budgetary planning and strengthening the role of the Fiscal Council. One of the main benefits of euro adoption would be to reduce FX risks. Croatian balance sheets exposure to FX (mainly euro) is substantial, with around 60% of household and corporate debt and over 75% of public debt denominated in foreign currency.

Croatia's structural features are much stronger than 'BB' peers. GDP per capita is 60% above the 'BB' median and the country scores better than 'BB' and 'BBB' peers in terms of governance indicators and human development, thanks in part to EU membership. The coalition government, installed in June 2017, has been able to implement its agenda relatively smoothly despite its small majority."

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