"Croatia's ratings balance strong structural features, including higher human development, governance indicators and GDP per capita than peers, with weak growth potential and high public sector debt," Fitch said in a statement late on Friday.
It added that the stable outlook reflects its view that the domestic economy will recover gradually from the coronavirus pandemic without significant imbalances, whereas the authorities will achieve medium-term fiscal consolidation, supported by the substantial growth in EU funding and a recent track record of fiscal prudence.
Here is what else Fitch said in the statement:
"Fitch expects GDP to contract by a record 9% of GDP in 2020, as the resurgence of the coronavirus pandemic in 2H20 offsets a slightly better performance of the tourism sector (annual tourism arrivals are expected to contract by 50% versus our previous forecast of 75%). Despite a large fiscal support package (above 10% of GDP in 2020 in both direct and indirect measures) household consumption and service exports have been badly affected by the pandemic, with the short-term outlook remaining weak as new restrictions are implemented. On the upside, good exports have proven more resilient to coronavirus-related pressure, preventing a sharper GDP contraction.
We forecast a moderate economic expansion of 3.8% in 2021 (compared with our previous 4.5% forecast and BBB peer median growth of 4.9%), given weaker carry-over effects and still subdued demand in the services sector. Investment will recover more rapidly thanks to increased public investment driven largely by earthquake reconstruction projects in Zagreb. We expect growth to accelerate to 6% in 2022 as the pandemic effects wane and demand is boosted by the gradual implementation of projects tied NextGenerationEU (NGEU, for which Croatia is set to receive EUR5.9 billion in grants, or 12.2% of GDP, which needs to be spent by 2026). Fitch assumes that EU Funds will boost growth by 2pp in 2022.
We have yet to estimate the medium- to long-term growth effects of NGEU as there is still little clarity surrounding the investment projects that will be funded. Moreover, there are risks surrounding capacity constraints given the amount of funds available, as well as the effectiveness of investment, given Croatia´s weak track record in tackling structural constraints. Nonetheless, it is clear that EU funds will be a supportive macro factor for the rating, limiting negative spill-overs from sectors that could see some long-term scarring (such as tourism, which is unlikely to fully recover by end-2022) and underpinning fiscal and external financing flexibility.
Fitch expects the budget deficit to narrow to 3.5% of GDP in 2021, following a projected deficit of 8% in 2020 and compared with the 2021 budget target of 2.9%. The authorities are likely to maintain some sectoral support (in addition to guarantee schemes) through at least 1H21, but we still expect budget spending to fall in nominal and real terms as automatic stabilisers elapse and other expenditure is streamlined. The government approved a tax reform in November that will reduce personal income tax rates and VAT loopholes starting next year. Although there are risks that this could weaken revenue growth in 2021, the current government has implemented similar reforms in recent years where the net effect was revenue neutral to positive.
The fiscal deficit should narrow further in 2022 to 2.2% of GDP based on solid nominal growth, supportive financing conditions and sustained confidence in the policy framework. The government has a solid track record of over-performing its fiscal targets since 2016 and has pledged to maintain fiscal prudence in light of euro-accession process. Moreover, abundant EU funds will help will provide additional space for public investment, even if on an overall basis most EU programmes are likely to be net budget neutral.
We expect the ratio of public debt/GDP to reach an all-time high of 87.4% in 2020 (versus the current BBB peer median of 52.7%), reflecting the combined growth and fiscal shock from the pandemic. The ratio should fall to 85.5% in 2021 (thanks in part to a stock-flow adjustment from pre-financing of NGEU) and further to 81.6% in 2022 as the recovery takes hold and the primary deficit narrows. This path of debt reduction would be consistent with meeting public finance convergence criteria for euro adoption.
Downside fiscal risks relate mainly to the materialisation of contingent liabilities, primarily around the transport sector (the national airline has already received budget support in 2020) and much higher expenditure needs around the pandemic response. On the upside, Croatia´s financing conditions have significantly improved, reflecting sound public debt management, longer maturities (over six years) and a solid financial/monetary institutional framework. The successful start of an asset purchase programme by the Croatia National Bank (CNB) reflects the latter. According to the IMF, the CNB has bought close to 5.5% of GDP in government bonds in the secondary market since March (one of the highest in the emerging market universe).
Croatia formally joined the Exchange Rate Mechanism (ERMII) and the Banking Union in July 2020, in line with the original timeline. In addition to meeting the convergence criteria, Croatia also committed with following through with structural measures, including reforming state-owned enterprises and the business environment. The government has suggested 2023 as the earliest date of euro adoption, but Fitch considers this timetable to be optimistic, with early 2024 as more likely entry date.
Meeting public finance targets will represent the biggest challenge, while the issue of euro adoption could become more contentious closer to adoption point. Overall, Fitch considers euro adoption as supportive to the rating, as underlined by our view that all things being equal, we would upgrade Croatia Long-Term Foreign-Currency IDR by two notches between admission to the ERM II to joining the euro.
The financial sector remains strong despite economic pressures, with banks maintaining high liquidity and sound capital ratios (24.7% in June according to the CNB). Ahead of Croatia´s entry into Banking Union, the ECB published its comprehensive assessment of the country´s largest banks, finding no capital shortfalls even in stress scenarios. Increased cooperation between European and national authorities will also strengthen Croatia´s supervisory and resolution framework.
Like other countries in the region, moratoria schemes have prevented a faster increase in non-performing loans (which stood at 5.5% in September according to the CNB), which could put more pressure on asset quality once these programmes expire. Credit growth has been resilient thanks to mortgage demand and pre-financing from corporates but is not expected to accelerate until macroeconomic conditions improve.
Croatia's external accounts have been hit by the coronavirus pandemic, particularly via a sharp narrowing of the services surplus (by close to 40% in nominal terms for 2020) due to the collapse of tourism revenue. However, strong import compression and large capital transfers in the form of EU support will keep the current account and balance of payments in surplus in 2020. We expect the current account surplus to improve modestly in 2021(to 1% of GDP) before narrowing again in 2022 as a projected investment boom drives strong growth in imports.
Combined with ongoing external deleveraging, this would result in a further narrowing of the net external debt position to 7.6% of GDP in 2022 (below the current peer median of 10.2% of GDP).
Parliamentary elections in July resulted in a favourable result for the ruling centre-right HDZ, which won 62 out of 151 seats and quickly received support from smaller parties to secure a new term. The HDZ rules in a minority position but thus far has obtained enough support to adopt legislation (such as the 2021 budget) without significant constraints. High level of political stability is reflected in Croatia´s strong governance indicators.
ESG - Governance: Croatia has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Croatia has a high WBGI ranking at 66.7 percentile, reflecting its track record of stable and peaceful political transitions, well established rights for participation in the political process, moderate institutional capacity, effective rule of law and a moderate level of corruption."
Jul 5, 2024
