June 10 (SeeNews) - Fitch Ratings said it has upgraded Croatia's long-term foreign- and local-currency issuer default ratings (IDRs) to 'BBB-' from 'BB+', with a positive outlook.
Croatia's promotion to investment grade comes on the back of positive fiscal dynamics and expectations that the government will continue to implement fiscal consolidation and improve the fiscal framework, while the macroeconomic conditions will remain stable in the medium term, the ratings agency said in a statement late on Friday.
Fitch said that the main factors, which could lead to a positive rating action in the future include a further reduction of public debt, progress towards euro adoption, and strengthening of growth prospects and competitiveness, including through structural reform.
On the other hand, a failure to reduce the government debt-to-GDP ratio and a deterioration in growth prospects or the emergence of macroeconomic imbalances could result in a negative rating action.
Fitch also said:
"The upgrade of Croatia's IDRs and Positive Outlook reflects the following key rating drivers and their relative weights.
High:
Croatia outperformed its budget target for the third year in a row in 2018, with the general government posting a surplus of 0.2% of GDP (versus a budget deficit target of 0.5% and Fitch's deficit forecast of 0.2%). The government achieved a surplus despite the materialisation of contingent liabilities from troubled shipyard company Uljanic, which added 0.7% of GDP to expenditure. Fiscal developments have been underpinned by expenditure restraint, increased revenue (tax intake rose by 7% in 2018), lower interest costs and favourable macro conditions.
Fitch expects fiscal dynamics to remain on a positive trajectory over the medium term, underpinned by confidence in the authorities' track record and commitment to continued fiscal consolidation, improvements in the fiscal framework and stable macroeconomic conditions. The commitment to join ERM2--a formal request to join the mechanism is expected in 3Q19--is also likely to serve as an anchor against abrupt fiscal policy changes, including ahead of the 2020 parliamentary elections. We forecast a surplus of 0.3% of GDP in 2019 (versus a budget deficit target of 0.4%), narrowing to 0.1% in 2020, as cyclical conditions turn less favourable. This compares with the current 'BBB' median deficit forecast of 2.8% of GDP for 2019-20.
Budget surpluses will reduce the general government debt/GDP ratio by around 3pp per year, to 68.6% of GDP by 2020. Our forecast is broadly in line with the authorities' projections in the latest Convergence Programme (68.5% of GDP by 2020), and would constitute a 15pp point reduction in the public debt ratio since 2015. Public debt is above the current peer median of 37.5% of GDP, but risks are limited by low contingent liabilities (1.7% of GDP at end-2018), government deposits of close to 6% of GDP and 'second pillar' pension fund holding of government debt of around 17.5% of GDP.
Medium:
Current account surpluses in recent years and de-leveraging have improved Croatia's external metrics and Fitch expects this trend to continue, with net external debt falling to around 10% of GDP by 2020 from 21.4% at end-2018. This would be broadly in line with the current 'BBB' median of 7.9% and represent a 50pp decline since 2013 (the sharpest fall among all BBB countries). After posting a surplus of 2.4% of GDP in 2018, the current account is set to narrow to an average of 1.5% in 2019-20 as goods export growth slows in the context of weaker external demand. By contrast, the capital account surplus should start to increase to close to 2% of GDP, reflecting capital transfers in line with accelerating inflows of EU funds.
Croatia's 'BBB-' IDRs also reflect the following key rating drivers:
Croatia's structural features are generally more favourable than 'BBB' peers. GDP per capita is 30% above the 'BBB' median and the country scores better than peers in 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.
We forecast real GDP growth to average 2.4% in 2019-20 lower than the current 'BBB' median of 3.1% but enough to finally return to the pre-crisis output level by 2020. Economic activity recovered strongly in 1Q19 (GDP expanded by 3.9% yoy), removing concerns of a sharper slowdown following a weak performance in 4Q18 due to a slump in export growth. Gross fixed capital formation has picked up as major EU-funded infrastructure projects begin, while private consumption growth has remained resilient on the back of positive labour market dynamics and favourable financing conditions. These trends are set to continue over the next two years, although headline growth is set to level off due to our projections of a slightly larger negative net trade contribution.
Croatia continues to face important structural challenges that limit medium-term growth to 2%. These include shortcomings in the business environment, a complex public sector framework, weak corporate governance, still high corporate debt and legacy issues in key sectors such as energy and healthcare. The result is limited economic diversification, labour disincentives (augmenting an already weak demographic outlook), reduced public policy efficiency and a relatively inflexible economy. Limited progress has been achieved in tackling these issues in recent years, but there is some scope for improvement as potential prior actions for joining ERM2.
The authorities remain committed to joining ERM2 and eventually the euro. After Croatia signs a formal agreement to join ERM2 and the Banking Union, the country will have 12 months to fulfil a number of institutional/structural commitments and conduct an Asset Quality Review (AQR). The approval to join would kick off the required waiting period to adopt the euro, which could take place by 2023 at the earliest. The benefits of Croatia joining the euro include a reduction in transaction costs and limiting exchange rate risks (around 60% of household and corporate debt and over 70% of general government debt is denominated in foreign currency).
Croatia benefits from low and stable inflation. A reduction in VAT rates for personal items in January has had a stronger pass-through effect on prices than initially expected, with headline inflation averaging only 0.6% yoy in January-April 2019. Labour costs also remain fairly stable, having risen by only 1.5% in 2018 despite unemployment falling to a record low of 8.5% in 1Q19. Given modest planned public wage increases over the next two years, Fitch now expects inflation to average only 1% in 2019-20.
The banking sector has maintained solid levels of capitalisation (22.9% end-2018) and abundant liquidity (loan to deposit ratio was 87% in 2018, the lowest rate in 17 years), reflecting stable macro conditions and rising savings in the economy. Asset quality has continued to improve, although NPL ratios are still high (9.5% at March 2019) and tied to lengthy restructurings."