October 24 (SeeNews) - Japan's Rating and Investment Information (R&I) said on Thursday it has upgraded Croatia's foreign currency issuer rating to BBB from BBB- over its sound economic and fiscal performance, and has kept the rating outlook stable.
"Croatia's economy is showing solid growth. Under the government's policy management focused on fiscal discipline, the fiscal balance remains in surplus and the government debt ratio is falling," R&I said in a statement, adding it expects the fiscal position to continue to improve.
Moreover, R&I is looking favourably at Croatia's latest steps towards joining the euro area, which also helped in the considerations for the rating upgrade.
In July, the Croatian authorities sent a letter of intent to join the European Exchange Rate Mechanism II (ERM II), the first formal step towards adopting the euro. The government hopes that Croatia will join ERM II in about a year, while the whole process of joining the euro area is expected to take at least four years to complete, including the two-year mandatory stay in ERM II.
The rating agency also noted that the current account surpluses and the decline in the external debt ratio, signal that Croatia's external stability is increasing.
R&I also said:
"The economy is expanding solidly, driven by domestic demand. In 2019, wage and job growth is continuing from the previous year, and the unemployment rate fell below 7%. Furthermore, an inflow of European Union (EU) funds boosted fixed capital formation. The European Commission (EC) and the central bank project that Croatia's real gross domestic product (GDP) will grow 3.1% in 2019. Domestically, there is no major downside risk to economic prospects. Unless Germany and Italy, the main export destinations of Croatia, fall into an economic slump, R&I expects Croatia's real GDP to keep growing above 2% in 2020 and beyond, supported by domestic demand.
The current account balance remains positive, with a surplus of 1.9% of GDP in 2018. While deterioration in the trade balance will result in a narrower current account surplus for 2019, the capital account balance will be in a surplus of over 1% thanks to EU fund disbursements. The combined current account and capital account surplus will be 2-3% of GDP. External debt decreased to 84.7% of GDP at end-June 2019. Since foreign reserves exceed the external debt maturing within a year, foreign currency liquidity is not a concern.
With the ratio of non-performing loans falling moderately, the banking sector enjoys solid earnings. Its liquidity coverage and capital adequacy ratios are well above requirements. Domestic currency loans are growing, reflecting lower interest rates and an increase in domestic currency deposits. A decline in currency risk for both banks and borrowers is a positive factor. R&I considers that the financial system remains stable.
The general government fiscal balance turned positive in 2017 and posted a surplus of 0.2% of GDP in 2018. The government projects a fiscal deficit of 0.3% of GDP for 2019. Despite the tax cut package introduced as part of a tax reform, tax revenue is higher than anticipated. The fiscal balance for 2019 is likely to be positive, as seen in the EC's projection of a surplus of 0.1% of GDP. In tandem with improvement in the fiscal balance, the outstanding general government debt to GDP ratio has been decreasing and is expected to be around 70% at end-2019.
The government projects that the fiscal balance will be a surplus of 0.2% of GDP in 2020. Because of the elections slated for the second half of the year, upward pressure on expenditure will likely increase. In light of this, along with a scheduled reduction in the value added tax rate, the fiscal balance may turn negative. With a view to joining the European Exchange Rate Mechanism (ERM2), a gateway to adoption of the common currency euro, however, the government is maneuvering its policy giving due consideration to fiscal discipline, as exemplified by the stricter medium-term fiscal targets it will introduce. Even if the fiscal balance moves into deficit, R&I believes that the deficit will be marginal.
While the tax reform has progressed, other structural issues are still to be addressed. Given the ongoing outflow of labor from Croatia, a failure to reinforce the supply side of the economy could decelerate economic growth in the medium to long term. R&I will keep an eye on whether the government is able to press ahead with structural reforms, as well as efforts to enter ERM2 in the target year of 2020."