May 29 (SeeNews) - S&P Global Ratings affirmed its 'BBB-/A-3' long- and short-term sovereign credit ratings on Croatia, and the stable outlook, despite the country's significantly weaker domestic and external growth outlook this year amid the ongoing coronavirus crisis, it said.
"We believe that existing buffers, including ample international reserves and the precautionary currency swap line with the European Central Bank (ECB), should mitigate immediate external liquidity pressures," S&P said in a statement late on Thursday.
It added that it anticipates a 9% contraction of Croatia's tourism-dependent economy this year due to the restriction introduced to prevent the COVID-19 spread, with the decline in tourism receipts putting significant pressure on the country's balance-of-payments performance.
The economy is expected to somewhat recover by growing 5.3% in 2021 and 2.5% in 2022, according to the S&P projections.
Here is what else the rating agency said:
"The stable outlook balances risks of weaker external liquidity amid the fallout from the COVID-19 pandemic, principally related to a substantial hit to Croatia's tourism sector, against the country's improved external balance sheet.
Downside scenario
Negative rating pressures could build if travel restrictions and the economic downturn result in more pronounced pressures on Croatia's balance-of-payments performance, with external liquidity deteriorating significantly beyond our expectations, or if they lead to a more durable weakening of public finances, setting public debt on a firm upward trajectory.
Upside scenario
We could raise the ratings over the next two to three years if Croatia's growth performance significantly outperforms our current expectations, boosting the country's income levels.
Rationale
We now project that Croatia's economy will contract by 9% in 2020 as a result of the strict measures to contain the spread of COVID-19 implemented at home and abroad. These are hitting the country's large tourism and hospitality sectors. However, we continue to believe that the reduction in macroeconomic imbalances over the last several years has helped put Croatia in a more favorable position to weather a temporary shock to its economy without permanent damage to the country's credit metrics.
Croatia is one of the most tourism-dependent sovereigns in Europe, given tourism contributes about 20% of GDP and one-third of current account receipts. The travel restrictions introduced over the past few months will severely hit the sector. Our base-case projection is that tourism revenue will contract by around 70% in 2020 versus 2019. What's more, uncertainty over the pace of the full removal of travel constraints in both Croatia and other EU states, as well as the potential changes to travel patterns, will likely lead to only gradual recovery of the tourism sector. This is one reason why we anticipate only a partial rebound in Croatia's GDP growth in 2021, with real GDP returning to 2019 levels not earlier than 2023. Severe fallout from the pandemic will continue putting the country's balance of payments performance under pressure amid Croatia's current account receipts shrinking by at least one-third in 2020.
That said, absent longer cross-border movement restrictions, we believe Croatia should be able to avoid a permanent damage to its credit fundamentals.
First, one feature that differentiates Croatia from some of its peers is accessibility by car for European holidaymakers, making its less dependent on the recovery of air travel. Nearby Germany accounts for the plurality of visitors to Croatia (24% of overnight stays), followed by Slovenia and Austria (each with 9% of total overnight stays). This is partly why we do not think that the whole summer tourist season will be lost this year.
Second, Croatia's external financing pressures could be cushioned by the country's ample foreign exchange reserves, which made up about 30% of GDP even after outright foreign exchange interventions of €2.2 billion in March, and the recently obtained precautionary €2 billion currency swap line with the ECB. We believe that, even under a downside scenario of 90% decline in tourism revenue--and absent other severe outflow pressures--these buffers and other monetary policy tools should allow the Croatian National Bank (HNB, the central bank) to stem currency depreciation pressures.
More generally, even though we project a substantial drop in Croatia's external services balance surplus, we also expect a pronounced reduction in imports. This will help keep the country's current account deficit at a manageable 3.5% of GDP in 2020. Moreover, the availability of non-debt external financing sources will likely help mitigate the current account balance's swing to a deficit. Specifically, net inflows from the EU budget are set to increase in 2020, some for pandemic-related support, both in form of current and capital transfers. Even after a jump to 46% of current account receipts in 2020, Croatia's external debt net of liquid external assets will remain modest following multiyear external deleveraging. Factoring all these projections, we estimate Croatia's gross external financing needs at moderate levels of around 90% of current account receipts and usable reserves in 2020 and beyond.
Third, given our projections of economic recovery starting already in the second half of 2020 and in light of the government's track record of fiscal prudence, we expect general government fiscal deficits to narrow substantially in 2021, which will put Croatia's public debt back on its pre-COVID-19 downward path.
Our ratings on Croatia are supported by its modest net external leverage, as well as the recent track record of conservative fiscal policies. The ratings remain constrained by Croatia's below-average income levels compared with European peers, still-high public debt, and the country's less-flexible, albeit stability-anchoring, monetary settings.
Institutional and economic profile: Policy focus is on the COVID-19 shock to the economy
Croatia's tourism-dependent economy is vulnerable to protracted travel restrictions.
We expect it will contract by 9% in 2020.
Elections are scheduled for July 2020, while policymakers focus on mitigating the impact of the pandemic.
Croatia's strict containment and lockdown regulations have helped significantly reduce the infection numbers, which remain well below those of larger European countries. As a result, Croatia started gradually easing restrictions at the end of April. That has already enabled parts of the domestic economy to resume operations. Because Croatia is less integrated into global value chains than many peers, the main channel of economic contagion is, in our view, the tourism sector. With subdued external demand, domestic demand will partly support the recovery in 2021, especially because we think the government will aim to avoid cutting investment expenditure.
Despite the traditionally volatile political context, Croatia's aspirations for euro accession will also anchor some structural reforms in the next two to three years, while the near-term focus will be on cushioning the impact of the COVID-19 pandemic. Progress, in improving the business environment's, public sector's, and judiciary's efficiency and raising productivity, for example, would spur income convergence with the EU average, and could help further slow net emigration. Parliamentary elections, following the recent dissolution of parliament in mid-May, are set to take place in July 2020.
Flexibility and performance profile: The shock to the tourism-dependent economy will pressure external and fiscal balances
We expect the fiscal deficit will rise to 6.8% of GDP in 2020.
The current account will turn to a deficit from 2020.
We expect that the central bank will be able to stem potential further depreciation pressures, not least with the perspective of entering ERM II this summer.
Fiscal consolidation in recent years has enabled the government's strong fiscal response to the pandemic. Among others, measures include payment of a minimum wage to those affected, deferrals of tax payments and social security tax payments, and loan programs. State-owned development bank Hrvatska banka za obnovu i razvitak is also playing an important role in response to the crisis, implementing a moratorium on loan repayments and granting liquidity loans and guarantees to beneficiaries in tourism and other sectors. The adverse effects of the pandemic on revenue and the measures in response together will widen Croatia's general government deficit to 6.8% of GDP in 2020, but deficits will narrow significantly thereafter.
That said, Croatia's already high government debt will jump in 2020 to 87% of GDP, or 79% in net terms. The high debt burden limits the government's fiscal room to maneuver. Moreover, over 70% of public debt is denominated in or indexed to foreign currencies, and the domestic banking sector's government debt holdings are a high 20% of assets. While guarantees to state-owned enterprises (SOEs) had reduced to a low 1% of GDP before the onset of the pandemic, we note that past generous state guarantee policies have proved to be a drain on the budget. The extension of state guarantees to government-related entities and other economic agents has been one of the government's key economic policy tools during episodes of economic crisis, and we believe that in the near term, the amount of outstanding state guarantees will increase again.
In response to the liquidity shock and financial market volatility induced by COVID-19, HNB has announced a series of measures, including providing banks with kuna liquidity through repurchase agreements and the reduction of the reserve requirement rate, as well as embarking on government bond purchases in the secondary market (it purchased over Croatian kuna 4.2 billion in March). The central bank has also remained committed to the soft peg of the kuna to the euro, including via foreign exchange interventions. To address future spikes in demand for euro liquidity and avoid pressure on international reserves, the HNB has agreed with the ECB on a precautionary €2 billion currency swap line until at least Dec. 31, 2020. We think that this amount could further increase when Croatia enters the European Exchange Rate Mechanism 2 (ERM II).
In July 2019, Croatia formally applied to enter the ERM II, the precursor to euro adoption. The authorities have made a number of policy commitments, including in particular the continued reduction of government debt, acceleration of reforms in the SOE sector, and cooperation with the ECB in its asset quality review and stress-testing of the top five banks to obtain entry into the Banking Union, which comes in tandem with ERM II entry. In May 2020, the government announced Croatia's completion of all required actions. Croatia targets entering ERM II by mid-July 2020, pending the decision by its European partners. We understand that the results of the banking sector asset quality review are soon to be published, and Croatia must also join the Single Supervisory Mechanism (SSM) for ERM II entry. ERM II entry could strengthen the credibility of Croatia's monetary arrangements in the medium term, even though the exchange-rate regime might become less flexible. In the longer term, all else being equal, euro adoption could prove beneficial for Croatia's sovereign creditworthiness because it will receive access to the eurozone's deep and liquid debt markets and benefit from the high credibility of the ECB's monetary policies."