S&P affirmed the short-term foreign and local currency sovereign credit ratings at 'B', while also revising its Transfer and Convertibility (T&C) assessment to 'BBB+' from 'BBB', the ratings agency said in a statement on Friday.
"The upgrade reflects Croatia's improved external position, which benefits from growing current account receipts on the back of strong tourism-related inflows, continued external deleveraging of the economy, and rapid growth of foreign currency reserves", S&P explained.
S&P also said in the statement:
The stable outlook balances Croatia's improved external and fiscal balances against still high government debt levels and structural rigidities weighing on Croatia's growth outlook over the next 12 months.
We could raise our ratings on Croatia if the government implements structural reforms that would more sustainably entrench fiscal consolidation and raise the economy's long-term growth potential. Moreover, in such a scenario, a stronger-than-expected reduction in Croatia's still high government debt levels would support a positive rating action.
Conversely, the ratings could come under downward pressure if structural reform efforts slowed, leading to lower economic growth and higher-than-forecast fiscal deficits. Moreover, we are closely monitoring the restructuring efforts at Agrokor and could consider a negative action if a disorderly restructuring undermines economic performance or leads to significant fiscal costs. This is not our base-case scenario, however.
The upgrade reflects Croatia's improved external position, which benefits from growing current account receipts on the back of strong tourism-related inflows, continued external deleveraging of the economy, and rapid growth of foreign currency reserves. Moreover, the ratings are supported by Croatia's improved fiscal picture, benefitting in part from the ongoing economic recovery, but also from structural reform efforts, such as the income tax reform that took effect in 2017. This in turn is helping accelerate the reduction of Croatia's high government debt burden, which still constrains the ratings.
In addition, the ratings remain constrained by Croatia's relatively shorter track record of implementing structural reforms amid bouts of political volatility and low per capita wealth levels in the context of the 28 EU member states.
Institutional and Economic Profile: Gradual progress of structural reforms helps safeguard the durability of economic recovery
- A favorable external environment and another record tourism season supported Croatia's recovery, which is entering its fourth year.
- The ongoing restructuring of retail conglomerate Agrokor dampened domestic demand somewhat, though consumption and investment growth were still robust.
- Structural challenges to the economy are apparent in the labor market and in the large role the public sector plays in the economy, and the government's reform efforts are only gradual.
At 2.8%, the initial real economic growth data for 2017 shows a slightly weaker picture than in our September publication. However, part of the weakness in the fourth quarter was driven by one-off factors. For example, the announcement of a new excise tax system and revised calculation for value-added tax (VAT) payments for companies on car purchases pushed car sales from December into January 2018 when sales surged by 30% year on year. Overall, Croatia's economy continued to be supported by external and domestic demand in 2017. A further reduction in the unemployment rate, as well as wage growth in the public and private sector, supported additional pick-up in consumption growth. Export growth benefitted from another record tourism season, but importantly, goods exports showed strength, as well. Investments slowed somewhat as Agrokor-related uncertainties took their toll on business and consumer confidence over the course of the year. Over our forecast horizon through 2021, we see a gradual deceleration of growth to about 2.5% in 2020 as cyclical tailwinds subside and structural constraints kick in.
Croatia's structural impediments are well known and the current government is making gradual progress toward resolving them. The business environment, as measured by global indicators, lags behind that of regional peers as the public administration remains marred by inefficiencies and the role of the public sector in the economy is still substantial. In addition, the unemployment rate remains high and appears mostly structural. Croatia's National Reform Program spells out several reforms that the government wants to implement, though progress is only gradual. In addition, the Croatian government has already implemented structural reforms to the VAT and income tax that took effect in 2017. Moreover, parafiscal fees, fees and taxes not directly payable to the government, were reduced by 30% in 2017 and the restructuring of the highway and motorway companies, including their debts, is progressing. Still, more sustained and robust reform efforts will be needed to entrench some of the fiscal gains the ongoing recovery has brought about.
After repeat bouts of political volatility, the current government of the center-right HDZ and the liberal HNS, in power since June 2017, appears to be on a more stable footing. The previous coalition of HDZ and MOST collapsed when some MOST party members did not support the finance minister in a parliamentary vote of no confidence after the collapse of Croatia's retail conglomerate Agrokor. The restructuring of Agrokor is continuing, despite a setback in February 2018 when the initially appointed restructuring advisor resigned. Nevertheless, Agrokor intends to complete the restructuring terms according to the initial plan by April 10, 2018. To that end, the company continues its frequent meetings with representatives from the creditor groups. Our base-case scenario remains that of an orderly restructuring process. Downside risks to the economy could emerge if a disorderly restructuring of Agrokor were to negatively affect its suppliers, mostly small and midsize enterprises and farms, and resulted in their coming under financial pressure. However, we understand Agrokor has made payments to smaller suppliers in order to mitigate the effect of its restructuring on them. Therefore, we currently see only limited downside risks to the Croatian economy as a result of the Agrokor turmoil (see "Ratings On Croatia Unchanged By Retail Group Agrokor's Announced Debt Payment Freeze," published April 7, 2017, on RatingsDirect). However, we will continue monitoring the situation, including the financial and operational restructuring, and its potential impact on the Croatian economy.
Flexibility and Performance Profile: Rapid reserve growth and continued deleveraging strengthen the external position
- Croatia's external position continues to improve thanks to continued external deleveraging, recurring current account surpluses, and the associated strong increase in foreign currency reserves.
- In 2017, Croatia achieved its first ever general government surplus, supporting the downward trend in the government debt ratio.
- Banks have increased their provisions related to exposure to Agrokor and should largely meet regulatory capital requirements, even in an adverse scenario.
In 2017, Croatia likely achieved its first ever surplus at the general government level. Stronger-than-expected revenues, partially from cyclical factors but also due to ongoing tax administration reforms, have helped move the general government balance to a surplus of 0.6% of GDP in 2017 according to our forecast. Over our forecast horizon, we expect Croatia will continue incurring small deficits averaging 0.8% of GDP over 2018-2021, as accelerated pick-up of EU structural and cohesion funds should drive up capital expenditures. The budget could display upside surprises should the government make more sustained headway on its structural reform agenda. We understand that the Croatian government continues working on a reform of the public administration, as well as reforms in the health care sector. Plans to introduce a real estate tax have again been delayed, however.
The general government debt ratio remains firmly on a downward path. The Croatian government has used the revenue windfall to pay down debt, as well as clear some of the arrears that accumulated in the health care system. In addition, the government continued its efforts to restructure the fully guaranteed debts of the Croatian roads companies. As a result, we expect 2017 results will show the government's debt ratio has fallen below a still high 80% of GDP. In line with our fiscal and growth forecasts, the ratio could drop another 10 percentage points by 2021 to just below 70% of GDP. A sustained reduction in Croatia's government debt burden will be important, as its debt profile still shows some weaknesses. Over 60% of outstanding debt is denominated in foreign currency, while the exposure of Croatian banks to the government still amounts to about 20% of their assets. Croatia's quasi-peg of the kuna to the euro shields the government somewhat from foreign currency risk. Moreover, we view positively that Croatia's government can increasingly refinance itself in the domestic market at longer maturities.
We do not expect the materialization of any contingent liabilities onto the government's balance sheet from the ongoing restructuring of Agrokor. We understand that the loan exposure of Croatian government-owned development bank, Hrvatska banka za obnovu i razvitak, to Agrokor is very small. It accounts for less than 2% of Agrokor's recognized debt or 3% of the bank's total assets. In addition, the lion's share of this exposure is secured by collateral. Moreover, we note that Agrokor is current on its tax obligations and that the government has not provided direct financial support to Agrokor. Nevertheless, Croatian banks' profitability was hit by loan-loss provisioning, both on direct exposure to Agrokor and to its related suppliers. Although additional provisioning on these exposures will likely be reported in 2018, we expect domestic banks' capitalization to remain above regulatory capital requirements at the systemwide level. Apart from Agrokor, domestic banks' asset quality continued to rebound in 2017, supported by the ongoing economic recovery and material assets disposals. This is reflected in the further decline in nonperforming loans, which dropped to 11.4% of assets from 13.8% over the course of 2017. Despite the high level of liquidity in the system, we don't expect a material pick-up in lending activity in 2018, mostly due to still low demand and weak creditworthiness of corporate customers. Overall, we classify Croatia's banking system in group '7' of our Banking Industry Country Risk Assessment (for more see "Banking Industry Country Risk Assessment: Croatia," published Jan. 16, 2017). T
he hit to bank profitability from Agrokor-related provisioning also boosted Croatia's current account surplus in 2017. Lower repatriation of profits by foreign-owned banks reduced the deficit on the income balance. At the same time, Croatia's growing surplus on the service balance, which grew thanks to overnight stays in Croatia being 12% higher than in 2016, is more than offsetting its simultaneously growing trade deficit, which is estimated to have exceeded 17% of GDP in 2017. Croatia's strong current account surplus also helped boost the central bank's foreign exchange reserves in 2017. In U.S. dollar terms, reserves grew by roughly US$4.6 billion or 32% year on year. In addition, interventions by the Croatian National Bank (the central bank) to the tune of €950 million (US$1.1 billion or 2% of 2017 GDP) to stem appreciation pressures on the kuna have helped reserves growth, as well. Lastly, positive valuation effects, thanks to the euro strengthening almost 14% against the U.S. dollar have had a buoying effect, as well as central bank reserves being mostly held in euro.
Growing foreign exchange reserves and current account receipts led to a significant strengthening of Croatia's narrow net external debt ratio, which fell to an estimated 39% of current account receipts (CARs) in 2017. We forecast it will decline further to about 31 % of CARs at the end of 2021, thanks to recurring, albeit shrinking, current account surpluses and continued deleveraging. After the Agrokor-related impact in 2017, we expect the current account surplus will decline to about 2.1% of GDP by 2021 as strengthening domestic demand will continue to push up imports. Croatia's net international investment position, as reported by the central bank, strengthened from around -71% of GDP in 2016 to -61% of GDP by the end of the third quarter 2017. This was supported by assets growing 5% over the course of the year, but also continued deleveraging that decreased liabilities by 2% over the year. Still, we forecast gross external financing needs of around 81% of CARs on average over 2018-2021.
The Croatian National Bank is committed to the quasi-peg of the Croatian kuna to the euro, which limits monetary policy flexibility, as does the highly euro-ized economy. As of June 2017, over 50% of loans and deposits were denominated in or linked to a foreign currency, usually the euro. Croatia will hold the rotating presidency of the Council of the European Union during the first half of 2020. By then, the country hopes to have been granted accession to the Schengen area. However, before Croatia can join the Schengen area, the country must solve its border disputes, most importantly the dispute with Slovenia in which the Permanent Court of Arbitration gave Slovenia direct access to international waters through Croatian waters. Moreover, a joint working group of the central bank and the government has launched a public debate on Croatia's adoption of the euro. While we do not expect euro adoption over our forecast horizon, we think Croatia could potentially consider joining the Exchange Rate Mechanism 2, a precondition for subsequent euro adoption, by 2020."
