September 25 (SeeNews) - S&P Global Ratings said it has revised to positive from stable the outlook on the long-term foreign and local currency sovereign credit ratings on Croatia, while affirming its 'BB' long-term and 'B' short-term foreign and local currency sovereign credit ratings on the country.
The positive outlook reflects S&P's expectation that Croatia's economic expansion will continue, helping further consolidation of public finances, while external ratios will benefit from continued deleveraging and the potential fallout from the situation around Agrokor remains contained, the ratings agency said in a statement late on Friday.
S&P noted that it expects Croatia's economy to grow by 3% this year, underpinned by robust domestic demand and strong exports, helping the government to maintain a stronger budgetary position than before and continue reducing its still sizable debt burden.
S&P also said in the statement:
"OUTLOOK
The positive outlook reflects our expectation that Croatia's economic expansion will continue, helping further consolidation of public finances, while external ratios will benefit from continued deleveraging, as well as that the potential fallout from the situation around Croatia's largest retail conglomerate, Agrokor, will remain contained.
We could raise our ratings on Croatia if economic recovery remains on track while the government continues to show ability and willingness to implement structural reforms and stick to its fiscal consolidation agenda, leading to sustainable consolidation of government finances. Moreover, we could consider an upgrade if Croatia's external ratios improve faster than in our base-case scenario as a result of stronger external deleveraging or faster growth of current account receipts.
We could revise the outlook to stable if Croatia's contingent liabilities, such as the lawsuits against the government, translated into a higher government debt burden, or 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, however, is not our base-case scenario.
RATIONALE
Our ratings on Croatia are supported by the country's declining general government deficit and its falling external indebtedness, primarily on the back of continued banking sector deleveraging. At the same time, the ratings remain constrained by Croatia's still-high government debt burden, low income levels in a European comparison, and continued bouts of political volatility.
Institutional and Economic Profile: After coalition reshuffle, focus is on structural reform agenda to ensure sustainability of economic upswing
- Favorable external and domestic developments bolster growth, whereas spillovers from Agrokor's ongoing restructuring remain contained.
- However, Agrokor's emerging financial issues have led to a coalition reshuffle, which may call into question the government's ability to continue its reform agenda.
- Structural challenges to the economy persist in the form of labor shortages and a high degree of state ownership in the economy, among others.
A mixture of external and domestic factors continues to drive the Croatian economy. As a result, we expect real economic growth of 3% in 2017 supported by strong exports, particularly in the booming tourism industry. Moreover, domestic demand contributes positively to growth as investments recover and private consumption strengthens on the back of improving labor markets and the tax reform passed in 2016, which increased disposable incomes. In the medium term, however, we expect structural factors may weigh on the Croatian economy. Croatia's business environment, especially as regards starting a business, remains weaker than regional peers', as indicated by the World Bank's Ease of Doing Business indicators, while skill mismatches and labor shortages are reported, despite still-high unemployment rates.
The effect of the ongoing restructuring of Agrokor appears contained so far. Besides a small dent in consumer confidence in the immediate aftermath of the government installing an extraordinary commissioner at Agrokor, investments and consumption have held up well over the course of 2017. Downside risks to the economy could emerge if a disorderly restructuring of Agrokor negatively affects its suppliers, mostly small and midsize enterprises and farms, and resulted in their coming under financial pressure. However, we understand Agrokor is currently servicing all debt obligations, including payments to suppliers, and has taken steps to mitigate the effect on suppliers. Therefore, we see downside risks to the Croatian economy as a result of the Agrokor turmoil as limited (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.
That said, as a result of the Agrokor crisis, the previous ruling coalition of HDZ (the Croatian Democratic Union) and Most (The Bridge) split, as some Most party members did not support the finance minister in a vote of no confidence in parliament. After the split, HDZ formed a new coalition with HNS (The Liberal Democrats). This episode underlines the political volatility in Croatia that has shaped the country for thepast two years and which could continue constraining the government's ability to address longstanding structural issues. These include structural unemployment, a high degree of state ownership in the economy, and a somewhat weaker business environment than European peers'. In order to address these and other issues, we understand the government's priority reforms are reform of the public administration and the pension system, and improvements in the business climate. A proposed introduction of a property tax has been postponed to allow further consultation on the final design.
Flexibility and Performance Profile: Public finances improve, due to strong economy, while external deleveraging continues.
- Fiscal balances continue to improve on the back of strong revenue growth and expenditure containment.
- At the same time, the refinancing needs of the government and government-related entities remain high.
- External deleveraging, especially by the financial sector, continues.
Alongside the strengthening recovery, public finances also continue to improve. After a better-than-expected general government deficit at 0.8% of GDP in 2016, we forecast that it will widen slightly to 1.1% this year. This is still lower, however, than our forecast of 1.3% at the time of the last review. Our current base-case scenario does not encompass a fiscal impact of the Agrokor situation. We understand that Croatian government-owned development bank Hrvatska banka za obnovu i razvitak (BB/Stable/B) has some loan exposure to Agrokor. However, this exposure is secured by collateral. Moreover, we note that the company is current on its tax obligations and that the government has not provided direct financial support to Agrokor. Still, we expect a slightly wider fiscal deficit over our forecast horizon through 2020 of, on average, 1.3% of GDP as a pick-up in EU-co-financed investment projects leads to higher budgetary outlays and the 2016 tax reform, which encompassed cuts to personal and corporate income taxes, may hinder revenue growth.
Substantial refinancing needs of both the government and government-related entities, the large share of foreign currency-denominated obligations in public debt, and the Croatian banking sector's high exposure to the sovereign continue to constrain our ratings. That said, improved debt management practices and potential asset-liability management exercises could improve the general government sector's debt profile. Moreover, we view positively Croatia's increasing ability to refinance itself on the domestic market at longer maturities. Faster economic growth and lower fiscal deficits should translate into a quicker reduction of Croatia's debt-to-GDP ratio, while in nominal terms, general government debt continues to increase. We expect Croatia's debt ratio will decline to about 75% of GDP by 2020, down from its peak of 86.6% in 2014.
Croatia's current account remains in surplus, thanks to a large and increasing service balance surplus driven by a record-breaking tourism season. Moreover, we expect the current account surplus will increase to about 3.7% of GDP this year from 2.7% in 2016. Due to the financial situation of Agrokor, the Croatian National Bank (Hrvatska Narodna Banka; the central bank) asked banks to provision their Agrokor exposure by at least 50%, hurting banks' profitability and reducing capital outflows in the form of profit dividends to their parents in 2017. We forecast the current account surplus will decline, due to strong import growth as a result of buoyant domestic demand. Nonetheless, external debt net of liquid external assets is likely to decrease further to less than 50% of current account receipts by 2020, according to our forecast.
Improvements in Croatia's banking sector indicated by recovering profitability, increasing lending, and declining nonperforming loans, could be jeopardized by Agrokor's financial stress. We understand that independent auditor reports on Agrokor's balance sheet will be made public and that banks were asked to provision at least half of their Agrokor exposure. Still, the final haircut to Agrokor's debt could be somewhat larger than the provisions, implying additional losses for banks. While larger banks' capitalization levels should be able to withstand such an impact, some smaller banks may be forced to raise additional capital. However, we note that a large part of Agrokor's direct liabilities are toward foreign banks and should therefore not affect the stability of the Croatian banking system. Still, we expect lower profitability for the sector as a whole this year. The impact could be more pronounced, depending on how Agrokor's suppliers are impacted by a debt restructuring, although we note that the company has taken steps to reduce the effect on its suppliers, notably as 50% of supplier debt has already been settled.
The Croatian National Bank is committed to the quasi Croatian kuna-euro peg, 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."