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S&P revises Croatia's outlook to positive on strengthening fiscal, economic performance

Author Maja Garaca
S&P revises Croatia's outlook to positive on strengthening fiscal, economic performance Credit Rating by NY (http://nyphotographic.com), Licenced under Creative Commons 3 - CC BY-SA 3.0

ZAGREB (Croatia), September 24 (SeeNews) – S&P Global Ratings said it has revised its outlook on Croatia to positive from stable, while at the same time affirming its 'BB+/B' long- and short-term foreign and local currency sovereign credit ratings on the country.

"The outlook revision reflects our expectation that Croatia's economy will continue to expand and government debt reduce further, with tail risks relating to Croatia's largest food retailer Agrokor gradually reducing following the settlement with the majority of its creditors", S&P explained in a statement issued late on Friday.

It noted that it could raise its ratings on Croatia if it maintains fiscal prudency, supported by expenditure control and revenue enhancing measures, reducing public debt.

"Further growth-enhancing structural reforms, enabling faster convergence with the EU average income levels, would also be beneficial for the ratings," S&P added.

The rating agency also cautioned that it could revise its outlook on Croatia to stable if reform progress stalled and fiscal consolidation reversed.

"In addition, the ratings could come under pressure if sizable contingent liabilities, for example from distressed sectors of the economy, fell on the government's balance sheet, or caused a drag on the economy," S&P noted.

The ratings agency also said:

"RATIONALE

Our ratings on Croatia reflect our view of its sound external position, with external indebtedness reducing on the back of persistent current account surpluses. Additionally, supporting the ratings are recent strong fiscal consolidation efforts, with the government likely to close another year with a headline fiscal surplus. Although this has enabled fast debt reduction, a high level of government indebtedness still constrains the ratings. The ratings also take into account Croatia's below-average income levels compared with that of European peers, past political volatility hampering structural reform efforts, and the country's stability-inducing but less flexible monetary arrangements.

Institutional and Economic Profile: Although cyclical growth momentum persists, raising potential growth remains a key challenge

- We expect Croatia's economic recovery will continue in 2018-2019, thanks to surging private consumption and sound export growth.

- Raising potential growth remains a key challenge, while net emigration continues and labor bottlenecks emerge.

- Political volatility is somewhat lower than in previous years, paving the way for structural reforms.

Croatia's economy continues to expand: We expect real GDP growth will reach 2.8% both in 2018 and 2019. We believe growth will stem from strong household consumption on the back of rising disposable incomes, employment growth, and strong consumer sentiment. In addition, exports continue to perform well, benefiting from another strong tourism season. Although investment growth has been subdued recently, mainly due to decreased public investment and Agrokor-related capital expenditure (capex) reduction, we expect it will accelerate toward the end of the year and into 2019. This will result from increasing drawings on EU funds and increasing public infrastructure investments (e.g. Peljesac bridge), as well as increasing construction activity, which benefits from subsidies for first-time home owners. Further tax cuts coming into effect in 2019 and high retained corporate profits will support consumer spending and investments.

As the cyclical recovery slows, increasing potential growth remains a key challenge. The government has made substantial progress in reforming the corporate, value added, and personal income tax system, with another set of reforms to be implemented in 2019. Relaxing taxes could offset the consequences of a declining population and high net emigration, a major structural challenge for Croatia. In the period 2014-2017, net emigration amounted to over 80,000 people and overall the population decreased by about 3%.

However, tax changes will only partly offset the negative effect of labor shortages on Croatia's growth prospects. Unemployment is falling to below 10%, partly due to emigration but also due to a recent rise in employment. Thus, addressing labor shortages reported across many sectors, such as tourism and construction, is a key challenge, particularly as the remaining unemployment appears partly structural.

In the long term, further educational and healthcare system reforms, rightsizing and improving efficiency of the state's role in the economy, and enhancing the business environment, could enable Croatia's real income to converge toward the EU average.

However, the political situation could hinder reform acceleration. In May, the former deputy prime minister and minister of economy resigned due to alleged conflicts of interest in the Agrokor restructuring. The Croatian Democratic Union (HDZ)-led government now has only a very slim majority following the loss of support from several members of parliament. That said, appetite for early elections across the political spectrum seems lower than in previous years, and the government could potentially rely on some independents to increase support for structural policy measures before the start of the regular electoral cycle, with parliamentary elections due in 2020.

Importantly, the restructuring of Croatia's largest food retailer Agrokor made significant progress, with the approval of the settlement deal by a large majority of the company's creditors reducing overall economic and political risks. The deal includes a debt-to-equity swap, making Russian government-related banks 47% owners, and loan write-offs. The restructuring could prove to be an opportunity for the economy to improve, as it will increase competition and remove market entry barriers, potentially attracting foreign investment. However, there are downside risks to employment resulting from the new operational companies' performances, and from lawsuits by creditors not included in the settlement.

Flexibility and Performance Profile: External and fiscal positions continue to improve

- Following a historical first budget surplus last year, we think fiscal performance will likely remain strong in 2018-2021, facilitating further reduction in government debt to GDP.

- External deleveraging is continuing and the current account remains in surplus.

- Croatia intends to join Exchange Rate Mechanism II (ERM II), the precursor for euro adoption, in 2020.

In 2017, Croatia posted the first general government surplus in its history and we expect another surplus of 0.2% of GDP in 2018. According to budget execution thus far in 2018, revenue performance remains strong, particularly on value-added tax (VAT), supported by the consumption-driven economic upswing. Expenditures, especially on public sector wages, have remained contained.

Over 2018-2021, we expect Croatia will return to posting small deficits, as accelerated pick-up of EU structural and cohesion funds push up capex, and further VAT cuts and social contribution scheme changes to inject funds into the health sector are implemented.

The recent fiscal performance has enabled fast debt reduction, and we project general government debt net of liquid asset will decline to a still high 60% of GDP by 2021, from the 75% peak in 2015. According to the authorities, expected improved budget performance will likely be used to further reduce debt, which is prudent given the remaining structural weaknesses in Croatia's government debt profile. More specifically, over 70% of public debt is denominated in foreign currency and the domestic banking sector's government debt holdings amount to about 20% of assets. We note that, in addition to swift progress in debt reduction, the government has lengthened the maturity profile and the recent liability management exercise of Croatian road companies, further aiding interest cost reduction. We also note that our debt projections could be subject to upside risks, should economic growth exceed expectations and reform efforts accelerate, in particular those in the public administration and the healthcare sector.

Although we believe that contingent fiscal risks are contained, some state guarantees could be activated and fall on the government's balance sheet. In particular, the resolution of the troubled Uljanik shipyard, which is currently in search of a strategic investor and could otherwise face bankruptcy, could cost the government up to 1% of GDP. The precise cost however depends on the final scenario, and the possible finalization of ships under construction.

Croatia's current account remains in surplus thanks to a large and increasing service balance surplus stemming from a strong tourism season. We expect the external surplus will moderate to about 2% on average in 2018-2021 from about 4% in 2017, a figure that was inflated by Agrokor-related bank provisioning that lowered foreign-owned banks' profits. We expect soaring household consumption will accelerate import growth and widen the goods trade deficit to over 18% of GDP by 2021. However, we expect services exports will continue their strong performance since visitor numbers had increased by 5% as of August 2018, and price increases have supported tourism-related receipt growth. As workforce bottlenecks in the tourism sector emerge, it is worth noting that Croatia's goods exports have also increasingly strengthened, e.g. in pharmaceuticals, metal products, scientific and control instruments, and the food sector. Drawing from neighboring countries' experience, further integration into European manufacturing supply chains could support real income convergence toward the EU average.

In addition to current account surpluses, interventions by the Croatian National Bank (the central bank) due to appreciation pressures on the Croatian kuna helped reserve growth. The central bank purchased a total of €726 million in the first half of 2018 from banks, and €16 million from the Ministry of Finance, bringing gross international reserves to €16.6 billion as of May 2018. This, together with strong current account receipts (CARs), has led to a significant reduction in Croatia's external debt net of liquid external assets (narrow net external debt). We forecast it will decline further to about 20% of CARs by year-end 2021, thanks to recurring, albeit shrinking, current account surpluses and continued deleveraging, as well as Agrokor-related debt write offs, which we expect will affect external debt figures in 2019. Deleveraging will also continue to strengthen Croatia's net international investment position in the coming years. Still, we forecast gross external financing needs of about 82% of CARs on average over 2018-2021.

Despite Agrokor-related effects, domestic banks' asset quality continued to rebound in 2017-2018, supported by the ongoing economic recovery and material asset disposals. We therefore expect a further decline in nonperforming loans going forward, from 11.4% of total loans reported at year-end 2017. Lending has begun to pick up and is especially driven by household loans supported by the strong sentiment.

The central bank is committed to the quasi-peg of the kuna to the euro, limiting monetary policy flexibility, as does the highly euroized economy. Over 50% of loans and deposits are denominated in or linked to a foreign currency, usually the euro. We expect inflation will be contained at about 1.6% on average over the coming two to three years. Croatia will hold the rotating presidency of the Council of the EU during the first half of 2020. The country also hopes to enter ERM II, the precursor to euro adoption, in 2020."

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