Scope Ratings AG has today confirmed the Republic of Croatia’s long-term local-currency rating at BB, following the release of its revised sovereign rating methodology, and has converted its status from subscription to public. The agency has also assigned a long-term foreign-currency issuer rating of BB, along with a short-term issuer rating of S-3 in both local and foreign currency. The sovereign’s senior unsecured debt in local and foreign currency was also rated at BB. All Outlooks are Stable.

Rating drivers

Scope’s affirmation of Croatia’s BB rating reflects the country’s European Union (EU) membership, recovery from a six-year recession and the government’s efforts to reduce fiscal deficits, which are stabilising the debt level and have resulted in the exit from the EU’s Excessive Deficit Procedure. At the same time, the rating also reflects i) the country’s low growth potential owing to adverse developments in the labour force and subdued productivity growth, ii) the sovereign’s high public-finance risk given an elevated debt level combined with sizeable foreign-currency exposure, iii) the private sector’s high external and foreign-currency-denominated debt stocks, and iv) the government’s significant institutional shortcomings despite the country’s EU membership, which have resulted in a burdensome business environment. The Stable Outlook reflects Scope’s assessment that risks remain broadly balanced, including challenges arising from the ongoing restructuring of the Agrokor Group.

Croatia’s economic outlook is weak. After exiting its six-year recession, real GDP growth turned positive in 2015 and is now expected to range between 2.0% and 2.5% over the coming years. The cyclical recovery, which Scope expects to continue in the coming years, is driven by stronger consumption due to an improving labour market, higher investment given an expected higher absorption of EU structural funds and a reversal in the credit cycle, and net exports. However, real GDP growth remains well below its pre-crisis level and GDP per capita on a purchasing power standards basis is only around 60% of the EU-28 average. In addition, the country is heavily dependent on tourism, with 2016 revenues constituting almost 20% of GDP. Moreover, adverse developments in the labour force and subdued productivity growth keep the country’s overall growth potential low at an estimated 1% p.a., a particularly weak outlook compared to other catching-up economies. While the unemployment rate has fallen from its 17% peak in 2013 to around 13% in 2016, the continuously shrinking labour force accounted for more than half of this reduction. In fact, at around 60%, Croatia’s employment rate is one of the lowest in the EU, driven by low activity rates after the age of 50. Croatia’s growth potential is further constrained by low productivity growth and a relatively large share of state-owned enterprises. Finally, the country’s cumbersome business environment, which results from inefficient public administration and policy instability, is underscored by its relatively poor competitiveness rankings.

In Scope’s assessment, Croatia’s public finance risk remains elevated, despite recent fiscal consolidation that resulted in the country’s exit from the EU’s Deficit Procedure in June 2017. The headline fiscal deficit fell from a record high of 7.8% of GDP in 2011 to 0.8% of GDP in 2016 and primary surpluses have been achieved since 2015. In addition, Scope expects the government to adhere to the 3% Maastricht threshold over the coming years. However, as a result of accumulating high deficits, the materialisation of contingent risks related to state-owned enterprises, and the six-year recession, Croatia’s public debt more than doubled from 40% in 2004 to 87% in 2015. Scope’s baseline debt-sustainability analysis expects the country’s debt-to-GDP ratio to gradually fall to below 80% by 2022, still significantly above its CEE peers and limiting the sovereign’s fiscal space. In addition, Croatia’s debt structure is unfavourable. Given the limited absorption capacity of the domestic market, about 76% of total issued government debt is in foreign currency. However, Scope notes that the share of non-residents holding Croatian government debt has fallen from about 50% in 2008 to around 38% at the beginning of 2017. In addition, at approximately 35%, the share of loans as a government funding instrument is significantly above peers, which Scope assesses as credit negative because it amplifies the sovereign-banking nexus.

In this context, the restructuring process of the Agrokor Group, whose 143 firms employ nearly 57,000 people in the region and generate EUR 6.5bn in annual revenues (15% of GDP), could have systemic effects on public finances and the banking sector. While the government has not explicitly assumed the debts of the company, by specifically treating debts to suppliers as superior to those owed to the financial sector (as stipulated in the ‘Lex Agrokor’), it has implicitly guaranteed those debts, which amount to more than EUR 2bn. In addition, this unequal treatment of creditors may result in costly lawsuits to the government. Similarly, although banks are well capitalised, liquid and profitable, the effects on Croatian banks’ balance sheets could be substantial since EUR 3.5bn of the known debts of around EUR 7bn (15% of GDP) are owed to such creditors. However, given the company’s admission that its past financial accounts are unreliable, the total restructuring value could be even higher.

External economic risks remain high, albeit on a slightly decreasing trend. The current account turned positive in 2013, and Scope expects continued surpluses to reduce Croatia’s external liabilities (although at a more moderate rate given higher domestic demand) and improve the country’s negative net international investment position, which stood at -73% of GDP in 2016. However, private sector external and foreign-currency-linked debt remains a major source of vulnerability. Despite declining modestly over the past few years, the gross external debt ratio remains high at slightly less than 100% of GDP in 2016, while annual gross external-financing needs are projected to remain well above 20% of GDP over the rating horizon. In addition, Scope notes that the high, albeit declining, share of debt denominated in foreign currency exacerbates Croatia’s external vulnerability. Conversely, Scope adds that, to date, this exposure has been mitigated by the quasi-peg of the kuna to the euro, which the Croatian National Bank has successfully pursued through foreign-exchange liquidity regulation and occasional interventions. In fact, gross international reserves increased by USD 1bn to USD 15bn in 2016, and short-term external-debt coverage remains adequate at around 300%, also comparing well against peers.

Ongoing political instability and fragmentation as well as policy uncertainty are expected to continue. The current government is already the 14th since the first multi-party elections were held in 1990, which prevents the country from effectively addressing its institutional shortcomings. International institutions (European Commission, IMF and the World Bank) have all noted on several occasions that weaknesses in public administration, slow implementation of the anti-corruption strategy, restrictive regulation in key infrastructure sectors, frequent changes in regulation and substantial inconsistencies in how they are interpreted, as well as the strong presence of the state in the economy, weigh on the business environment.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative “BBB” (“bbb”) rating range for the Republic of Croatia. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis. For the Republic of Croatia, the following relative credit weaknesses have been identified: 1) growth potential of the economy, 2) economic policy framework, 3) macro-economic stability and imbalances, 4) fiscal performance, 5) public-debt sustainability, 6) market access and funding sources, 7) external debt sustainability, 8) vulnerability to short-term shocks, 9) recent events and policy decisions, 10) financial-sector oversight and governance, and 11) macro-financial vulnerabilities and fragility. No relative credit strengths have been signalled. The combined relative credit weaknesses indicate a sovereign rating of BB for Croatia. A rating committee has discussed and confirmed these results.

For further details, please see Appendix 2 of the rating report.

Outlook and rating-change drivers

The confirmation of the Stable Outlook reflects Scope’s view that risks to the ratings remain broadly balanced. The ratings could be upgraded if: i) growth potential increased on the back of structural reforms; ii) sustained fiscal consolidation led to a steady and more rapid reduction in public debt; and iii) public-administration reforms improved the burdensome business climate. Conversely, the ratings could be downgraded if: i) fiscal slippage and an accumulation of private debt reversed the public and external debt deleveraging processes; ii) political instability further postpones the reform programme; and iii) investor sentiment turned, leading to significant capital outflows and exchange-rate volatility.

For the detailed research report, please click HERE.

Rating committee

The main points discussed by the rating committee were: i) Croatia’s growth potential, ii) macroeconomic stability and imbalances, iii) EU membership and institutional framework, iv) fiscal performance, v) market access and funding sources, vi) public debt sustainability, vii) external debt structure and reserves adequacy, viii) the restructuring of the Agrokor Group and ix) peers.

Methodology

The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available at www.scoperatings.com.

The historical default rates used by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/governance-and-policies/regulatory/esma-registration. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.

The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.

Rating prepared by Rudolf Alvise Lennkh, Lead Analyst
Person responsible for approval of the rating Dr Giacomo Barisone, Managing Director

The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The subscription ratings/outlooks were last updated on 05.05.2017.

The senior unsecured debt ratings as well as the short term issuer ratings were assigned by Scope for the first time.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on Republic of Croatia are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of the ratings under review, in order to conclude the review and disclose ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.

The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: the Ministry of Finance of the Republic of Croatia, Central Bank of Croatia, BIS, European Commission, European Central Bank, OECD, IMF, WB, and Haver Analytics.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability
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