For the detailed rating report, click here.

Scope Ratings has today upgraded the Republic of Croatia’s long-term local-currency and foreign-currency issuer ratings to BB+ from BB. The sovereign’s senior unsecured debt ratings in both local and foreign currency were also upgraded to BB+ from BB. The short-term issuer ratings have been affirmed at S-3 in both local and foreign currency. All Outlooks are Stable.

Rating drivers

The drivers for the upgrade of Croatia’s long-term ratings are: i) the successful conclusion of the debt settlement plan for the Agrokor Group, the country’s largest and most systemically important private company, which has been in financial distress since 2017; ii) fiscal consolidation efforts, leading to a sustained outperformance of the EU Convergence Programme target; and iii) declining external indebtedness and build-up of foreign-exchange reserves, supported by current-account surpluses and EU fund inflows. The upgrade reflects changes in Scope’s assessments in the ‘public finance risk’ and ‘external economic risk’ categories of its sovereign methodology. The ratings remain constrained by high public-debt levels, a significant foreign-currency exposure in public- and private-sector debt, low potential growth, and institutional shortcomings alongside a burdensome business environment.

The first driver of the rating upgrade is the successful conclusion of the debt settlement plan for the Agrokor Group – which is systemically important for Croatia given group revenues in 2017 accounted for around 11% of GDP. The deal mitigates the risk of adverse economic and financial effects that previously constrained the rating. The debt settlement plan involves debt-to-equity swaps and loan write-offs and eliminates the risk of a disorderly restructuring. This contains the direct risks to the budget stemming from the state’s de facto guarantee of the debts of Agrokor’s suppliers, which amount to more than EUR 2bn and is treated senior to debts owed to the financial sector. In addition, the risk of material volatility in tax revenues is reduced in view of Agrokor’s large contribution to the national budget. However, any future operational restructuring that lowers investment or increases unemployment could still weigh on Croatia’s economic performance.

The second driver underpinning the rating upgrade is the improved budgetary performance. Croatia’s significant fiscal consolidation has led to its exit from the EU’s Excessive Deficit Procedure in June 2017. In 2017, the fiscal balance improved to a surplus of 0.8% of GDP, outperforming the Convergence Programme target by more than 2pp, due to strong growth in tax revenue, falling interest expenses and spending constraints on public investment. Going forward, the government’s Convergence Programme for 2018-2021 projects a modest budget deficit of 0.5% of GDP in 2018 and 0.4% in 2019. This is in line with the IMF’s expectations, but more cautious than the European Commission’s spring forecast of around a surplus of 0.8% of GDP for both years considering the better-then-anticipated performance in 2017.

Scope expects debt to continue to decline over the medium term while remaining somewhat higher than the convergence criterion of 60% of GDP in the period to 2023, supported by expected primary surpluses and moderate real GDP growth. This is consistent with the government’s 2018 Convergence Programme projections, implying compliance with the debt benchmark of the Stability and Growth Pact.

Scope notes positively the government’s efforts to improve debt management, which supports a sustained reduction in debt servicing costs and longer debt maturities. As a result, the declining share of short-term government debt, at 4.8% of the total stock in 2017, compares well against the peer average, as does the average residual maturity of debt at 4.5 years. In addition, the share of non-residents holding Croatian government debt fell from about 50% in 2008 to around 39% at the end of 2017, now in line with that of peers.

Croatia has committed to adopt the euro, which the Croatian National Bank (HNB) believes will bring considerable benefits given the country’s close economic and financial integration with the euro area. According to the European Commission’s latest convergence report, Croatia meets three of the four economic criteria for joining the euro area (price stability, long-term interest rates and public finances but not yet on the exchange rate criterion). The Croatian kuna is not yet a part of the Exchange Rate Mechanism II (ERM II), the precursor to euro area entry. Croatian Prime Minister Andrej Plenkovic has targeted 2020 for entry into ERM II. Scope would view the entry into ERM II as credit positive, curtailing risks from the government and economy’s high exposure to the euro.

The third driver supporting the rating upgrade is the improvement in external buffers. An increase in the export of goods and, particularly, services, partly due to regaining a portion of lost market share (Croatia’s share in world goods exports is up by 24% since 2014), contributed to a strong current-account surplus of around 3.7% of GDP in 2017. Lower repatriation of profits in the banking sector associated with the Agrokor crisis supported the 2017 surplus, which Scope expects to be a one-off event. In view of moderate upward pressures on the currency, due to robust performance in exports and inflows of EU funds, the HNB has accumulated sizeable reserves worth EUR 15.7bn at the end of 2017, up from EUR 13.5bn in 2016. According to recent IMF estimates, Croatia’s official reserves amounted to around 130% of short-term external debt in 2017 and are expected to increase to 160% in 2019, comfortably above a 100% adequacy benchmark.

In Scope’s view, current-account surpluses will continue to reduce Croatia’s negative net international investment position – which was -62% of GDP in Q4 2017, more than 7pp up from Q4 2016 levels – albeit at a more moderate rate given higher domestic demand.

Despite these factors, the ratings are constrained by the country’s high public debt at 78% of GDP in 2017, the result of an accumulation of high deficits during a six-year recession and still elevated compared to the debt of peers. As the Croatian economy remains heavily euroised, currency risk is a major vulnerability with around 73% of total government debt linked to the euro.

While deleveraging in corporate and household sectors has significantly reduced the banking sector’s currency risks, around 60% of total loans outstanding remains denominated in a foreign currency. However, Scope considers some of these risks to be mitigated by the kuna’s de-facto peg to the euro.

The European Commission estimates Croatia’s growth potential at only about 1.5%, which is particularly weak compared to other transition economies, owing to low productivity growth and labour trends. While the unemployment rate has fallen from its 19.8% peak in 2013 to around 12.2% in 2017, this was mainly due to negative demographics and emigration leading to a shrinking pool of workers. Productivity levels remain significantly below the EU average, weakened by subdued investment still substantially below pre-crisis levels.

Lastly, fragmentation in public administration, restrictive regulations in key infrastructure sectors, weaknesses in educational and health systems, as well as the state’s strong presence in the economy weigh negatively on the business environment (23rd in the EU according to the World Bank’s Doing Business report), hindering the implementation of public policies, and weakening the efficient use of resources.

Core Variable 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 up to three notches on the Qualitative Scorecard (QS) depending on the size of relative credit strengths or weaknesses versus peers based on analysts’ qualitative analysis.

For the Republic of Croatia, the following relative credit weaknesses have been identified: 1) growth potential of the economy, 2) macroeconomic stability and sustainability, 3) fiscal policy framework, 4) debt sustainability, 5) market access and funding sources, 6) external debt sustainability, 7) vulnerability to short-term external shocks, 8) banking-sector oversight and governance, and 9) financial imbalances and fragility. No relative qualitative credit strengths have been signalled.
The combined relative credit strengths and weaknesses indicate a sovereign rating of BB+ for Croatia.

A rating committee discussed and confirmed these results.

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

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced.

The ratings/outlook could be upgraded if: i) the implementation of structural reform strengthens productivity and labour market outcomes; ii) public debt reduces materially going forward; and/or iii) reforms towards stronger institutions and a more robust financial sector open a clear path for participation in ERM II as the pre-requisite to joining the euro.

Conversely, the ratings/outlook could be downgraded if: i) public finances deteriorate due to a reversal in fiscal consolidation; ii) the reform programme is postponed, further impairing the efficiency of public administration; and/or iii) there is heightened exchange rate volatility, weighing on external-debt sustainability.

Rating committee

The main points discussed by the rating committee were: i) Croatia’s growth potential, ii) macroeconomic stability and imbalances, iii) the debt settlement of the Agrokor Group, iv) EU membership, convergence and institutional framework, v) fiscal consolidation, vi) debt management strategy, vii) debt sustainability scenarios, viii) external debt structure and reserve adequacy, and ix) peer analysis.

Methodology

The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on 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. 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 on 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 GmbH.
Rating prepared by Levon Kameryan, Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 01.09.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 01.09.2017.

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, World Bank, 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 the issuance of the rating, 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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