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Scope Ratings GmbH has today upgraded the Republic of Croatia’s long-term issuer and senior unsecured local- and foreign-currency ratings to BBB- from BB+, along with the short-term issuer ratings to S-2 from S-3 in both local and foreign currency. All Outlooks are Stable.

Rating drivers

The upgrade of Croatia to an investment-grade rating of BBB- is underpinned by: i) improving fiscal performance with the government debt-to-GDP ratio decreasing by more than nine percentage points over the past three years; and ii) declining external liabilities alongside a build-up of reserves supported by current account surpluses since 2013. The upgrade reflects improvements in Scope’s assessment for Croatia under the ‘public finance risk’ and ‘external economic risk’ categories of the agency’s sovereign rating methodology. The assigned Stable Outlook balances the economy’s vulnerability to external shocks against credit strengths from ongoing fiscal consolidation and pursuit of entry into the euro.

The first driver of the upgrade is Croatia’s improving fiscal metrics supported by a strengthened fiscal framework and continued economic recovery. Stronger fiscal outturns resulted in Croatia’s exit from the EU’s Excessive Deficit Procedure (2014-2017) in June 2017. Croatia has posted a budgetary surplus for two consecutive years, recording balances of 0.8% of GDP in 2017 and 0.2% in 2018. Over the medium-term, Scope expects modest improvements in the budget balance from 0.1% of GDP in 2019 to 0.5% in 2020 in line with the European Commission (EC)’s May 2019 forecast. Based on the 2019 Convergence Programme covering the 2019-2022 period, Croatia is projected to continue to outperform its medium-term budgetary objective, including from 2020 onwards when a more stringent structural deficit objective of 1% of GDP kicks in. Croatia’s output recovered to pre-crisis levels in Q1 2019. Real GDP growth edged down to 2.6% in 2018, from 2.9% in 2017, a growth rate that Scope expects to be maintained over 2019-2020.

Croatia has adopted a 2019-2021 public debt management strategy, planning to further reduce its public debt-to-GDP ratio by over six percentage points to 68.5% by 2020, and to 65.4% by 2021, which would comfortably comply with the EU’s debt criterion. The government’s forecast is more conservative than IMF and EC forecasts, both of which foresee stronger reductions in the debt ratio. Scope notes positively the government’s strategy to reduce debt servicing costs and issue debt with longer maturities. In June 2019, Croatia issued a 10-year Eurobond worth EUR 1.5bn with a fixed annual coupon of 1.125%, the most favourable borrowing terms to date, to refinance maturing debt. As a result, the weighted average maturity of government debt is set to improve to 5.3 years in 2019 from 3.6 years as of 2015, with almost 90% of debt having a fixed interest rate.

In Scope’s view, the recent introduction of the Fiscal Responsibility and State Audit Office acts, integrating EU and IMF recommendations, will strengthen Croatia’s fiscal policy framework. The new fiscal responsibility law is fully in line with the EU’s Stability and Growth Pact and reflects its multi-annual programming framework. The pension reform, which came into force in January 2019, raises the retirement age to 67 as of 2033 for both men and women, from 65 and 62 respectively. It also penalises early retirement, thus enhancing the long-term viability of the pension system.

The adoption of the Budget Act in 2019 would strengthen medium-term planning and include contingent liabilities – such as state guarantees assessed at 3.3% of GDP in 2017 by Eurostat – into the budgeting process. According to the European Commission, however, there has been limited progress in improving corporate governance in state-owned enterprises. More recently, the payment on state guarantees in the amount of HRK 4.54bn (EUR 0.61bn), equivalent to 1.2% of GDP, extended to shipbuilding company Uljanik was a one-off event in Scope’s view, which has nonetheless significantly weighed on the budgets of 2018 and 2019. Scope believes the likelihood of additional, material fiscal costs from the crystallisation of contingent liabilities from Uljanik to be low. Moreover, the successful completion of the creditor settlement for the Agrokor Group (a systematically important food retailer with revenues amounting to around 11% of 2017 GDP), which includes the transfer of its operational business to a new holding company, curbs the risk of adverse impacts from the restructuring on Croatia’s budget and growth.

The second driver of the upgrade is Croatia’s strengthening external buffers and financial stability, which support the country’s progress towards entry into the EU's Exchange Rate Mechanism II (ERM II). Croatia has posted current account surpluses, which averaged 3.5% of GDP in the 2015-18 period, primarily driven by strong services exports. Moreover, Croatia has fully regained the export market share in its goods trade that it lost during the sovereign debt crisis. Alongside valuation effects, this has reduced Croatia’s net debtor position (its net international investment position as a percentage of GDP) by over 22 percentage points since 2015, to 52.5% of GDP at the end of 2018. The structure of external liabilities has improved, with foreign direct investments – less prone to flight in times of market stress – now accounting for 47% of gross liabilities, compared to 37% in 2015.

The Croatian National Bank has continued to accumulate foreign-exchange reserves thanks to strong export performance and inflows of EU funds, with reserves amounting to EUR 18.4bn in April 2019, up 8% from the beginning of the year. According to the IMF, the National Bank’s reserves amount to more than 160% of short-term external debt, comfortably above a 100% adequacy benchmark. The National Bank’s robust macroprudential policies have contained the increase in the debt of households, which amounted to 35% of GDP in Q4 2018, almost unchanged compared to Q4 2017, and below the 39.2% as of Q4 2015.

Croatia meets three of the four economic criteria for joining the euro area (price stability, long-term interest rates and public finances but not the exchange rate criterion), according to the EC’s 2018 Convergence Report. The Croatian kuna is not yet part of the Exchange Rate Mechanism II (ERM II), the precursor to euro area entry, in which a country must participate without severe fluctuations between its currency and the euro for at least two years. In May 2019, Finance Minister Zdravko Maric stated that Croatia aims to send a letter of intent to join the ERM II within the next two months. As part of the process, Croatia has already submitted a request to establish a close cooperation with the European Central Bank on the supervision of Croatian banks within the Single Supervisory Mechanism. Scope expects the government to remain committed to structural reforms necessary to ensure the political support of euro area member states for its ERM II admission. Scope would view the successful entry into ERM II as credit positive, curtailing risks from the economy’s high exposure to the euro.

Croatia is the largest recipient of European structural and investment funds as a share of its GDP, receiving up to EUR 10.7bn during the 2014-20 period (equivalent to 20.8% of 2018 GDP). As of end-2018, only around 64% of this total amount had been allocated to projects. The negotiations for the EU’s next Multiannual Financial Framework 2021-27 will be important for Croatia’s investment and growth outlooks.

Despite these credit strengths, several medium- to long-term macroeconomic imbalances constrain Croatia’s BBB- ratings. First, even after material reductions, Croatia’s public debt-to-GDP ratio of 74.6% in 2018 remains elevated compared with that of central and eastern European peers, and far above pre-crisis level of 39% in 2008. Similarly, gross financing needs as a share of GDP at around 11% in 2019 (down from an average of 16.3% between 2008-2016, supported by the government’s debt management strategy) remain high, amounting to 25% of government revenues.

Secondly, currency risk is a major vulnerability for the economy and fiscal dynamics of Croatia, with 58% of loans and 75% of public debt denominated in foreign currency, almost entirely in euros. Scope considers some of these risks to be mitigated by the kuna’s de-facto peg to the euro – maintained credibly within a tight band since the euro’s inception, alongside by the well-capitalised and liquid banking sector, with system-wide Tier 1 ratios at around 19% of risk-weighted assets, comparing favourably when looked at against regional peers. However, while the share of non-performing loans in total loans has continued to gradually fall to below 9% in 2018, down from 13% in 2015 supported by non-performing loan sales, it remains one of the highest in the region.

Thirdly, the European Commission estimates Croatia’s growth potential at only around 2% over 2019-2020. This is particularly weak compared to that of other transition economies, owing to Croatia’s low productivity and investment growth, alongside adverse demographics, particularly owing to emigration flows and demographic ageing. According to the EC’s 2018 Ageing Report, Croatia’s old-age dependency ratio (calculated as the population aged 65 and over as a percentage of those aged 15-64) is projected to increase from 29.3% in 2016 to 40.3% in 2030. R&D expenditure, at 0.86% of GDP in 2017, is significantly lower than the EU average of 2.07%. According to the EC, Croatia will not reach its national target of 1.4% R&D spending by 2020.

Total investment amounts to a moderate 20% of GDP, roughly unchanged since 2011, in part due to lower absorption of EU funds, and has been well under pre-crisis levels of 27% of GDP during 2006-2008. Investment activity is set to benefit, however, from mostly EU-financed infrastructure projects, including the construction of the Pelješac bridge, which would support trade and tourism in the region. Public investment is materially below pre-crisis levels at 3.5% of GDP in 2018. At the same time, expenditure on public employment is the highest in the region as a share of GDP at 11.7%, due to the high fragmentation of the public administration.

Lastly, the state’s strong presence in the economy, restrictive regulations in key infrastructure sectors as well as weaknesses in the education and health systems weigh negatively on the business environment (24th in the EU according to the World Bank’s 2019 Doing Business report). This hinders the implementation of public policies and weakens the efficient use of resources.

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 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 findings.

For the Republic of Croatia, the following relative credit weaknesses have been identified: i) growth potential of the economy; ii) macroeconomic stability and sustainability; iii) debt sustainability; iv) vulnerability to short-term external shocks; and v) financial imbalances and fragility. No relative qualitative credit strengths were established.

The combined relative credit strengths and weaknesses generate a one-notch downward adjustment and indicate a sovereign rating of BBB- for Croatia.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its sovereign methodology. Here, Croatia has displayed weaker-than-average scores compared with those of central and eastern European peers on the World Bank’s Worldwide Governance Indicators.

Social factors are reflected in Croatia’s falling, though still elevated unemployment rate at 8.5% as of May 2019; declining but above-EU average poverty levels (the proportion of people at risk of poverty or social exclusion was 26.4% for Croatia in 2017, compared to 22.4% for the EU-28 as a whole); gradually falling income inequality but high regional disparities. In addition, the share of people aged 20-64 who are employed remains relatively low at 65.2%, compared to the EU average of 73.1%. The EC’s Digital Economy and Society Index, which assesses EU members states’ digital competitiveness, ranks Croatia 20th, after the Czech Republic and Portugal. Croatia is one of the weakest performers among EU members in the United Nations’ E-Government Survey, which measures the effectiveness in delivery of public services using information and communication technologies. Finally, environmental factors are considered during the rating process, but did not play a direct role in this rating action.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12-18 months.

The ratings/outlook could be upgraded if, individually or collectively: i) the implementation of structural reform strengthens productivity and labour market outcomes; ii) public debt falls faster than expected going forward; and/or iii) external liabilities decline more than expected and/or the high foreign-currency exposure of Croatia is assessed to pose a lesser risk than currently the case to the growth, fiscal and financial stability outlooks.

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

Rating committee
The main points discussed by the rating committee were: i) Croatia’s growth outlook, labour market and demographic trends; ii) contingent liabilities; iii) ERM II convergence update; iv) fiscal consolidation; v) public debt sustainability and debt management strategy; vi) external sector developments; vii) financial sector developments and viii) peers.

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 as well as 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.

Solicitation, key sources and quality of information
The rating 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: Croatian National Bank, Ministry of Finance (Croatia), Croatian Bureau of Statistics, the European Commission, the European Central Bank (ECB), the Statistical Office of the European Communities (Eurostat), the IMF, the OECD, the BIS 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.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst: Levon Kameryan, Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 27.07.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5, D-10785 Berlin.

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