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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Republic of Croatia’s long-term issuer and senior unsecured debt ratings at BBB- in both local and foreign currency and revised their Outlooks to Positive. The country’s short-term issuer ratings have been affirmed at S-2 in both local and foreign currency, with Stable Outlooks.

Summary and Outlook

The Outlook revision to Positive on Croatia’s ratings reflects an ongoing commitment to euro-area accession reforms. Efforts include addressing financial system and external sector vulnerabilities, facilitated by Croatia’s participation in the EU’s banking union and the presence of the Croatian currency in the European Exchange Rate Mechanism (ERM II). These developments have strengthened the roadmap for adopting the euro in the medium term, a key policy priority of the current Croatian administration.

Croatia is likely to be ready to adopt the euro by 2023 despite the disruption caused by the pandemic. This timeline would be in line with the authorities’ official target. The country’s progress towards euro adoption is supported by the eurozone authorities’ commitment to enlargement and political backing for Croatia’s membership. Joining the eurozone would enhance several rating-relevant areas by bringing about improvements in Croatia’s level of institutional strength, monetary policy flexibility and enabling it to issue debt in a reserve currency that is also its national currency (the euro), while curbing exchange-rate risk for public and private balance sheets.

In Scope’s view, risks to the timeline for Croatia’s admission to the eurozone mostly relate to uncertainty regarding how the coronavirus pandemic will evolve over the coming months. This could make it more challenging for Croatia to fulfil price stability and public finance criteria, causing it to miss the 2023 target. Although Scope does not foresee major domestic political obstacles to introducing the euro, maintenance of a commitment to reform in financial-system governance is crucial over the period ahead to fully comply with EU treaties in fields of central bank independence and central bank integration in the Eurosystem.

The revised outlook reflects updated assessments of the ‘external economic risk’, ‘financial stability risk’ and ‘institutional and political risk’ categories under Scope’s sovereign rating methodology.

Croatia’s ratings remain constrained, however, by several medium-to-longer term credit challenges relating to: i) elevated public debt, due to cyclical budget deterioration as well as the cost of fiscal support measures in response to the Covid-19 crisis, which has additionally resulted in medium-term government financing needs rising to some of the highest among peers; ii) low growth potential in the medium term, reflecting low investment and productivity growth and unfavourable demographics in the form of an ageing population and net emigration, which constrain the labour supply; and iii) the economy’s relatively high reliance on tourism revenues, making it more vulnerable to Covid-19 shocks. In addition, currency risk remains a vulnerability for the economy and fiscal dynamics, given that a substantial share of the public and private debt portfolio is denominated in euros. This is mitigated, however, by ERM II participation.

The Positive Outlook represents Scope’s opinion that risks to the sovereign ratings are tilted to the upside over the next 12 to 18 months.

The ratings could be upgraded if, individually or collectively: i) additional progress was made towards euro-area accession; ii) growth potential rose with the help of structural reforms in the labour market, productivity and/or infrastructure; and/or iii) public debt-to-GDP declined faster than expected, supported by the authorities’ fiscal consolidation.

Conversely, the Outlooks could be revised to Stable if, individually or collectively: i) there was a considerable postponement in the timetable for euro-area accession due, for example, to weaker reform momentum or inadequate commitment to convergence criteria; and/or ii) Scope observed a lasting deterioration in fiscal dynamics due, for example, to a failure to narrow budget deficits or to weaker growth prospects.

Rating rationale

The Outlook’s revision to Positive is driven by the authorities’ ongoing commitment to euro-area accession reforms, including the significant progress achieved in reducing financial and external sector risk, which have strengthened Croatia’s monetary settings in the aggregate. The process of adopting the euro, including progress under commitments made under the ERM II and the banking union, reinforces credit-positive prudence in policymaking and reform momentum. Adopting the euro would support Croatia’s ratings by improving its institutional strength and monetary policy flexibility, while providing access to the deep and liquid capital markets of the eurozone and to the ECB’s asset purchases and refinancing operations, which would support Croatia’s debt financing costs. The issuances in a strong reserve currency (the euro) after the accession would also reduce external-sector risk, including foreign-exchange risk in Croatia’s euro-denominated public and private debt portfolio.

In September 2021, Croatia signed¹ a memorandum of understanding with the European Commission (EC) and eurozone member states. The document details the steps Croatia needs to take before it starts printing euros upon receiving a final decision on euro adoption from the European Council. The Council’s decision will be based on the conclusions in the Convergence Report to be prepared by the EC and the ECB. These conclusions will assess Croatia’s fulfilment of convergence criteria (sound and sustainable public finances, price stability, long-term interest rate convergence, exchange rate stability) and structural policy measures announced prior to joining the ERM II in July 2020². The next Convergence Report is expected to be published by June 2022. Given that the process to enter the euro area requires a minimum of two years under the ERM II, 1 January 2023 would be the earliest feasible date for accession.

Scope does not anticipate Croatia will face any hurdles to meet the interest rate-convergence and exchange rate-stability criteria. The 12-month average secondary market yield³ on Croatian government bonds with maturities of 10 years stood at 0.45% as of December 2021. The average yield on German bonds with comparable maturities was around negative 0.4% for the same period, the lowest such rate among EU member states. This puts the interest rate-convergence criterion well within Croatia’s reach. This criterion stipulates that an acceding member’s long-term interest rate should not be higher than two percentage points above that of the three best-performing member states in terms of price stability.

The exchange-rate criterion is expected to be met after the minimum two-year phase under the ERM II, during which the kuna is allowed to fluctuate versus the euro within stringent limits. Croatia’s record of a credible de-facto peg of the kuna to the euro and the Croatian National Bank’s sufficient reserves back the credibility of the exchange rate during the current period of participation in the ERM II. International reserves increased to EUR 24.2bn as of end-November 2021, from EUR 18.6bn one year before. In addition, the country’s central bank can borrow up to EUR 2bn from the ECB⁴ via a swap line agreement until the end of March 2022.

Scope expects the government to aim to keep its fiscal deficit below 3% of GDP (Maastricht criteria) over 2022-24 to qualify for euro adoption. Scope’s expectation is supported by Croatia’s record of prudent fiscal policies prior to the pandemic, resulting in fiscal surpluses over 2017-19. Scope projects the fiscal deficit will gradually narrow to 2.7% of GDP in 2022, 1.8% of GDP in 2023 and 1.5% of GDP in 2024, from an estimated 4.1% of GDP in 2021. As a result, the general government debt-to-GDP ratio is projected to diminish at a sufficient pace (the gap between the current debt level and the reference of 60% of GDP needs to shrink by at least 5% annually on average over three years) to 77% by 2024, from an estimated 84% in 2021. This would enable Croatia to avoid an excessive deficit procedure.

The projected improvements in Croatia’s budget position and debt dynamics are being actively assisted by an improved outlook for tax revenue growth. The latter should follow a recovery in indirect taxation, caused primarily by a recovery in personal consumption and tourism activities, as well as the gradual expiry of pandemic-related temporary support measures and Croatia’s good prospects for economic recovery in the near term. Scope forecasts Croatia will grow by 4.8% in 2022 and 4.0% in 2023, from an estimated figure of 10.5% in 2021.

Pandemic-related mismatches in supply and demand as well as rising energy prices have driven a rapid rise in inflation across the EU. Croatia’s fulfilment of the price stability criterion (its 12-month average inflation rate cannot be more than 1.5 percentage points above that of the three member states with the lowest inflation rate) will thus depend on price developments in the rest of the EU. It will also depend on whether any of those member states with the lowest inflation are identified as outliers due to exceptional factors (consequently excluding them as benchmark countries for the reference value). As of December 2021, Croatia’s 12-month average inflation rate was 2.7%, compared to the 0.8% average for the three countries with the lowest inflation rate (Greece, Malta and Portugal) and 2.9% for the EU as a whole. In the context of the coronavirus pandemic, there is a high level of uncertainty as to how these rates will evolve in the coming months.

Scope does not foresee major domestic political obstacles to Croatia adopting the euro. In 2018, the government of Prime Minister Andrej Plenković adopted a medium-term strategy for the adoption of the euro, making it a policy priority. The appointment of Plenković’s second cabinet in 2020 confirms a renewed commitment to this strategy. Recent initiatives protesting the government's plan for eurozone admission have failed to collect enough signatures for a referendum.

However, Scope has taken note of recent allegations concerning insider trading among top Croatian central bank officials, which, if proven, could potentially affect Croatia’s convergence assessment. The 2020 Convergence Report⁵ noted that there are still some deficiencies in Croatia’s institutional framework, including that Croatian law does not comply with all the requirements for central bank independence.

Croatia’s sovereign ratings also reflect the following key rating drivers.

Firstly, even when accounting for projected reductions, Croatia’s public debt-to-GDP ratio of 77% by 2024 will remain elevated compared to that of peers in Central and Eastern Europe and above the pre-pandemic level of 73% in 2019. Similarly, government gross financing needs as a share of GDP will remain high at around 11% annually over 2022-24, although this is below the IMF risk benchmark of 15%.

Secondly, currency risk is a vulnerability for Croatia’s economy and fiscal dynamics. More than half of all bank loans and over two thirds of public debt are denominated in foreign currency. Almost all of this is in euros. Scope considers these risks to be mitigated by ERM II participation and the kuna’s credible historical de-facto peg to the euro.

Furthermore, Croatia’s small, open economy remains vulnerable to external shocks and is reliant on external demand. Croatia’s high reliance on the tourism and travel sector, which represents around one quarter of GDP (including indirect impacts on other economic sectors), increases the macroeconomic outlook’s exposure to pandemic-related developments.

Thirdly, Scope projects Croatia’s medium-term growth potential to be a tepid 2.5-3% annually despite relatively low income levels. This is the outcome of insufficient economic and labour market reform and, consequently, weak productivity growth, limited economic diversification, and adverse demographics. Croatia’s population declined by 0.7% annually between 2016-2020. The old-age dependency ratio (those aged 65 years or over as a percentage of those aged 15-64) is projected⁶ to increase to 41% by 2030, from 33% in 2020, reflecting population ageing and emigration flows, which constrain labour supply. Positively, net migration has declined over the last few years, from over 22,000 persons leaving in 2016 to less than 1,000 persons leaving in 2020.

The front-loading of EU monies starting from 2022, following the European Commission’s endorsement⁷ of Croatia’s recovery and resilience plan (EUR 6.3bn in grants or 12.5% of 2020 GDP), support medium-term public investment and economic growth. However, Scope notes that Croatia has a weak track record of absorbing EU funds (only around a 50% absorption rate over the 2014-20 EU multi-annual period as of September 2021, one of the lowest among EU member states in Central and Eastern Europe). This weak take-up contributed to low rate of investment in the economy, at just 21% of GDP over the last five years. This rate is particularly weak when compared to other regional peers, and it remains an important growth constraint.

 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, provides a first indicative rating of ‘bbb+’ for Croatia. The country does not receive a positive adjustment to this indicative rating from a reserve currency adjustment under Scope’s methodology. Hence, the indicative rating of ‘bbb+’ can be adjusted by up to three notches via the qualitative scorecard (QS), depending on the size of qualitative credit strengths or weaknesses relative to a peer group of countries.

No relative qualitative credit strengths have been identified for Croatia. The following relative qualitative credit weaknesses have been identified, however: i) growth potential of the economy; ii) macroeconomic stability and sustainability; iii) debt profile and market access; iv) current account resilience; v) financial imbalances; and vi) social risks.

The QS generates a two-notch downward adjustment and indicates BBB- long-term ratings for Croatia.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during the rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar. This pillar has a 20% weighting in the quantitative model (CVS) and the qualitative overlay (QS). Under governance-related factors, Croatia has average performance compared to peer member states in Central and Eastern Europe as assessed under the World Bank’s Worldwide Governance Indicators. Croatia’s EU membership enhances credible macroeconomic policymaking and a stable governance framework. In general, policymaking has enjoyed relative continuity in Croatia.

The country’s performance across key social factors is mixed. This is reflected in income inequality and a poverty ratio that are both around the EU average (23% of the population was at risk of poverty or social exclusion in 2020, compared to a figure of 22% for the EU-27); an unemployment rate (7.1% as of November) that is higher than the EU average (6.5%); and moderate labour force participation rates. The European Commission’s Digital Economy and Society Index 2021, which ranks the EU-27 countries according to digital competitiveness, puts Croatia in 19th place (below average).

Environmental factors are explicitly considered in the rating process via the ESG risk pillar’s environment sub-category. Croatia’s share of renewable energy in final energy consumption was estimated at 31% in 2020, higher than the EU’s 22%. Around 64% of Croatia’s electricity came from renewables in 2020, mainly hydropower.

Rating committee
The main points discussed by the rating committee were: i) Croatia’s growth outlook; ii) convergence; iii) fiscal and debt dynamics; iv) labour market and demographics; v) external sector developments; vi) financial sector developments; vii) ESG; and viii) peers.

Rating driver references
1. European Commission, press release
2. ECB, Economic Bulletin, Issue 8/2020
3. ECB, long-term interest rate statistics for EU member states
4. ECB, press release
5. Convergence Report 2020
6. Eurostat, old-age dependency ratio
7. European Commission, press release

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021) is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#!governance-and-policies/regulatory-EU. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.
 
Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation NO
With access to internal documents                              NO
With access to management                                       NO  
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Levon Kameryan, Senior Analyst
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 28 June 2019.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.
 
Conditions of use / exclusion of liability
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