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Rating action

Scope Ratings GmbH (Scope) has today upgraded the Republic of Croatia’s (Croatia) long-term issuer and senior unsecured local- and foreign-currency ratings from BBB- to BBB+ and revised the Outlooks to Stable. Scope has also affirmed Croatia’s short-term issuer rating of S-2 with a Stable Outlook in both local and foreign currency.

Summary and Outlook

The rating upgrade reflects Croatia’s recently formalised entry into the euro area on 1 January 2023 and adoption of the euro as its local currency, with multiple credit-positive implications through the use of a global reserve currency, and stronger governance and flexibility of monetary policy. The replacement of the Croatian kuna with the euro will significantly curtail foreign-currency risks evident in its widely euroised economy, banking system and public debt stock.

The fact that Croatia stands ready to join the euro area next year at the earliest possible date under Exchange Rate Mechanism II (ERM II) agreements underlines the authorities' firm commitment to their reform agenda and the broad political backing for Croatia’s accession across Europe and the euro area. This is despite disruptions due to Covid-19 and Russia’s full-scale invasion of Ukraine, which have driven inflationary developments in Croatia and Europe and caused budgetary deterioration as fiscal support was extended to mitigate the shocks.

Croatia’s ratings remain constrained by several medium- to longer-term challenges relating to: i) elevated public debt, having risen sharply in 2020 due to cyclical budget deterioration and the cost of fiscal support measures in response to Covid-19; ii) modest growth potential, reflecting low investment and productivity growth and unfavourable demographics constraining the labour supply; and iii) the economy’s relatively high reliance on tourism revenues, making it more vulnerable to potential recurrent Covid-19 restrictions and external developments. In addition, currency risk remains a vulnerability for the economy and fiscal dynamics until euro adoption, given that a substantial share of the public and private debt portfolio is denominated in euros. This is mitigated by ERM II participation and these risks will be effectively eliminated from 1 January 2023.

The upgrade reflects updated Scope assessments of Croatia under the ‘public finance risk’ and ‘external economic risk’ categories of its sovereign methodology.

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

The ratings/Outlooks could be upgraded if, individually or collectively: i) the growth potential rose with the help of structural reforms; and/or ii) fiscal performance improved, resulting in a significant decline in the general government debt-to-GDP ratio over the medium term.

Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) the economic outlook weakened materially, due to, for example, a more protracted war in Ukraine with negative repurcussions on key trading partners; and/or ii) fiscal dynamics deteriorated significantly.

Rating rationale

The upgrade of Croatia’s ratings reflects the credit-positive implications of entering the euro area and adopting the euro, a global reserve currency, as its local currency from 1 January 2023. After a positive assessment of Croatia’s fulfilment of convergence criteria in the June 2022 Convergence Report by the European Commission (EC) and the ECB¹, the EC issued a proposal for a Council decision² on the adoption by Croatia of the euro. After a Economic and Financial Affairs Council (ECOFIN) recommendation, the European Council endorsed the Commission proposal on 24 June. The proposal has also gathered the necessary support from all euro area member states and the European Parliament.

As a final step for formalising Croatia’s euro area membership from 2023, the ECOFIN adopted relevant legal acts on 12 July³, removing any uncertainty regarding the timetable of Croatia’s accession and thereby forming the basis of this rating upgrade, which incorporates a forward-looking view of Croatia’s credit fundamentals as a euro area member state from 2023.

In Scope’s view, becoming the euro area’s 20th member state will improve Croatia’s institutional strength and flexibility of monetary policy, and provide access to the deep capital markets of the euro area and the ECB’s asset purchases and refinancing operations, which on aggregate are expected to significantly support debt financing costs for the public and private sector. The adoption of the euro will eliminate foreign-exchange risk in Croatia’s euro-denominated public and private debt portfolios, which have constituted important credit constraints to date.

The Croatian authorities have shown an ongoing commitment to euro area accession reforms, including significant progress in reducing financial and external sector risk, which have strengthened Croatia’s monetary governance. The process of adopting the euro, including progress on commitments made under ERM II and Banking Union, reinforces credit-positive prudence in policymaking and reform momentum.

In the June 2022 Covergence Report, the EC and ECB assessed possitively Croatia’s record of meeting several convergence criteria as a prerequisite to joining the euro. First, Croatia meets the criterion for interest rate convergence. The reference value of a maximum 2.6% yield on a single bond with a residual maturity of 7.5 years was met in April 2022, with Croatia’s rate calculated at 0.8% as a 12-month moving average. This criterion stipulates that an acceding member’s long-term interest rate should not be more than two percentage points above that of the three best-performing member states. Overall, Croatia benefits from a decreasing trend of interest expenses, as general government interest expenditure as a percentage of GDP has declined markedly over recent years, from 3.4% in 2015 to 1.6% in 2021.

Second, the exchange rate convergence criterion was also met after the minimum two-year phase under the ERM II, during which the kuna was 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. Croatia’s foreign exchange reserves stood at EUR 24.85bn as of end-May 2022, broadly stable from EUR 25bn at the end of 2021. The 12 July ECOFIN adopted a final conversion rate of 7.53450 kuna per 1 euro.

Third, Croatia has also met the public finance convergence criterion despite the Covid-19 pandemic and the Russian full-scale invasion of Ukraine, as it is not subject to an Excessive Deficit Procedure. Croatia’s general government deficit was 2.9% of GDP in 2021, below the 3% Maastricht threshold, and Scope expects the deficit to stay below 3% also over 2022-24, with an estimated deficit of 2.8% of GDP in 2022 and 2.5% in 2023. These expectations have not been derailed by the amended 2022 budget, which incorporates measures in response to the Russian full-scale invasion of Ukraine, such as counteracting cost-of-living pressures, support to businesses, and higher expenditure for hosting Ukrainian refugees, among others, with an overall cost increase relative to the original budget of HRK 10.9bn, or 6.3%. Croatia’s fiscal outlook benefits from robust tax revenue growth prospects and a solid economic recovery.

Scope expects Croatia’s economic outlook to benefit from European support and euro area membership over the medium term and forecasts Croatia’s real GDP to grow by 3.5% in 2022 and 3.7% in 2023, after 10.2% in 2021. Grants from the EC’s Next Generation EU programme, along with fulfilment of reforms under agreed milestones, will support the public investment outlook and its contribution to growth and structural improvements for the Croatian economy. Under Croatia’s recovery and resilience plan, it will receive EUR 6.3bn in grants or 11% of 2021 GDP until the end of 2026, with most funds expected to be paid out by 2024. The EC has estimated that implementing the country’s recovery and resilience plan could increase the level of real GDP by 2.9% by YE 2026⁴. At the same time, Scope notes that Croatia has a weak track record of absorbing EU funds (only around a 59% absorption rate over the 2014-20 EU multiannual financial framework as of July 2022). This weak take-up contributed to the low rate of investment in the economy, at just 22% of GDP on average over the last five years. Finally, euro area membership should support inward foreign direct investment and strengthen trade ties to other member states, which are already the country’s biggest trading partners, supporting an overall robust medium-term economic outlook for Croatia.

Finally, Croatia has also fulfilled the price stability convergence criterion, despite the inflationary shock of Russia’s full-scale invasion of the Ukraine driving up energy and food prices globally, but especially in Western economies. These price pressures were further excacerbated by pandemic-related mismatches in supply and demand. As a consequence, HICP inflation reached 10.8% YoY in May 2022 in Croatia, above the euro area average of 8.1%. The price stability convergence criterion stipulated that Croatia’s 12-month average inflation rate could not be more than 1.5 percentage points above that of the three member states with the lowest inflation rate. The June 2022 Convergence Report confirmed Croatia’s fulfilment of the price stability criterion, as its inflation rate stayed below the reference value (which was 4.9% in April 2022, versus Croatia’s 12-month average annual HICP inflation rate of 4.7%) over the assessment horizon.

At the same time, Croatia’s BBB+ sovereign ratings reflect the following credit challenges.

First, Croatia’s general government debt-to-GDP ratio of 79.8% at YE 2021 is high compared to that of peers, having increased from its pre-pandemic level of 71.1% in 2019. Scope expects Croatia’s debt ratio to decline to 76.5% at the end of this year, and then trend down to an expected 66.3% by the end of 2027. These projections are supported by a potential growth estimate of 3% over the medium term, and high GDP deflators this and next year estimated at an average 4%. Similarly, government gross financing needs as a share of GDP will remain relatively high at an average 11% annually over 2022-24.

Second, Croatia’s small, open economy remains vulnerable to external shocks and reliant on external demand. Its high reliance on the tourism and travel sector, which represents around a quarter of GDP (including indirect impacts on other economic sectors), increases the economy’s sensitivity to potential recurring Covid-19 travel restrictions and external developments. This was highlighted by the large swings in economic actvity over 2020-21, with real GDP dropping by 8.1% in 2020 as strict lockdowns and travel restrictions were introduced, only to rebound by 10.2% in 2021 as those restrictions were eased. Still, overall tourist arrivals were still well below their pre-pandemic level, at 12.8m in 2021, only around two-thirds of its 2019-level of almost 20m arrivals.

Finally, a core credit constraint is Croatia’s modest medium-term growth potential estimated at around 3% annually despite relatively low income levels with GDP per capita of around EUR 17,400 at the end of 2021, which compares to EUR 38,200 in the EU-27 and EUR 42,300 in the euro area. This is the outcome of insufficient economic and labour market reforms and, consequently, weak productivity growth, and adverse demographics. Croatia’s working-age population is projected to decline by 0.9% annually over the next five years on average. The old-age dependency ratio (those aged 65 years and over as a percentage of those aged 15-64) is projected to increase to 41% by 2030, from 35% in 2022, reflecting population ageing and emigration flows, which constrain the labour supply. On a positive note, net migration has improved over the last few years, from around 32,000 persons leaving in 2017 to less than 1,000 persons leaving in 2020.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative credit rating of ‘a-’ as regards Croatia. The ‘a-’ indicative ratings can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Croatia, the following relative credit weaknesses have been identified: i) growth potential of the economy, ii) macro-economic stability and sustainability; iii) debt sustainability, iv) current account resilience; v) social risks.

Combined relative credit weaknesses identified in the QS generate a two-notch downward adjustment. An additional one-notch positive adjustment was made at the rating committee level to account for Scope’s expectation that Croatia will be issuing its local-currency debt in euros from 1 January 2023, and therefore benefit from a one-notch reserve currency adjustment to its indicative ratings as per Scope’s sovereign ratings methodology. As such, aggregate adjustments signal a sovereign credit rating of BBB+ 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. Croatia’s CVS score reflects an ageing society via an elevated and increasing old-age dependency ratio compared to peer economies. Croatia has experienced negative net migration over the last ten years averaging around 19,000 persons annually between 2011 and 2020. But, since a peak in 2017, these numbers have been falling, reaching a net outflow of only 632 persons in 2020. Income inequality – captured by the ratio of the income share of the 20% of persons with the highest household incomes to the 20% of persons in society with the lowest household incomes – is low in an international comparison and similar to that of Croatia’s sovereign peer group. Labour force participation of around 67% of the active labour force (ages 15-64) is below the euro area average of around 75% and the peer group average. The EC’s Digital Economy and Society Index 2021, which ranks the EU-27 countries according to digital competitiveness, puts Croatia in 19th place (below average), highlighting challenges in developing the labour force’s digital skills. Overall, the ‘social risks’ component of the QS assessment is evaluated as ‘weak’, indicating social outcomes are relatively weaker than for its ‘a-’ sovereign peers.

Finally, in the sovereign ESG pillar’s environmental risk sub-category, Croatia’s performance is in line with that of indicative sovereign peers. This is due to a high score on the natural disaster risk assessment vis-à-vis the World Risk Index, and a high score for the economy’s carbon intensity (proxy for transition risk to a greener economic model). This is despite the level having been above the EU-27 average. Finally, Croatia shows strong performance in terms of its footprint of consumption relative to available biocapacity. The government is aiming for a 45% reduction in carbon emissions by 2030 relative to 1990 levels and net carbon neutrality by 2050. Croatia’s share of renewable energy in final energy consumption was estimated at 31% in 2020, higher than the EU’s 22%. A full phase-out for coal is planned for 2033. Around 64% of Croatia’s electricity came from renewables in 2020, mainly from hydropower. Environmental policies and challenges are considered under a QS assessment of ‘environmental risks’, which is evaluated as ‘neutral’ versus the sovereign peer group.

Rating Committee
The main points discussed by the rating committee were: i) euro area accession and rating implications, ii) growth prospects and inflation outlook, iii) fiscal dynamics, iv) financial stability risks, v) external economic risks, vi) ESG risks, and vii) peer comparison.

Rating driver references
1 June 2022 Convergence Report
2 Proposal for a Council decision on the adoption of the euro by Croatia 
3 ECOFIN conclusions 12 July 2022 
4 Analysis of the recovery and resilience plan of Croatia

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings’ 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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: Julian Zimmermann, Senior Analyst
Person responsible for approval of the Credit Ratings: Dr. 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 January 2022.

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
© 2022 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis 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.