Rating action

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

For the updated report accompanying this review, click here.

Summary and Outlook

Croatia’s BBB+ ratings are underpinned by the following credit strengths: i) euro area membership since January 2023, which has materially curtailed foreign-currency risks in the external, financial sectors and the public balance sheet, and which bolsters Croatia’s resilience to external shocks, ii) a declining public debt trajectory, anchored by prospects of comparatively robust nominal growth, favourable funding conditions and positive, albeit modest, primary fiscal surpluses; iii) and sound structural reform momentum, which was bolstered by the euro area accession process and is expected to continue in line with the implementation of the country’s Recovery and Resilience Plan.

Despite these credit strengths, Croatia’s ratings remain constrained by several medium- to longer-term challenges relating to: i) still-elevated public debt levels, albeit the debt-to-GDP ratio has substantially declined relative to end-2020, ii) modest growth potential, reflecting low investment and productivity growth and unfavourable demographics constraining the labour supply; and iii) the economy’s low degree of diversification, in particular related to its relatively high reliance on tourism revenues, making it more vulnerable to adverse external developments.

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 negative external shock with negative repercussions on key trading partners; and/or ii) fiscal dynamics deteriorated significantly.

Rating rationale

Croatia’s BBB+ ratings reflect the significant reduction in external and financial sector foreign-currency risks following the country’s adoption of the euro, a global reserve currency, as its local currency on 1 January 2023. Croatia’s euro area membership was formalised in July 2022, and drove Scope's upgrade of its ratings, based on a forward-looking view of credit fundamentals as a euro area sovereign issuer. Entry in the eurozone is also expected to raise near-to-medium term growth prospects, through streamlined trade and financing flows and lower borrowing costs.

The adoption of the euro has markedly lowered foreign exchange risks for the Croatian economy, particularly its banking sector, and public sector balance sheet. Before euro area accession, foreign currency denomination of household and corporate debt stood at 45% and 65% of the total, respectively, primarily in euros. Additionally, more than two-thirds of public debt was denominated in euros. With around 20% of banking sector assets exposed to the general government, the changeover to euros significantly lowers domestic lenders’ foreign currency exposure. More broadly, euro area membership will increase the country’s resilience to external shocks, through heightened institutional strength and monetary policy flexibility. Access to the deep capital markets of the euro area and the ECB’s asset purchase programmes and refinancing operations will support funding flexibility at times of global financial stress.

Scope expects that Croatia’s accession to the euro and Schengen areas will support medium-term growth prospects, through increased inward foreign direct investment flows, streamlined commercial flows and increased international tourism receipts. Croatia’s trade sector is already highly EU-oriented, with more than two-thirds of the country’s foreign trade being conducted with EU trading partners. As of 2018, 80% of Croatian exports and 75% of imports were denominated in euros¹. A reduction in trade barriers should facilitate increased trade flows and a deeper integration in regional value chains. Finally, euro area membership should also lead to lower borrowing costs for the Croatian economy, in line with well-anchored inflation expectations, lower regulatory costs and currency risks. These structural improvements, alongside the roll-out of investments included in the Recovery and Resilience Plan (RRP) and the absorption of Cohesion funds, will support the growth outlook over the medium term.

Croatia’s post pandemic recovery has outpaced that of most peers, with real GDP standing at around 10pp above its pre-pandemic level by end-2022, following annual real GDP growth of 13.1% and 6.2% in 2021 and 2022. The economic momentum decelerated markedly in the second half of last year, with quarterly growth rates (QoQ, SA) of -0.5% and 0.6% in the third and fourth quarter of 2022, respectively. This slowdown primarily reflected the dampening impact of high inflation (with the HICP reaching 10.7% on average), tightening funding conditions and heightened uncertainty on private demand. These headwinds will continue to weigh on economic activity in the beginning of 2023, but Scope expects growth will gradually gain momentum over the course of the year, as improving real income dynamics and lower uncertainty allow for a pick up in private demand. Inflationary pressures have started to subside, with HICP inflation declining to 8.8% in April (off a November 2022 high of 13%), primarily due to an improved external environment and favourable base effects. Price pressures should continue to moderate over the coming months, albeit only gradually, in view of the persistence of underlying price pressures, in part reflecting tight labour markets (unemployment rate at 6.1% as of April, close to multi-decades low). Scope expects growth will decelerate to 1.8% in 2023, before increasing to 2.5% in 2024 and converging to the medium-term average in subsequent years, which Scope estimates at around 3% annually.

Croatia’s BBB+ ratings are further supported by a declining public debt trajectory, anchored by a commitment to fiscal discipline, a robust growth outlook and good debt affordability.

Croatia entered the pandemic crisis after a period of steady primary fiscal surpluses, averaging at 2.5% of GDP over 2016-19, which allowed for a robust decrease in the debt-to-GDP ratio over the same period (-8.6pp, to 71.0% in 2019). The pandemic crisis led to a sharp reversal in this improving trend, with the headline government deficit and debt ratio increasing to 7.3% of GDP and 87.0% of GDP in 2020, respectively, amid falling economic output and a jump in public expenditures to mitigate the impact of the health crisis.

After moderating to a deficit of 2.5% of GDP 2021, the general government balance turned positive in 2022 (0.4% of GDP). This improvement resulted from the phase-out of most Covid-19 era support measures and a significant rebound in revenue, boosted by the continued, robust recovery in economic output (which brought real GDP more than 10pp above its 2019-level) and elevated inflation. These positive developments outweighed spending pressures stemming from the energy crisis, with successive government support packages including cuts to VAT on energy products, increased social transfers and the introduction of a cap on energy and food prices, for a total budgetary cost of 1.5% of GDP in 2022². These positive developments led to a 10pps decline in the debt-to-GDP ratio in 2022 to 68.4%, below its end-2019 level.

Moving forward, Scope expects the fiscal balance to return to annual deficits from 2023, reflecting the delayed impact of price pressures on inflation-indexed government expenditure items (public wages, welfare benefits) and slowing economic growth. In addition, support measures will continue to weigh on the fiscal balance in 2023. In March 2023, the government announced a fourth package of policies aimed at shielding the private sector from price pressures worth EUR 1.7bn (2.5% of GDP), including an extension of the freeze on electricity and gas prices for much of the public and private sectors³.

Scope expects the general government balance to worsen in 2023/24, displaying headline deficits of 0.8% of GDP in 2023 and 1.4% of GDP in 2024, before improving in subsequent years and stabilising at around 1.0% of GDP until 2028. At the same time, the primary balance should remain in surplus over the forecast horizon (averaging at 0.6% of GDP over 2024-28). In addition, interest expenditures are expected to remain moderate, after having declined sharply in the years leading up to the pandemic (from 3.4% to 1.4% of GDP over 2015-22). This improving trend is expected to ease over the medium-term, in line with the tightening of global funding conditions and the increase in borrowing rates for the Croatian government, which brought the yield on euro-denominated ten-year government bonds to 3.7% on average in April 2023. Nevertheless, Scope expects net interest payments to increase only moderately over the medium term, peaking at about 3.6% of revenue in 2024, before resuming a downwards trend is subsequent years, remaining solidly below pre-pandemic averages. This view reflects the positive impact of euro area accession on Croatia’s borrowing costs as well as that of the government debt refinancing profile, under which securities issued at times of elevated interest rates are refinanced under more favourable terms.

Robust debt affordability, along with favourable expected nominal growth rates (expected to average 6% over 2023-28), underpins Scope’s expectations of a steady decline in the debt-to-GDP ratio over the coming years, edging below the 60% Maastricht criterion by 2027 and ending a forecast horizon at around 58% by end-2028. Downside risks to the debt trajectory relate, among others, to the fiscal costs of Croatia’s adverse demographic trends, in particular with regards to additional public spending on health. Recent forecasts from the IMF estimate the net present value of health care spending changes over 2022-50 totalling 48.2% of GDP⁴.

Finally, Croatia’s BBB+ ratings are anchored by the Croatian government’s ongoing commitment to structural reform which will be key to improve the country’s long term growth outlook and address structural economic bottlenecks. This momentum was anchored by the euro area accession process in recent years and is set to benefit from government’s national RRP and associated investments.

The macroeconomic imbalances that emerged over the period of negative real growth over 2009-14 were gradually rectified in subsequent years. These imbalances were connected to significant levels of external, private, and government debt in an environment of sluggish potential growth. The subsequent economic recovery (with annual real GDP growth averaging at 3.1% over 2015-19), alongside a prudent fiscal stance and structural reforms improving labour market and business conditions, led to a steady reduction of these vulnerabilities. The process of adopting the euro, including progress on commitments made under ERM II and Banking Union, achieved convergence in banking supervision and monetary policy and reinforced prudence in macroeconomic policymaking.

Scope expects further structural improvements over the coming years, in line with planned policies under the country’s RRP. Croatia stands to receive EUR 9.2bn (around 14% of GDP, of which EUR 5.5bn in grants and EUR 3.7bn in loans) via the EU Recovery and Resilience Facility (RRF)⁵, alongside EU cohesion funds of around EUR 9bn until the end of 2027⁶. This substantial allocation of EU funds will enhance the government’s reform agenda, including measures aimed at further improving the country’s business and regulatory environment, enhancing its fiscal framework, and implementing active labour market policies. The plan’s investments will also support the digitalisation of the economy and the development of key physical infrastructure, promoting in particular the decarbonisation of the Croatian economy and the expansion of renewable energy generation capacities, all the while easing near-term funding pressures for the government. The European Commission has estimated that implementing the country’s recovery and resilience plan could increase the level of real GDP by up to 2.9% by YE 2026⁷.

While Croatia holds a comparatively weak track record of absorbing EU funds, Scope notes that it has made improvements in this regard, with a nearly 78% absorption rate over the 2014-20 EU multiannual financial framework as of end-2022. Similarly, Croatia compares favourably to European peers to the absorption of funds available under RRF, with more than 40% of grants already disbursed by end-Q1 2023⁸.

Despite these credit strengths, several challenges weigh on Croatia’s BBB+ sovereign ratings.

First, Croatia’s general government debt-to-GDP ratio of 68.4% at YE 2022 remains relatively high, despite having edged 2.7pp below its pre-pandemic levels and around 19pp below its pandemic-induced peak of 87% at YE 2020. Scope expects Croatia’s debt ratio to decline further to 64.3% at the end of this year, and then trend down to around 58% by the end of 2028. 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 5.5%. Similarly, government gross financing needs as a share of GDP will remain relatively elevated at an average 9% annually over 2023-25.

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 adverse external developments, as was the case during the Covid-19 pandemic. This exposure was highlighted by the large swings in economic activity over 2020-21, with real GDP dropping by 8.5% in 2020 as strict lockdowns and travel restrictions were introduced, only to rebound by 13.1% in 2021 as those restrictions were eased. Overall tourism arrivals rebounded robustly last year, at 17.8m, though they remained 9% below their 2019 level. Croatia occupied the 39th spot (of 89) in the 2023 Global Economic Diversification Index⁹, pointing to the comparatively low degree of diversification of the Croatian economy. Similarly, Croatia holds comparatively weak positions in the Observatory of Economy Complexity’s indices – ranking 34th globally for trade, 46th for technology and 43rd for research¹⁰.

Finally, a core credit constraint is Croatia’s modest medium-term growth potential estimated at around 3% annually coupled with relatively low income levels with GDP per capita of around EUR 17,100 at the end of 2022, which compares to EUR 35,200 in the EU-27 and EUR 38,500 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 1.0% annually on average over the 2023-30 period. 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. Based on current trends, the World Bank expects income per capita (in purchasing power standards) to plateau at around 80% of the EU27 average, from about 70% currently¹¹. Trends in net negative migration have improved over the last few years, from around 32,000 persons leaving in 2017 to 4,500 persons leaving in 2021.

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 ‘bbb+’ as regards Croatia. The ‘bbb+’ indicative rating is further supported by the methodology’s reserve currency adjustment which provides a one notch uplift to the CVS indicative. 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) macro-economic stability and sustainability; ii) debt sustainability, iii) current account resilience; iv) social risks.

Combined relative credit weaknesses identified in the QS generate a one-notch downward adjustment and indicate 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 its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

In the sovereign ESG pillar’s environmental risk sub-category, Croatia’s performance compares favourably with that of indicative sovereign peers. This is due to positive scores concerning the Croatian economy carbon intensity (as measured by CO2 emissions per units of GDP), its exposure to natural disaster risk as assessed under the World Risk Index, and its footprint of consumption relative to available biocapacity. These balance an average score with regards to the country’s level of greenhouse gas emissions per capita. 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 2021, higher than the EU’s 22%. A full phase-out for coal is planned for 2033. Nearly 70% 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.

The country’s performance across key social factors is weak relative to peers. 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 11,200 persons annually between 2012 and 2021. But, since a peak in 2017, these numbers have been declining, reaching a net outflow of only 4,512 persons in 2021. 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 70% 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 2022, which ranks the EU-27 countries according to digital competitiveness, puts Croatia in 22nd 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 sovereign peers.

Finally, 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 and euro area memberships enhance credible macroeconomic policymaking and a stable governance framework. In general, policymaking has enjoyed relative continuity in Croatia.

Rating Committee
The main points discussed by the rating committee were: i) euro area accession, 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. IMF Working Paper - Patterns in Invoicing Currency in Global Trade, 2020
2. European Commission, Spring 2023 - Economic forecast for Croatia
3. Government of the Republic of Croatia - The government's response to the global energy crisis: 1.7 billion euros to protect households and the economy from rising prices
4. IMF - Fiscal Monitor, April 2023
5. Bruegel - European Union countries’ recovery and resilience plans, February 2023
6. European Commission - €9 billion for Croatia's economic, social, and territorial cohesion, green and digital transition for 2021-2027
7. European Commission – Croatia 2022 Country Report
8. Croatian Government – National Reform Program
9. World Government Summit - Global Economic Diversification Index 2023
10. Observatory of Economic Complexity - Economic Complexity Index, 2021
11. World Bank – Croatia Country Economic Memorandum, 2022

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for this Credit Rating and Outlook is (Core Variable Scorecard, version 2.1), available in Scope Ratings’ list of models, published under 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 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, Associate Director
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 15 July 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory 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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