Fitch Ratings has affirmed Croatia’s long-term foreign currency issuer default rating at ‘BBB’ with a positive outlook. Below we provide the breakdown of the key drivers of this assessment.
First of all, we start with the credit fundamentals. According to Fitch, Croatia’s ratings are supported by strong structural features, including higher human development and governance indicators than peers, supported by the membership in the EU, and a GDP per capita that is around 40% higher than the ‘BBB’ median. On the other hand, Croatia is facing high (although decreasing) public sector debt and a weak record of structural reform implementation, which when combined with failing demographics, stunts potential growth.
Next up, we have the positive outlook. The agency expects that Croatia will be in a position to join the euro in January 2023, with strong progress being made towards meeting convergence and reform criteria under Exchange Rate Mechanism II (ERM II), as well as the political support at the wider EU level for Croatia’s membership. Breaking this down further, Croatia has met all structural reform criteria under ERM II and currently meets most of the convergence criteria, i.e. interest rate, exchange rate, and public finances. The only thing that could pose a problem for the euro adoption is the price stability criteria, which is affected by the rising inflation in recent months. The inflation peaked at 7.3% in March (the highest since 2008), and on average hovered around 4%-4.1% from April 2021 to March 2022.
Nevertheless, the agency does not expect this to pose that big of a risk, as inflation has increased across the EU. This is important because the way that the price stability criteria are looked at is by taking the three best performers in terms of inflation and adding/removing 1.5 p.p., then comparing it to a country to see if it passes the criteria. As some countries started with a very low base in terms of inflation, this could become an issue for Croatia’s ascension. However, the agency believes that the EU will use the flexibility provided in the convergence criteria (for example removing the inflation rates of some of the members it considers outliers from the calculation) when assessing Croatia in May, with a likely positive outcome in July. Because of this, they do not expect a delay of more than one year if Croatia fails to meet the inflation criteria.
Going further, the agency also talked about inflation itself. They forecast that HCPI (harmonized consumer price indices) will average at 7% in 2022, with the possibility of it reaching double digits in Q2 2022, as energy and commodity prices continue to have an impact. The government’s decision to reduce VAT on food and energy, as well as put caps on electricity and gas means that a part of these costs won’t be passed to final consumers. In 2023, they forecast a 3.5% inflation rate, with a possibility of even higher inflation because of a demand for higher wages.
Because of these reasons, they expect growth to slow to 3.3% in 2022 due to the base effect and slowdown in household consumption as inflation affects consumer spending. They also expect a slowdown in trade with key trading partners (particularly in the EU), but at the same time, this will be somewhat mitigated as service sectors such as tourism continue to recover due to Croatia’s structural advantages. They expect GDP growth to amount to 3.7% in 2023, assuming a reduction in external risk and higher investments, driven by EU programs. Finally, Fitch estimates EU transfers of up to 5% of GDP per year in the next four years will sustain the economic momentum.
Fitch also touched on the downside risks, primarily the Russia Ukraine crisis. The effect on Croatia is very limited in this regard, as Russia and Ukraine make up 1.5% of exports, and 1% of investments and tourists. Even though Croatia stands at the EU avg. in terms of energy dependency (56%), the opening of last year’s LNG terminal means that Croatia can reduce its dependence on Russian gas to zero. Still, higher energy costs will affect the country, combined with further supply chain disruptions.
Moving on to the financial position of the country, Fitch estimates that Croatia is in a stable fiscal position. As Croatia’s fiscal deficit decreased to 2.9% of GDP in 2021, owing to the revenue growth combined with expenditures decrease, Fitch estimates that the revenue growth will continue, but that expenditures will increase in order to combat the inflation. Because of this, they forecast a headline deficit of 2.8% in 2022, before decreasing to 1.9% in 2023.
Next up, they also talked about the falling debt. In 2021, public debt/GDP fell to 79.8% (-7.8 p.p. YoY), thanks to the improved fiscal position and economic expansion. Fitch expects it to fall to 75.5% in 2022 and 72.6% in 2023. Modest primary deficit and high nominal growth support the forecast of an average 3 p.p. decrease in debt stock per year over the next 5 years. This would also be consistent with meeting the convergence criteria, even though the public debt/GDP will remain above the 60% Maastricht debt ceiling. They expect the financing costs to rise gradually, following global trends, but also that the euro adoption and good debt management to reduce financing risks.
Croatia’s solid external position was also analyzed. Croatia’s external sector continues to benefit from the current positive account trends, rising foreign investment and strong EU support, with net external debt broadly in line with ‘BBB’ peer median of 5% of GDP. They expect the current account surplus to narrow to an avg. of 1% of GDP in 2022-2023 as the trade deficit widens in line with higher energy imports. This, however, should be offset by rising EU inflows as absorption increases. Furthermore, a large FX reserve (over 40% of GDP) will allow the Croatian National Bank to maintain exchange rate stability ahead of euro adoption.
Finally, the rating agency also commented on factors that could lead to a downgrade/upgrade. Starting with the negative, we have two. Firstly, if a significant delay in the timeline of the eurozone ascension happens. Secondly, if the general government debt increases over the medium term. Ending with the positive factors, Croatia will get an upgrade if the Economic and Affairs Council of the EU confirms that Croatia met its eurozone membership criteria, or if there is evidence of an improvement in medium-term growth prospects (for example, from the implementation of structural reforms of EU-led investments, that could lead to a faster than expected reduction on govt. debt/GDP.
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