Moody’s Affirms Croatia’s Baa2 Ratings, Changes Outlook From Stable to Positive

On Friday, Moody’s Investors Service (Moody’s) changed the outlook on the Government of Croatia to positive from stable, while at the same time affirming its long-term issuer and senior unsecured ratings at Baa2. 

Moody’s shift to a positive outlook for Croatia is influenced by the growing probability of a more substantial reduction in the country’s debt burden than initially anticipated. This is expected to contribute to enhanced fiscal strength. Additionally, the positive outlook is supported by the potential for increased economic growth in Croatia, along with signs of improved institutional effectiveness and governance. Notably, the effective implementation of the extensive investments and reforms outlined in Croatia’s Recovery and Resilience Plan (RRP) further reinforces Moody’s assessment of the country’s institutional and governance strength.

The Baa2 ratings affirmation for Croatia underscores its robust fiscal, institutional, and governance strength, surpassing its peers. However, economic vulnerabilities persist due to heavy reliance on tourism, coupled with challenges related to an aging population. Ongoing exposure to geopolitical and banking sector risks remains a credit constraint. Croatia’s long-term country ceilings for local and foreign currency bonds remain at Aa2, reflecting a typical six-notch gap between the local currency ceiling and rating in the euro area. This aligns with the region’s strong institutional framework, legal regulations, and crisis management mechanisms, indicating minimal exit risk from the euro area.

Moody’s anticipates Croatia’s government debt will reach 61.1% of GDP by end-2023, decreasing further to 58.3% in 2024 and 56.3% in 2025. This represents a substantial reduction from its pre-pandemic level of 70.9% in 2019 and the pandemic peak of 86.8% in 2020. The accelerated decline surpasses Moody’s prior expectations. While Croatia’s elevated debt has been a historical credit weakness, the decreasing debt-to-GDP ratio aligns it more closely with its Baa-rated peers. Moody’s foresees Croatia’s debt affordability metrics remaining stronger than most peers, as the government effectively refinances maturing debt at lower rates despite global interest rate shifts.

The rapid debt reduction results from robust GDP growth in 2021-2022 post-pandemic, alongside nominal growth in the high-inflation environment of 2022-2023. Although the pace will moderate, with real GDP growth at 2.8% in 2023 and 2.6% in 2024, continued reduction is expected. Moody’s attributes this to a broadly balanced primary fiscal position, even though rising demands for expenditure and loan-funded investments may lead to deficits of 1.9% of GDP in 2024 and around 1% in 2025. Despite fiscal balance improvements from a 7.3% deficit in 2020 to a 0.4% surplus in 2022, efforts to support households and businesses during the inflationary shock could result in a small deficit of 0.4% of GDP in 2023.

After a period of robust growth in 2021-2022 post-pandemic, Moody’s projects Croatia’s growth to hover around 3% in 2023 and the following years, surpassing expectations for the euro area and many Central and Eastern European peers. Croatia’s economic resilience is attributed to its service-oriented structure, particularly in tourism, which has fared better than manufacturing amid energy price increases and the broader European economic slowdown. Steady wage growth, matching inflation due to a tight labor market, has fueled robust consumption. While the tourism sector’s growth potential is deemed limited, Moody’s anticipates continued moderate growth in exports and consumption. The primary driver of the improved growth outlook is the substantial EU investment funding available to Croatia. With the revised national Recovery and Resilience Plan, Moody’s expects Croatia’s total Recovery and Resilience Fund (RRF) to reach around 13% of 2023 GDP, complementing the approximately 10% from the EU’s regular 2021-2027 budget.

The RRF investments, focusing on green and digital transitions, labor supply, and education, are set to directly boost GDP growth in the coming years. Coupled with reforms in public administration, health, judicial, and education systems, Moody’s anticipates a meaningful contribution to Croatia’s long-term growth beyond the RRF’s conclusion in 2026. Croatia’s smooth implementation of reform and investment projects under the Recovery and Resilience Plan positions it as a front-runner in accessing RRF funding. Progress suggests enhanced institutional and governance effectiveness, aligning with Moody’s sovereign methodology. Croatia’s successful efforts to meet the criteria for the Euro and Schengen areas in 2022 further underscore institutional improvements.

The Baa2 ratings affirmation underscores Croatia’s fiscal resilience and institutional strength, surpassing rating peers, despite lingering challenges in controlling corruption. High-income levels and the ability to withstand economic shocks further support the ratings. However, Croatia faces constraints due to a heavy reliance on tourism, limited economic diversification, and structural issues related to an aging population. Additional credit constraints include moderate exposure to geopolitical and banking sector risks.

Croatia’s ESG Credit Impact Score stands at a neutral to low level (CIS-2), indicating moderate negative exposure to environmental and social risks. The country’s institutional strengths are highlighted by its commitment to euro adoption and the effective implementation of the Recovery and Resilience Plan. Environmental risks are moderately negative (E-3), primarily due to physical climate risks that could impact tourism demand. Given the concentration of tourist arrivals during peak summer months, rising temperatures and extreme weather conditions in the Mediterranean may pose challenges over time.

Social risks for Croatia involve adverse demographics, net migration outflows, and relatively high youth unemployment, although access to basic services is deemed satisfactory. The overall social issuer profile score is assessed as moderately negative (S-3). The country’s institutions and governance strength receive a positive G issuer profile score (G-1). This reflects the government and central bank’s high credibility in managing economic policy, leading to Croatia’s successful adoption of the euro in January 2023. The effective implementation of the Recovery and Resilience Plan further underscores institutional competence.

Moody’s would upgrade Croatia’s ratings if the government debt burden continues to fall more significantly than expected, while debt affordability is maintained. Continued, effective implementation of Croatia’s RRP would also support our assessment of Croatia’s economic as well as institutions and governance strength, thus also supporting the case for an upgrade.

Moody’s would consider changing the outlook back to stable, and in an adverse scenario, to negative if there was to be a reversal in the trend of debt reduction, accompanied by a significant loosening of government fiscal policy. A significant weakening of the growth outlook relative to Moody’s expectations, as well as a weakening of Croatia’s ability to effectively implement its national RRP, would also support the case for a stabilization of the outlook. An increase in geopolitical risks negatively impacting the Croatian economy and public finances would also be credit-negative.

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