On Friday, Moody’s upgraded the Government of Croatia’s senior unsecured and long-term issuer ratings in foreign and local currency to Ba1 from Ba2 and changed the outlook to stable from positive.
Moody’s decision to upgrade Croatia’s ratings to Ba1 reflects the following key drivers:
ENHANCED INSTITUTIONAL CAPACITY AND POLICYMAKING AS THE COUNTRY ENTERS A CRITICAL PHASE OF EURO AREA ACCESSION
The first driver of the upgrade is based on Croatia’s progress towards euro-area accession and the associated strengthening of institutional capacity and policy making. On 10 July 2020, the euro-area finance ministers, the President of the ECB and the finance ministers and central bank governors of Denmark and Croatia formally approved Croatia’s entry into ERM II, which is one of the final steps prior to becoming a member of the euro area. The announcement amid the coronavirus disruption came against the background of Croatia’s comprehensive reform programme.
In Moody’s view, the successful completion of the reform programme speaks to the credibility of Croatia’s ambition to join the euro area. Moody’s believes that Croatia’s policy effectiveness has strengthened over the recent years. The government and the central bank have provided a more predictable and stable framework for economic activity in a very uncertain environment. The policy response to mitigate the impact of the coronavirus pandemic has been timely and efficient, with the central bank providing targeted support at times of market volatility.
Moody’s expects Croatia to continue to pursue sound economic and financial policies, as entering the euro area will require both sustainable economic convergence and readiness to participate in the banking union. On economic convergence, compliance with the convergence criteria is already advanced, as noted in the ECB’s 2020 convergence report.
From a macroprudential and banking perspective, Moody’s believes that the close cooperation between the ECB and the CNB and the inclusion of eight of the largest banks operating in Croatia under the ECB’s supervision will further enhance the system’s regulatory environment and promote the adoption of best practices.
CROATIA’S REDUCED EXPOSURE TO FOREIGN CURRENCY DEBT RISK
The second driver for the upgrade relates to Croatia’s strengthened fiscal credit profile despite the negative impact of the coronavirus pandemic. Under Moody’s Sovereign Ratings Methodology, a high share of foreign-currency denominated debt lowers fiscal strength considering the currency-depreciation risk that would trigger a sudden rise in interest costs and debt stock relative to GDP. In the case of Croatia, the tightly managed floating HRK-EUR exchange rate already mitigates this risk. Entering ERM II has further decreased this risk, as it brings Croatia closer to its predominant currency of issuance, the EUR. In 2019, 71.4% of Croatia’s general government debt was denominated in euros, down from 73.8% in 2016. By contrast, the share of HRK-denominated bonds rose from 22% to 28.4%.
Moody’s expects to fully eliminate the adjustment once Croatia effectively joins the euro area. Given the very uncertain environment and the need for Croatia to implement post-ERM II reforms, Moody’s believes Croatia could join the euro area towards 2025.
Regarding the government’s balance sheet, 2020 will mark a reversal in the declining debt trend against the backdrop of the coronavirus pandemic. Moody’s expects Croatia’s real GDP to contract by 8.6% this year, as both domestic and external demand are affected by the coronavirus pandemic. Accounting for 25% of GDP when considering direct and indirect effects, the Croatian tourism sector is strongly being affected by travel restrictions. As a result, Moody’s expects the fiscal deficit to reach 7.5% of GDP in 2020. This, in turn, is expected to push the debt-to-GDP ratio to 88.5% in 2020 and debt-to-revenues to 192.5%.
However, Moody’s expects the sharp deterioration in the debt metrics to be temporary and forecasts a gradual decline starting in 2021, when debt-to-GDP is expected to reach 86.7%, followed by 85.9% in 2022. The gradual reduction in public debt will be supported by a gradual economic recovery and a prudent fiscal stance as the government targets convergence towards the Maastricht criteria.
RATIONALE FOR THE STABLE OUTLOOK
The stable outlook reflects balanced credit strengths and challenges at the Ba1 rating level. Stronger- than-peers’ institutions and low susceptibility to event risk support the credit profile. Croatia’s fiscal strength combines a higher debt load compared to peers, while debt affordability is strong and foreign currency debt risk is declining with ERM II entrance. In terms of economic strength, Croatia’s much higher-than-peers’ wealth per-capita is somewhat offset by the country’s relatively smaller size, slower growing and more volatile economy.
The stable outlook also reflects Moody’s balanced view of the country’s prospects going forward. Croatia’s improved economic fundamentals and enhanced institutional capacity will provide resilience at the Ba1 rating level. At the same time, the stable outlook captures heightened risks for permanent scars with respect to Croatia’s economic and fiscal strength against the backdrop of the coronavirus’ new infection wave, with potentially a negative impact on both domestic and external demand.
