-- In our opinion, the Croatian government's reforms have so far been
insufficient to eliminate the structural rigidities that hamper the country's
-- We believe that the government's fiscal resolve has weakened, leaving
structural budgetary weaknesses, such as high personnel and social
expenditures, which together make up just under three quarters of central
government spending, unaddressed.
-- We are therefore lowering our long- and short-term sovereign credit
ratings on Croatia to 'BB+/B' from 'BBB-/A-3'.
-- The outlook is stable, reflecting our view that Croatia's wealth
levels, relatively diversified economy, and future receipt of EU funds could
help stabilize external imbalances and government finances while improving
On Dec. 14, 2012, Standard & Poor's Ratings Services lowered its long- and
short-term sovereign credit ratings on Croatia to 'BB+/B' from 'BBB-/A-3'. The
outlook is stable.
The T&C assessment remains 'BBB+'. We assigned a recovery rating of '4',
reflecting our view of a 30%-50% recovery in the event of default.
The downgrade reflects our view that structural and fiscal reforms implemented
so far have been insufficient to foster economic growth and place public
finances on a more-sustainable path. Because Croatia's economy is highly
euroized, with a semi-fixed exchange rate regime, we consider flexible labor
and product markets and the maintenance of external and fiscal buffers to be
of greater importance to offset possible external shocks than for sovereigns
with floating exchange rate regimes. In our opinion, labor and product market
flexibility in Croatia is lacking. Policy inertia and opposition from vested
interests that benefit from long-entrenched entitlements have contributed to
wage and price rigidities, the low participation rate, and loss of economic
Croatia's public sector employs about one-third of the workforce. The budget
is dominated by personnel and social expenditure: together nearly
three-quarters of central government spending, leaving little room for public
investment. Given the strength of incumbents inside and outside the public
sector, Croatia's unsustainably high entitlement spending--in light of
economic drift, low labor participation, and population aging--will be
politically challenging to cut back, in our view. As a consequence, we no
longer consider Croatia to possess the economic flexibility and policy resolve
of an investment-grade sovereign.
Revenue-based fiscal consolidation, driven by a 2% increase in the VAT rate
and improved tax collection, saw the fiscal position improve modestly in 2012
compared to 2011. Nevertheless, the recently adopted supplementary budget for
2012 underlines the challenge the government faces in adhering to its own
spending plans for the wage bill, subsidies, and social transfers: all were
revised upward. The government's medium-term fiscal framework indicates a
continued preference for revenue-based budgetary consolidation rather than
current expenditure cuts to meet what we view as unambitious fiscal goals.
This includes the widening deficit in 2013, a deviation from the previous
government plans and from our expectations, and growing nominal expenditure,
based on what we believe to be overly optimistic growth assumptions. We see
risks of expenditure slippages despite amendments to the collective bargaining
agreements with trade unions, which the government expects will deliver 0.6%
of GDP in savings on the wage bill during 2013.
Since 2009, the Croatian economy has been either in recession or stagnant. We
estimate about a 2% contraction for 2012, despite a strong tourism season.
Private-sector deleveraging, high unemployment, rising inflation, low credit
growth, and a VAT increase are all weighing on domestic demand. During 2013,
we expect the economy to stagnate, and then recover only gradually to trend
growth of 2% by 2015, well below the pre-crisis average.
We believe that the government's growth program--mainly increasing investment
by state-owned enterprises, backed by external funding from international
financial institutions--may temporarily boost domestic demand. In our opinion,
however, this will be offset by weak private demand, given high unemployment
and unfavorable credit conditions. The growth program is also likely to
exacerbate high external vulnerabilities, pushing up investment and external
At just under 200% of current account receipts (CARs), Croatia's net external
liability position is already substantial, albeit it marginally declined from
2009, as the current account deficit has dropped to less than 1% of GDP
(excluding errors and omissions). While the current account is expected to
remain close to balance in 2012-2013, the economy will continue to depend
heavily on external financing to rollover the high stock of liabilities to
nonresidents. External debt service (including the rolling over of short-term
debt) is about 75% of CARs. Foreign banks account for 90% of bank assets in
Croatia and external bank financing has contracted moderately in 2012,
although we expect external bank support to remain strong.
The stable outlook balances our expectation of Croatia's EU accession, which
would see the country benefit from EU structural and cohesion funds and higher
foreign direct investment, against our view of limited prospects for major
growth- and competitiveness-enhancing reforms.
Strong progress in reducing economic imbalances, particularly the reliance on
external financing, and the implementation of growth-enhancing structural
reforms could lead us to consider raising the ratings.
Conversely, we could consider lowering the ratings if the government fails to
reduce the structural rigidities in the economy, external imbalances widen, or
there is significant deviation from budgetary targets, which could increase
the risk of sudden deterioration in the economy's funding position.
Related Criteria And Research
-- Sovereign Government Rating Methodology And Assumptions, June 30, 2011
-- Criteria For Determining Transfer And Convertibility Assessments, May
-- Introduction Of Sovereign Recovery Ratings, June 14, 2007
Croatia (Republic of)
Sovereign Credit Rating BB+/Stable/B BBB-/Negative/A-3
Senior Unsecured BB+ BBB-
Recovery Rating 4
Transfer & Convertibility Assessment BBB+