Fitch Changes Its Mind – The Outlook for Croatia’s Rating is Negative

Fitch Ratings has changed its outlook on Croatia’s rating from stable to negative, confirming Croatia’s long-term foreign currency rating at ‘BBB-‘ and the long-term domestic currency rating at ‘BBB’.

The ceiling for the rating, or the highest level it can be raised to, has been confirmed at ‘BBB+’. The short-term rating ‘F3’ has also remained unchanged.

The recently published draft of the Croatian state budget for 2013 proposes an increase in the consolidated general government budget deficit from an estimated 3.5 percent of GDP this year to 3.8 percent of GDP next year. Fitch warns that according to the ESA 95 measure, the targeted deficit next year will actually amount to 3.9 percent of GDP, which is 0.7 percentage points higher than the forecast from September.

The budget proposal anticipates a milder path of budget consolidation compared to that planned in the medium-term strategy published in July, the agency notes.

Public finances remain a key risk for the rating, Fitch emphasizes, noting that a credible medium-term fiscal consolidation plan is necessary for the dynamics of public debt to become sustainable.

They highlight that their September revision of the outlook to stable was based precisely on the government’s commitment to a prudent fiscal policy in the medium-term perspective in accordance with the Fiscal Responsibility Act.

The new budget contradicts the medium-term fiscal strategy and calls into question the credibility of the Fiscal Responsibility Act, which prescribes an annual reduction of expenditures by one percent of GDP until a primary surplus is achieved, Fitch warns.

They note that their decision in September was based on the assumption that the government would implement the plan announced in July.

The change in fiscal plans so early in the government’s mandate reduces the credibility of its fiscal strategy and affects the dynamics of public debt, they warn.

According to the new plan, the government intends to stabilize public debt at 56 percent of GDP in 2014. However, this projection relies on overly optimistic growth forecasts, Fitch believes.

An analysis of debt dynamics based on more realistic assumptions about GDP growth closer to average market estimates, which predict that GDP will grow by 0.3 percent next year, by one percent in 2014, and by 1.5 percent in 2015, shows that debt will stabilize only in 2016, and at a higher level of 62 percent of GDP, Fitch notes.

The higher deficit is a result of increased spending, particularly investments by state-owned enterprises (so-called off-budget users) in infrastructure, which increases their deficits in 2013 by 0.4 percentage points of GDP compared to the plan from July.

Spending is also increased by the standard indexation of pensions and higher interest costs (by two billion kuna) and support for shipyards (900 million kuna).

Furthermore, Croatia will become a member of the European Union in July 2013, and changes in the tax system to align VAT and excise duties with those in the EU positively affect budget revenues and exceed the costs of payments into the Union’s budget. This obligation begins for Croatia next year.

Plans to achieve the targeted deficit in 2013 rely on reaching an agreement with public sector unions to reduce the wage bill by 7.9 percent in nominal terms (1.8 billion kuna or 0.5 percent of GDP) compared to the estimated wage costs in 2012. There is a risk that this will not be achieved, the agency believes.

The government has reduced wage costs by less than half of the planned amount this year of 2.3 billion kuna, but has amended the legal regulations on wage negotiations in the public sector, which should enable reaching an agreement with the unions, which the government expects to achieve by the end of this year.

They also state that domestic banks are becoming increasingly dependent on the state due to increased shares of treasury bills and loans to the central government, which places greater emphasis on the government’s ability to consolidate public finances and maintain market confidence.

In the rationale for the negative outlook for the rating, Fitch states that the slowed consolidation plan has delayed the achievement of a primary surplus and the stabilization of public debt. Maintaining the investment rating requires Croatia to stabilize state debt in the medium term by 2016 and to begin reducing it. The revised fiscal targets are hardly in line with this, Fitch emphasizes.

They also note that a shortfall in the fiscal plan or growth weaker than expected would jeopardize this goal and could lead to a downgrade of the rating.

Raising the rating would require the government to achieve faster fiscal consolidation than Fitch currently predicts, either through larger fiscal adjustments or through higher growth than expected.

Fitch has already emphasized the importance of structural reforms for improving growth in the medium term. Moves on the structural reform front announced in July would support growth forecasts and ratings.

Shocks that would affect borrowing costs, economic growth, or the exchange rate would worsen the debt dynamics compared to Fitch’s baseline scenario.

The Croatian economy suffers from a high share of public and external debt, high euroization, and weak economic activity since 2009. These factors create an unfavorable backdrop for debt dynamics, making Croatia vulnerable to adverse shocks. Debt repayment maturities become more challenging in the period from 2014 to 2015, highlighting the importance of timely fiscal consolidation.

The Croatian economy is stagnating, complicating fiscal consolidation. Growth projections in the new budget are unchanged compared to July and are overly optimistic. The Ministry of Finance forecasts that real GDP will grow by 1.8 percent in 2013, driven by investments and trade, and predicts growth of three percent for 2014. Fitch forecasts growth of only 0.3 percent in 2013 and 1.3 percent in 2014.

They assess that the Ministry of Finance’s growth forecasts appear particularly optimistic when considering the weak state of Italy and other key export markets in the European Union, as well as the deleveraging of banks and households. The economy is on track to record a decline of 1.7 percent in 2012. Progress in structural reforms is crucial for stimulating the medium-term potential for GDP growth.

Fitch plans to hold a teleconference early next week to clarify the latest moves related to the credit rating, it is stated in the announcement, noting that details will be provided in a separate announcement.