‘The crisis has revealed the weaknesses of the Croatian economic model’

Given the weakness of foreign demand and difficulties in shifting the economy towards exports, the benefits that typically accompany EU membership may not be fully realized in Croatia, and a return to moderate and healthy growth rates in the medium term is unlikely, according to the rating agency Moody’s.

Croatia’s credit strength lies in the fact that its economy is classified as upper-middle class by income, and in the medium- and long-term prospects related to EU membership, Moody’s states in its ‘Credit Opinion’ report published on Tuesday.

As credit challenges, the agency cites a relatively uncompetitive economy, which records weak growth and largely relies on domestic demand, as well as a rising level of indebtedness and deficits, and significant vulnerability to external risks.

Croatia is relatively wealthy compared to other countries in Central and Eastern Europe that joined the EU in 2004. However, the global financial crisis has revealed the weaknesses of its economic model, which relies on personal consumption and construction based on external borrowing.

After a period of growth from 2001 to 2007, the Croatian economy is now in recession. In 2012, it fell by 2 percent in real terms, and this year Moody’s expects a further decline of 1.2 percent. Economic growth of 0.3 percent is forecasted for next year.

Despite a recent noticeable change in policy, the government’s efforts to implement reforms have yet to support internal devaluation or unlock the potential for economic growth.

Given the weakness of foreign demand, as well as difficulties in directing the economy towards exports, Moody’s believes that the benefits typically associated with EU membership may not be fully realized in Croatia.

As a result, a return to moderate and healthy growth rates in the medium term is unlikely. Moreover, the government’s scope for action is limited as its room for financial maneuvering and capacity to stimulate the economy are constrained by a relatively high level of indebtedness and short-term financial costs associated with EU membership, Moody’s states.

Croatia is also facing significant external vulnerabilities, a consequence of its substantial reliance on foreign loans prior to the global financial crisis. Although the private sector is deleveraging, external debt is high at 105 percent of GDP.

The indicator of Croatia’s external vulnerability is approximately 196 percent, which is very high by any standard, Moody’s notes.

However, the decline in aggregate demand has reduced the balance of payments deficit and should help contain external debt in the medium term, the agency believes.

Moody’s maintains Croatia’s rating at Ba1. The rating outlook is stable, as the agency believes there is limited risk that the government’s fiscal and debt position will deteriorate significantly.

Croatia’s rating could increase in the event of a strong economic recovery, along with sustainable reductions in government indebtedness.

On the other hand, the rating could also decrease if there is a further deterioration in the economic environment, which would result in a sharp increase in the level of indebtedness and/or high risks due to the country’s external vulnerability, among other things stated in Moody’s credit opinion.