S&P Improves Outlook to Positive, Maintains Croatia’s Credit Rating at BB

Standard & Poor’s (S&P) maintained Croatia’s long-term credit rating at ‘BB’ and short-term at ‘B’ on Friday, but raised the outlook from stable to positive as the Croatian economy continues to grow, while the debt burden decreases.

In a statement, S&P estimates that Croatia’s gross domestic product (GDP) growth will be 3 percent this year, supported by strong domestic demand and robust exports, which will help the government maintain a stronger budget position than before and continue to reduce the still significant debt burden.

The positive outlook reflects S&P’s expectation that Croatian economic growth will continue, aiding in further consolidation of public finances, while external imbalances will benefit from further deleveraging, and potential weakness due to the situation surrounding Agrokor remains limited.

If the recovery is sustained, a potential rating upgrade

“We could raise Croatia’s rating if the economic recovery is sustained, while the government continues to demonstrate the ability and willingness to implement structural reforms and adheres to its fiscal consolidation plan, which will lead to sustainable consolidation of public finances,” S&P stated.

They added that they could consider raising the rating if external imbalances improve faster than their baseline scenario as a result of stronger foreign deleveraging or faster growth in balance of payments receipts.

>>>Fitch Maintains Croatia’s Rating at ‘BB’, Outlook Stable

The agency also noted that they could lower the outlook to stable if Croatian liabilities, such as lawsuits against the state, result in an increase in the burden of public debt or if efforts to implement structural reforms slow down, leading to lower economic growth or higher-than-expected fiscal deficits.

Additionally, S&P indicated that they are closely monitoring efforts related to the restructuring of Agrokor and could consider negative action if disorderly restructuring undermines economic performance or leads to significant fiscal costs. However, they emphasized that this is not their baseline scenario.

Croatia’s rating is supported by a decreasing budget deficit and a reduction in foreign indebtedness, primarily due to the deleveraging of banks. At the same time, the rating remains constrained by Croatia’s still high debt burden, low income levels compared to Europe, and ongoing political volatility.

After the coalition reconstruction, the focus is on plans for structural reforms to ensure the sustainability of economic momentum. Favorable external and internal developments have strengthened growth, and the spillover effects of Agrokor’s current restructuring remain limited, S&P stated.

However, they warned that the situation in Agrokor has led to a coalition reconstruction, which could call into question the government’s ability to continue its reform agenda.

Structural challenges for the economy persist in the form of labor shortages and a high degree of state ownership in the economy, S&P noted.

Impact of the Agrokor crisis limited

A mix of external and domestic factors continues to drive the Croatian economy. Therefore, S&P expects a real economic growth rate of 3 percent in 2017, supported by strong exports, particularly in the booming tourism industry.

Additionally, domestic demand contributes positively to growth as investments recover, and personal consumption strengthens on the back of improvements in the labor market and tax reforms implemented in 2016 that increased disposable income.

In the medium term, however, S&P expects that structural factors could pressure the Croatian economy.

They state that the Croatian business environment, particularly regarding company formation, remains weaker than in comparable regional countries, as indicated by the World Bank’s “Doing Business” study, and there are discrepancies regarding labor skills and labor shortages, despite a high unemployment rate.

The effects of the current restructuring of Agrokor appear to be limited so far. Despite a slight deterioration in consumer confidence immediately after the government appointed a special commissioner in Agrokor, investments and consumption have held up well as the year progresses.

>>>S&P: The Agrokor Crisis Will Not Affect Croatia’s Credit Rating

Negative risks to the economy, S&P believes, could arise if disorderly restructuring of Agrokor negatively impacts its suppliers, mainly small and medium-sized enterprises and farms, resulting in them coming under financial pressure.

“However, we understand that Agrokor is currently servicing all its debt obligations, including payments to suppliers, and has taken steps to avoid impacts on suppliers. Therefore, we believe that negative risks to the Croatian economy as a result of the turmoil in Agrokor are limited. Nevertheless, we will continue to monitor the situation, including financial and operational restructuring and their potential impact on the Croatian economy,” S&P stated.

The agency further noted that after the collapse of the coalition with Most, HDZ formed a new coalition with HNS. This episode highlights the political volatility that limits the government’s ability to address long-standing structural issues. This includes structural unemployment, a high degree of state ownership in the economy, and a somewhat weaker business environment than in comparable European countries.

In an effort to address these and other issues, the government’s priorities are reforms in public administration and the pension system, as well as improving the business climate. The proposed introduction of a property tax has been postponed for further consultations on its final form.

Improvement of public finances

With the strengthening recovery, public finances are also improving. After a smaller-than-expected general government deficit of 0.8 percent in 2016, S&P expects the deficit to slightly increase to 1.1 percent this year. However, the agency’s analysts state that this does not encompass the fiscal impact of the crisis in Agrokor.

The Croatian Bank for Reconstruction and Development, which is state-owned, has provided loans to Agrokor. However, its exposure is secured by collateral. S&P analysts also state that the government has not provided direct financial assistance to Agrokor.

Nevertheless, they expect a slight increase in the fiscal deficit by 2020, averaging around 1.3 percent of GDP.

Significant refinancing needs of the government and government-related entities, a large share of public debt denominated in foreign currency, and high exposure of the Croatian banking sector to the state continue to constrain the country’s rating, S&P says.

Improved debt management practices and potentially better management of state assets could enhance the debt profile of the public sector. Moreover, S&P states that they view positively the increased ability of Croatia to refinance in the domestic market with longer maturities.

Faster economic growth and lower fiscal deficits should lead to a quicker reduction in the share of public debt to GDP, while in nominal terms, the general government debt could continue to rise. The rating agency expects that the share of public debt will fall to approximately 75 percent of GDP by 2020, after peaking at 86.6 percent of GDP in 2014.

Write-off of Agrokor’s debt could be greater than banks’ provisions

Improvements in the Croatian banking sector, indicated by a recovery in profitability, an increase in lending, and a reduction in non-performing loans, could be jeopardized by financial stress in Agrokor, S&P warns.

>>>Provisions due to exposure to Agrokor ‘significantly reduced’ HPB’s profit

They state that revised financial statements of Agrokor will be publicly released, and banks have been asked to make provisions for at least half of their exposure to the group.

“However, the final write-off of Agrokor’s debt could be somewhat greater than the provisions, implying additional losses for banks. While the capitalization levels of large banks should be sufficient to withstand this impact, some smaller banks may be forced to raise additional capital. Nevertheless, we note that a large portion of Agrokor’s direct obligations is to foreign banks and therefore should not affect the stability of the Croatian banking system. However, we expect lower profitability for this sector as a whole this year,” S&P analysts state.

>>>S&P Downgraded Agrokor’s Rating Due to Unpaid Coupon on Bond

They add that this impact could be more pronounced, depending on how much Agrokor’s suppliers are affected by the debt restructuring. However, they also note that they observe that the group has taken steps to mitigate the impact on its suppliers, especially since 50 percent of the debt to suppliers has already been resolved.

S&P also states that the Croatian National Bank is committed to maintaining the exchange rate of the kuna against the euro, which limits the flexibility of monetary policy, as well as the highly euroized economy. Since June 2017, more than 50 percent of loans and deposits have been denominated in foreign currency or linked to it, primarily to the euro, concludes S&P’s analysis.

In December last year, S&P raised the outlook for Croatia’s credit rating from negative to stable, marking the first positive shift for Croatia’s rating in the last nine years. In March of this year, the agency maintained Croatia’s existing rating at BB, with a stable outlook, and has now raised the outlook to positive.

All three major rating agencies – Fitch, S&P, and Moody’s – continue to hold Croatia’s credit rating two notches below investment grade. However, while Fitch and Moody’s maintain stable outlooks, S&P now holds a positive outlook, indicating that its next move could also be an upgrade of the rating itself.