S&P Increases Croatia’s Rating Due to Entry into the Euro Area

Standard & Poor's agency raised Croatia's long-term and short-term ratings on Thursday to 'BBB+/A-2', with stable outlooks, as Croatia will benefit from entering the euro area and as the economy continues to grow steadily.

S&P is already the second agency, after Fitch on Wednesday, to raise Croatia's rating in an extraordinary announcement, after the EU Council officially confirmed Croatia's entry into the euro area starting next year on Tuesday.

Stable Growth in the Coming Years

In S&P's assessment, it is stated that the stable outlook reflects expectations that the growth of the Croatian economy will remain stable over the next two years, despite rising inflation and the economic consequences of the conflict in Ukraine.

– We expect the Government to remain committed to its reform program, receive significant EU funds, and gradually restore the fiscal space it lost after the pandemic – the assessment states.

It is emphasized that the rating could be further increased if economic growth accelerates beyond expectations. In that case, S&P expects fiscal consolidation and a reduction in the net debt of the general government above current projections.

– A positive rating could also come from deepening Croatia's European integrations if it enables institutional improvements, for example, in the judiciary, education, and the broader business environment – S&P emphasizes.

On the other hand, the rating could be downgraded if there is a significant weakening of the fiscal position and weaker economic growth than expected.

– Such weakening could occur if the prolonged conflict in Ukraine produces increasingly severe pan-European economic consequences or if a sudden disruption of European energy supplies exacerbates recessionary tendencies across the continent – the assessment states.

It adds that trends of net emigration and an aging population also pose a long-term risk to Croatia's growth and public finances.

Benefits from ECB's Monetary Policy

According to S&P analysts, Croatia will benefit as a member of the euro area from the flexibility of the European Central Bank's (ECB) monetary policy, while remaining foreign exchange risks will diminish in a strongly euroized economy.

They also believe that Croatia's short-term economic outlook is stable, thanks to solid tourism revenues and strong drawdown of EU funds.

– Furthermore, we believe that Croatia has limited direct dependence on Russian hydrocarbons, especially after the recent expansion of the liquefied natural gas (LNG) terminal on Krk and advanced substitution of oil supply from the sea – it is emphasized in S&P's assessment.

S&P states that joining the euro area will eliminate all remaining exchange rate risks in a highly euroized economy, where about 75 percent of the banking sector's assets and 67 percent of liabilities are denominated in euros. In a similar way, the exchange rate risks of the state balance sheet will also be eradicated.

– This should reduce the share of Croatian government debt denominated in foreign currency from the current over 70 percent to nearly zero, as this debt is almost exclusively denominated in euros – the assessment states.

S&P Raises Economic Growth Estimate to 3.5 Percent

The agency has raised its estimate for the growth of the Croatian economy this year from the previous 2.5 to 3.5 percent, thanks to significant growth in the first half of the year and prospects for a strong tourist season at pre-pandemic levels.

– Rising energy and commodity costs are likely to reduce disposable income and curb consumer spending during the second half of 2022 and spill over into 2023. We predict that economic growth will slow to 2.5 percent in 2023 – S&P emphasizes.

In the medium term, the agency estimates that the economy will grow solidly, thanks to investments from EU funds and the recovery of tourism.

The economic consequences for Europe due to the Russian military intervention in Ukraine and inflationary pressures pose short-term risks.

– There are still some long-term risks from the pandemic for the recovery of Croatian tourism due to the relatively low vaccination rate in the country. As of July 7, 2022, less than 60 percent of Croatia's population was fully vaccinated against COVID-19, compared to the EU average of 76 percent – the agency states.

Average Inflation This Year at 8 Percent

Its analysts expect inflation to rise as the Russian-Ukrainian conflict has driven up energy prices.

They estimate that the average inflation in Croatia this year will rise from last year's 2.6 to 8 percent due to rising energy prices, wage increases, and rising costs in the hospitality sector.

The general government deficit could, however, amount to 3 percent of GDP this year.

– The government has already introduced subsidy schemes to alleviate pressures on fuel and energy prices, which add 1.1 percent of GDP to the expenditure account. We believe there are risks to our deficit projections as the current energy crisis may require additional state subsidy schemes in the second half of 2022 – conclude S&P analysts.