Fitch Ratings on Friday affirmed Croatia's long-term foreign-currency issuer default rating (IDR) at BBB-, assessing the outlook as stable and noting that it expects gradual recovery from the coronavirus crisis with the help of EU funds as well as that limited capacity to absorb EU money poses a problem.

“Croatia’s ratings balance strong structural features, including higher human development, governance indicators and GDP per capita than peers, with weak growth potential and high public sector debt.

“The Stable Outlook reflects Fitch’s view that the economy will recover gradually from the coronavirus pandemic without significant imbalances and the authorities will achieve medium-term fiscal consolidation, underpinned by substantial EU fund support and a recent track record of fiscal prudence,” the agency says.

Fitch expects the economy to contract by a record 9% in 2020, noting that the resurgence of the coronavirus pandemic in the second half of the year has badly affected household consumption and service exports, despite a large fiscal support package of above 10% of GDP.

In June Fitch predicted that Croatia’s economy this year would contract by 8.4%.

The short-term outlook remains weak as new restrictions are implemented but good exports have proven more resilient to coronavirus-related pressure, preventing a sharper GDP contraction, the agency notes.

Growth projection for 2021 lowered from 4.5% to 3.8%

The agency forecasts a moderate economic expansion of 3.8% in 2021 compared with its previous 4.5% forecast, given weaker carry-over effects and still subdued demand in the services sector.

Investments will recover more rapidly thanks to increased public investment-driven largely by earthquake reconstruction projects in Zagreb.

In 2022 growth is expected to accelerate to 6% as the pandemic effects wane and demand is boosted by the gradual implementation of projects tied to the EU’s recovery fund Next Generation EU (NGEU), from which Croatia is set to receive €5.9 billion in grants.

Fitch assumes that EU funds will boost growth by 2pp in 2022.

The agency notes that it has yet to estimate the medium- to long-term growth effects of NGEU as there is still little clarity surrounding the investment projects that will be funded.

“Moreover, there are risks surrounding capacity constraints given the amount of funds available, as well as the effectiveness of investment, given Croatia’s weak track record in tackling structural constraints.

“Nonetheless, it is clear that EU funds will be a supportive macro factor for the rating, limiting negative spill-overs from sectors that could see some long-term scarring (such as tourism, which is unlikely to fully recover by end-2022) and underpinning fiscal and external financing flexibility.”

Budget deficit at 8%, public debt 87.4% of GDP

Fitch expects the budget deficit this year to be 8% of GDP, raising its June forecast by one percentage point.

In 2021, the budget deficit is expected to narrow to 3.5% of GDP, as the government is likely to cut spending, maintaining only some sectoral support (in addition to guarantee schemes).

The government approved a tax reform in November that will reduce personal income tax rates and VAT loopholes starting next year. Although there are risks that this could weaken revenue growth in 2021, the current government has implemented similar reforms in recent years where the net effect was revenue-neutral to positive, Fitch says.

“The fiscal deficit should narrow further in 2022 to 2.2% of GDP based on solid nominal growth, supportive financing conditions and sustained confidence in the policy framework.

“The government has a solid track record of over-performing its fiscal targets since 2016 and has pledged to maintain fiscal prudence in light of euro-accession process,” Fitch notes.

It expects the public debt to GDP ratio to reach an all-time high of 87.4% in 2020, reflecting the combined growth and fiscal shock from the pandemic.

The ratio should fall to 85.5% in 2021 and further to 81.6% in 2022 as the recovery takes hold and the primary deficit narrows.

Downside fiscal risks relate mainly to the materialisation of contingent liabilities, primarily around the transport sector and much higher expenditure needs around the pandemic response.

On the upside, Croatia’s financing conditions have significantly improved, reflecting sound public debt management, longer maturities (over six years) and a solid financial/monetary institutional framework, Fitch notes.

Strong financial sector, euro introduction likely in 2024

The financial sector remains strong despite economic pressures, with banks maintaining high liquidity and sound capital ratios, the agency notes.

Moratoria schemes have prevented a faster increase in non-performing loans and credit growth has continued.

Combined with ongoing external deleveraging, this would result in a further narrowing of the net external debt position to 7.6% of GDP in 2022, the agency says.

The government has suggested 2023 as the earliest date of euro adoption, but Fitch considers this timetable to be optimistic, with early 2024 as more likely entry date.

“Fitch considers euro adoption as supportive to the rating, as underlined by our view that all things being equal, we would upgrade Croatia Long-Term Foreign-Currency IDR by two notches between admission to the ERM II to joining the euro.”

The main factors that may lead to an upgrade or other positive rating action are progress toward eurozone accession, general government debt/GDP returning to a firm downward path over the medium term, and strengthening of growth prospects and competitiveness, Fitch says.

The main factors that may lead to a downgrade or other negative rating action are failure to reduce general government debt over the medium term, for example due to a more pronounced and longer period of fiscal loosening and economic contraction, and deterioration in medium-term growth prospects.