Moody's Investors Service, one of the three leading international credit rating agencies, on Friday decided to place "the Government of Croatia's Ba1 foreign and domestic-currency long-term issuer ratings and foreign-currency senior unsecured ratings on review for upgrade."

The decision to place the ratings on review for upgrade of Croatia’s ratings by two notches to Baa2 “was caused by the recommendation of the EU Economic and Financial Affairs Council on 17 June proposing that Croatia adopt the euro as its domestic currency as of 1 January 2023.”

The review period which is expected to last until mid-July will allow Moody’s to determine whether progress towards formalizing Croatia’s membership of the euro area through the adoption of the relevant EU legal acts will take place as expected.

The EU’s Economic and Financial Affairs Council (ECOFIN) on 17 June issued a recommendation proposing that Croatia should adopt the euro on 1 January 2023, following the European Commission’s and the European Central Bank’s (ECB) positive assessment of Croatia’s fulfilment of convergence criteria published on 2 June.

The heads of state and government of the EU gave their assent to the recommendation made by ECOFIN at the European Council on 23-24 June. In light of this, Moody’s expects Croatia’s membership of the euro area to be formalized with the adoption of the relevant legal acts at the ECOFIN meeting on 11-12 July.

Fiscal strength is one of the factors of the assessment of a sovereign’s creditworthiness

The eventual adoption of the euro would have significant positive implications for Croatia’s credit profile, the agency underscores.

“Most notably, it would reduce Croatia’s share of government debt denominated in foreign currency from over 70% at present to close to zero, as this debt is almost wholly denominated in euros. This, in turn, would have a significant positive impact on our assessment of the government’s fiscal strength as it eliminates the risk of a debt-to-GDP increase in case of a devaluation. It also significantly reduces government funding risks. Fiscal strength is one of the four factors of Moody’s assessment of a sovereign’s creditworthiness.

Croatia’s economy is already highly integrated with that of the euro area and the country has maintained a managed float of its domestic currency against the euro for a number of years, Moody’s recalls.

Nevertheless, we expect that euro adoption will have positive effects on Croatia’s economic strength over the medium to long term by reducing transaction costs and eliminating any remaining foreign currency risks for transactions between Croatia and the euro area, which already accounts for more than half of all of Croatia’s imports and exports. This is likely to spur further economic integration and foreign direct investment into Croatia, supporting its longer-term growth potential.

Furthermore, euro adoption will also reduce foreign currency risks for the banking sector, and will also have a positive impact on our assessment of government liquidity and external vulnerability risks.

As a euro area member, Croatia would in a future crisis stand to benefit from potential ECB support programmes such as the asset purchase programmes that were first introduced in 2015, while eventual membership of the European Stability Mechanism (ESM, Aaa stable) would also support the government’s ability to fund itself in a crisis situation. Lastly, the ability of the Croatian institutions to steer the country into the euro only two years after joining ERM II ? the antechamber of the currency bloc? supports our assessment of the effectiveness and strength of the country’s institutions and governance.

The review period will allow Moody’s to assess whether progress towards formalizing Croatia’s euro area accession in EU law will be finalised by mid-July as currently expected. If these expectations are met, Moody’s is likely to upgrade Croatia’s ratings by two notches to Baa2, the agency concludes.

The long-term country ceilings of Croatia for local and foreign currency bonds remain as of now unchanged at A2.