Moody's on Friday raised Croatia's credit rating by two levels to an investment grade and assessed that Croatian economy's outlook is stable following to the formal completion of the decision-making for Croatia's entry into the euro area.

On 12 July, the Economic and Financial Council of the European Union (Ecofin) gave the final approval for Croatia’s admission to the euro zone on 1 January 2023 when the country is switching to the euro.

According to a press release issued by this international credit rating agency, “Moody’s Investors Service (“Moody’s”) has today upgraded the Government of Croatia’s foreign- and domestic-currency long-term issuer ratings and foreign-currency senior unsecured debt ratings to Baa2 from Ba1.”

“The outlook has been changed to stable from ratings under review. This concludes the review for upgrade that was initiated on 24 June 2022.”

“The upgrade of the ratings to Baa2 is driven by the adoption of the legal acts formalizing Croatia’s adoption of the euro by the EU Economic and Financial Affairs Council (ECOFIN) on 12 July 2022. Croatia will adopt the euro as its domestic currency on 1 January 2023, thereby eliminating any foreign currency risk for the government’s largely euro-denominated debt burden and reducing government liquidity risk.

Moody’s also sees euro adoption as credit positive for Croatia’s economic strength as it will remove foreign currency risk and transaction costs also for the private sector, spurring further economic integration of Croatia with the euro area.

Ability of Croatia’s institutions to complete rigorous process towards euro adoption on time

Furthermore, the ability of the country’s institutions to complete the rigorous process towards euro adoption within the planned time frame also supports Moody’s assessment of the strength of Croatia’s institutions and governance.

Stable outlook balances continued strength of Croatia’s economic and fiscal recovery

“The stable outlook balances the continued strength of Croatia’s economic and fiscal recovery from the initial shock of the coronavirus pandemic against risks to the macroeconomic and geopolitical environment in Europe stemming from rapidly rising inflation, concerns around the stability of the EU’s energy supply and the Russian invasion of Ukraine (Caa3 negative),” reads the press release.

The long-term country ceilings of Croatia for local and foreign currency bonds have been raised to Aa2 from A2. This reflects the fact that for euro area countries, as Croatia will be from 1 January 2023 on, a six-notch gap between the local currency ceiling and the local currency rating, as well as a zero-notch gap between the local currency ceiling and foreign currency ceiling, is typical, reflecting benefits from the euro area’s strong common institutional, legal and regulatory framework, as well as liquidity support and other crisis management mechanisms. It also is in line with our view of de minimis exit risk from the euro area.

Rationale for upgrading Croatia’s ratings

“Most notably, the adoption of the euro reduces 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, has a significant positive impact on Moody’s assessment of the government’s fiscal strength as it eliminates the risk of a sudden and potentially significant increase in the local currency value of government debt relative to GDP in the event of a devaluation of the local currency relative to the euro,” reads the press release.

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 in a narrow band against the euro since 1999. Nevertheless, we expect that euro adoption will have additional 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, Croatia’s adoption of the euro 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 European Central Bank (ECB) support programmes such as the asset purchase programmes that were first introduced in 2015, while membership of the European Stability Mechanism (ESM, Aaa stable) will 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.

Agency expects Croatia’s GDP growth to remain robust at 3% in 2022

The stable outlook balances the continued strength of Croatia’s economic and fiscal recovery from the initial shock of the coronavirus pandemic against risks to the macroeconomic and geopolitical environment in Europe over the coming 12 to 18 months as well as country-specific challenges that include the effective absorption of EU funds and adverse demographic trends.

The Croatian economy has continued to recover strongly from the sharply negative impact of the coronavirus pandemic on the country’s tourism sector and overall economy in 2020.

In its baseline scenario, the agency expects Croatia’s GDP growth to remain robust at 3% in 2022 while the debt burden will continue to decline at a more moderate pace, although the continued strength of the tourism sector’s rebound from the pandemic could produce outcomes that are stronger than our baseline forecast this year.

However, there are prominent risks to the economic and fiscal outlook for Croatia stemming from a deteriorating macroeconomic environment in Europe. Such risks tied to rapidly rising inflation and concerns about the stability of the energy supply of several EU member states are in large part also linked to geopolitical risks and heightened uncertainty stemming from Russia’s invasion of Ukraine and the on-going military conflict. Although the direct risks of a potential energy supply shock are limited for Croatia, in an adverse scenario, the euro area could enter a recession over the next 12 to 18 months, which would also have material negative implications for the economic and fiscal outlook for Croatia.

Moreover, Croatia’s relatively weak track record of absorbing EU investment funds raises question marks around whether the country’s economy will be able to derive the full benefits of the very substantial funding available for Croatia under NGEU and the EU’s regular budget for 2021-2027. Croatia’s medium to long term growth potential also continues to face significant challenges from the projected decline of the country’s working age population.

Upward pressure could build on the ratings if Croatia manages to maintain a strong economic performance and growth potential as well as a continued reduction of the government debt burden over the coming years. This would notably be supported by evidence of effective implementation of the investments and reforms tied to the EU’s post-pandemic recovery fund Next Generation EU, which would support economic growth in the near term but also growth potential over the longer term.

Possible negative pressure tied to resurgence of pandemic-related complications or to fallout of Russia’s invasion

Negative pressure could build on the ratings in the event of a sharp deterioration of Croatia’s growth potential relative to Moody’s expectations, most likely tied either to a resurgence of pandemic-related complications for the tourism industry or to the economic and political spillover effects from the Russian invasion of Ukraine. A failure to effectively implement the investments and reforms of Next Generation EU would also weigh negatively on Moody’s assessment of Croatia’s growth potential and the strength of its institutions and governance, says the agency.

All three major agencies raise Croatia’s credit rating to highest level in history

The Fitch agency raised Croatia’s credit rating to BBB+ on Wednesday, and on Thursday, Standard & Poor’s upgraded its credit rating by two levels – from BBB- to BBB+, with a stable outlook.

Until the first half of 2019, Croatia had a non-investment rating from both Fitch and S&P, and now the country is at the third level of the investment rating, its highest level in history.

A regular review of the rating by S&P was scheduled for September, but due to the importance of the confirmation of Croatia’s entry into the euro area S&P decided to raise the rating earlier.