OREANDA-NEWS. Fitch Ratings has affirmed Croatia's Long-Term Foreign and Local Currency Issuer Default Ratings (IDR) at 'BB' with Negative Outlooks. The issue ratings on Croatia's senior unsecured foreign and local currency bonds have been affirmed at 'BB'. The Country Ceiling has been affirmed at 'BBB-' and the Short-Term Foreign Currency and Local Currency IDRs at 'B'.

KEY RATING DRIVERS

The ratings balance Croatia's high government and external debt loads and weak growth performance, against favourable governance indicators and relatively high per capita GDP.

The level of gross general government debt (GGGD) is a rating weakness. GGGD reached 86.7% of GDP at end-2015, almost double the 'BB' median (45.5%). It has increased rapidly from below 40% in 2008, as a result of years of wide fiscal deficits and negative growth, which reflected delayed post-crisis fiscal consolidation and a lack of structural reform. Croatia posted average general government deficits equivalent to 5.6% of GDP in 2009-15, while in real terms the economy contracted by an average 0.5% over the same period.

The deficit narrowed to 3.2% of GDP in 2015 (below the 'BB' median of 3.6%). This is better than we expected at the time of the last review, underpinned by improved tax compliance and the economy's return to positive growth. In 2016 the deficit will narrow further, to a forecast 2.6% of GDP. The improvement also reflects under-execution of capital spending. The lack of a permanent government means some items of spending are on hold. However, despite the improved fiscal deficit, public debt will remain very high during the forecast period, with the government set to continue to post deficits of around 2.5% of GDP, and nominal growth likely to remain quite subdued. Fitch forecasts GGGD to be 86.3% of GDP in 2018.

Political risk has risen since our last review, which could delay progress on fiscal adjustment and structural reforms. Following a vote of no confidence in the prime minister, Tihomir Oreskovic, parliament was dissolved on 15 July. A new election will be held on 11 September. Mr Oreskovic had only taken power in January 2016, at the head of a short-lived coalition of the centre-right Croatian Democratic Union (HDZ) and the pro-reform MOST (Bridge) party. Recent polls indicate that the centre-left Social Democratic Party (SDP), which was in power in 2011-15, has a lead over the HDZ.

Some progress on the planning of key reforms was made by the Oreskovic government, which could allow a new government to take action quickly. However, regional elections scheduled for May 2017 may delay politically difficult reforms. Moreover, an outright victory for either the HDZ or SDP is highly unlikely. Fitch expects the next government to be a coalition between one of the two largest parties and MOST. This could achieve significant reforms, but it may not prove durable, as demonstrated by the previous HDZ-MOST administration

The growth outlook, in the near and long term, remains a rating weakness. Croatia posted positive growth in 2015 for the first time since 2008. However, at 1.6%, the rate was quite weak, and well below the 'BB' median (3.9% on the five-year average). Fitch forecasts that growth will reach 1.8% this year, and average 1.9% in 2017-18. In the near term, growth will be driven by domestic demand, underpinned by lower energy prices, rising real wages, and another strong tourism season. Tourism will remain a key growth driver. Heightened security risk in many competitor markets is likely to boost tourism inflows this year. Transport connections outside of Europe have improved, increasing Croatia's potential tourist inflows.

Private investment will also support growth. Although merchandise exports are performing well, their contribution will be limited by their low share in overall GDP (24.4% in 2015 according to Eurostat, the sixth lowest in the EU and the lowest among CEE member states). This ratio is likely to rise gradually as Croatia increasingly integrates with international supply chains.

Potential growth is estimated at 1%-2% per year, a very low rate for a country at Croatia's income level. This is not consistent with any significant rate of convergence with western Europe, and will see Croatia fall further behind better-performing CEE countries. Croatia's low potential growth rate reflects a large and inefficient public sector, slow resolution of bad loans, weak progress on structural reform and a challenging demographic outlook. At the 'BB' level, Croatia's GDP per capita is a rating strength.

At 47.6% of GDP in 2015 (almost three times the 'BB' median of 16.4%), net external debt is a rating weakness. Most external debt is owed by corporates, particularly in the real estate and construction sectors, reflecting the very slow process of post-crisis deleveraging. Deleveraging in the financial sector has been quicker, and Croatian banks returned to a positive net foreign asset position in 2015. Fitch forecasts that net external debt will fall during the forecast period, to 34.3% of GDP by 2018, helped by continued current account surpluses.

Croatia's banking sector is stable, liquid and well capitalised. According to estimates provided by banks to the Ministry of Finance, the conversion of Swiss franc loans into euros carried out in 2015 and 1H16 cost the banking sector HRK7.3bn. At end-1Q16, the share of Swiss franc loans fell to 2% of the total, from around 7% at end-2015. 66% of loans are now in euros, but given the kuna's peg to the single currency, the risks are much smaller. At 7.1 months of current external payments (CXP) in 2015 ('BB' median: 4.1 months), the CNB has a healthy level of reserves and has repeatedly shown itself willing to intervene to support the kuna. In 2015 non-performing loans remained high at 16.3% of the total. However, this was a drop from 16.7% in the previous year. High foreign ownership (over 90%) in the banking sector mitigates contingent liabilities to the sovereign balance sheet.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Croatia a score equivalent to a rating of 'BBB-' on the Long-Term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Public finances: -1 notch, to reflect the non-linearity of public debt at high levels.

- External finances: -1 notch, to reflect the high level of net external debt (which is not captured in the SRM) and the vulnerability to kuna depreciation against the euro.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The Negative Outlook reflects the following risk factors that may, individually or collectively, result in a downgrade:

- Failure to put the public debt/GDP ratio on a sustained downward path, as a result of policy direction, fiscal underperformance, rising financing costs, or weaker nominal GDP growth.

Future developments that may, individually or collectively, result in a revision of the Outlook to Stable include:

- Progress on fiscal consolidation leading to greater confidence that public debt/GDP will decline over the medium term.

- Strengthening growth prospects and competitiveness, particularly through the implementation of structural reforms.

KEY ASSUMPTIONS

We assume Croatia's track record of monetary and exchange rate stability remains intact, minimising the risks to household, corporate and public sector balance sheets, all of which are heavily euroised.