OREANDA-NEWS. Fitch Ratings has affirmed Croatia's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BB' and 'BB+' respectively. The Outlooks are Stable. The issue ratings on Croatia's senior unsecured foreign and local currency bonds have also been affirmed at 'BB' and 'BB+' respectively. The Country Ceiling is affirmed at 'BBB-' and the Short-term foreign currency IDR at 'B'.

KEY RATING DRIVERS
The affirmation of Croatia's Long-term IDRs reflects the following factors:

Fiscal outcomes relative to targets have been affected by the application of new ESA 2010 accounting rules to Croatia's headline deficits and debt. These were not unexpected and have had only a marginal impact on deficits. However, the inclusion of two major state-owned enterprises in general government accounts has added an average 7.8 percentage points to gross general government debt (GGGD)/GDP over the period 2008-2013. Thus, GGGD rose to 75.7% of GDP from 67.1% as at end-2013. Conversely, the stock of government-guaranteed debt has fallen by a similar amount, leaving broader public sector debt more or less unchanged.

Latest data indicates that more buoyant revenues, chiefly higher VAT receipts, more than offset upward pressure on expenditure and delivered an estimated general government deficit (GGD) of 5% of GDP for 2014, marginally down from 5.2% in 2013, but above the Excessive Deficit Procedure (EDP) target of 4.6%.

The fiscal policy framework for 2015-2017 is based on more realistic macroeconomic assumptions than in past years - growth is expected to turn positive in 2015 (+0.5%), rising to 1.5% by 2017 - and envisages an appreciable reduction in the GGD to 3.8% of GDP in 2015, 3.6% in 2016 and 2.3% in 2017. These projected outcomes will continue to exceed EDP targets.

The authorities plan cuts in expenditure on pensions, public sector pay, healthcare and education to fulfil their commitments under the EDP. However, measures to attain these goals have yet to be specified in detail, and may be tempered by the forthcoming elections and the authorities' fear of derailing a weak economic recovery. Fitch therefore expects headline GGDs to fall only modestly to 4.5% of GDP in 2015 and 3.9% in 2016.

Concerted fiscal consolidation and accelerated structural reforms would enhance sovereign creditworthiness and help free up fiscal space for better utilising EUR12.5bn of pre-committed EU structural, cohesion and other funds technically available to Croatia in 2014-2020. At present, Croatia's absorption rate of such funds remains at the bottom of the league table for EU member states, while the approach of parliamentary elections in early-2016 suggests that the pace of structural reforms is likely to remain gradual in the near term.

Prolonged recession continues to impair the prospects for fiscal consolidation and public debt sustainability. Last year marked Croatia's sixth consecutive year of recession, albeit shallower (-0.5%) than 2013 (-1%), as the economy laboured under the twin pressures of private sector deleveraging and fiscal consolidation. More buoyant industrial production and retail sales coupled with an upturn in productivity point to a weak recovery in 2015 (+0.5%), with net exports providing most of the impetus. However, the onset of mild deflation (Fitch is projecting minus 0.5% for 2015), suggests that nominal GDP will remain virtually unchanged in 2015.

Taking account of ESA 2010 revisions, Fitch estimates that Croatia's GGGD ended 2014 at 81% of GDP. Fiscal financing needs are high at 20% of GDP but so, too, is fiscal financing flexibility. The bulk of fiscal financing needs are met from the domestic market, domestic borrowing costs have fallen to historical lows and cash reserves stand at 6.5% of GDP. Nonetheless, public debt sustainability is far from secure: debt/GDP is unlikely to peak until 2016, when Fitch estimates that it will be 88%, while weak fiscal outcomes and/or continued recession could easily undermine our base case.

The government has sought to alleviate the recent appreciation of the Swiss franc and its adverse impact on some HRK23.8bn (7% of GDP) of CHF-pegged loans held by households, fixing the HRK-CHF exchange rate at historical levels for one year and leaving the banks to bear the cost. While this move will support the household sector and potentially forestall more intense deleveraging, it will dent the profitability of the mainly foreign-owned banking sector.

Croatia's per capita income is high relative to 'BBB' and 'BB' peers, contributing to greater debt tolerance, while the current account has swung into surplus to the tune of over 1% of GDP since 2013. These factors are important supports for the ratings. Still, Croatia remains highly leveraged relative to peers: net external debt (NXD) stood at over 60% of GDP at end-2014, giving rise to large gross external financing needs. Household, corporate and bank deleveraging have begun to make inroads into this debt stock, but public external borrowing remains significant.

RATING SENSITIVITIES

The Stable Outlook reflects Fitch's view that upside and downside risks to the rating are evenly balanced. The main risk factors that could, individually or collectively, trigger negative rating action are:

- Significant fiscal slippage leading to escalating public debt/GDP ratios
- Prolonged recession, potentially accompanied by deflationary pressures, which would further weaken the prospects of securing public debt sustainability
- Increased contingent liabilities, or further crystallisation of these liabilities on the government's balance sheet. Government-guaranteed debt currently amounts to around 9% of GDP

Conversely, the following factors could, individually or collectively, result in positive rating action:
- Greater progress on deficit reduction in line with the EDP, leading to a declining public debt/GDP ratio over the medium term
- Clear signs of economic recovery, underpinned by further structural reforms

KEY ASSUMPTIONS
The ratings and Outlooks are based on the following key assumptions:

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.