Fitch Ratings, the international rating agency, has today changed the Republic of Croatia's rating Outlook to Stable from Positive. The Long-term foreign and local currency ratings are affirmed at 'BBB-' (BBB minus) and 'BBB+' respectively. The Short-term rating is affirmed at 'F3', while the country ceiling is affirmed at 'BBB-' (BBB minus).
"The change in Outlook is driven by a combination of disappointing fiscal performance, limited structural reform implementation and an increased risk of delays to the country's EU accession process," says Nick Eisinger, Fitch Analyst for Croatia. Uncertainties have grown over Croatia's European Union (EU) accession talks, initially scheduled to commence in mid-March 2005 but now subject to delay, following an opinion from the International Criminal Tribunal for ex-Yugoslavia ("ICTY") that Croatia is not cooperating sufficiently in handing over alleged war criminals. Because of the importance of EU accession to Croatia, Fitch believes that the ICTY issue is likely to be resolved, possibly during the second half of this year, and this should lead to the start of accession negotiations. However, the risks of a more substantial delay to EU accession cannot be discounted in view of the delicacy of the issue, the government's thin parliamentary majority and changing political dynamics within the EU itself. A lengthy delay to Croatia's EU bid could undermine the beneficial impact on policy direction and stability that the accession process typically exerts.
The return to a Stable Outlook is also due to worse-than-expected developments in public finances over the past two years. Budget targets have been missed, and Fitch expects further fiscal slippage in 2005 on the new 4.2% of GDP deficit target agreed with the IMF. The authorities now face a major challenge in addressing some of the key structural problems inherent in public finances, such as the state pension indexation system, in order to bring the budget balance down to a more sustainable level and reverse the increase in government debt (47% of GDP at end-2004) witnessed over the past two to three years. Fitch assumes that the budget deficit will be reduced gradually over the next two years, but at a pace slower than projected by the government. Fitch calculations do not see the general government debt-to-GDP ratio stabilising until after 2007, while slippage on current fiscal plans would further delay the stabilisation of government debt.
A narrowing of the current account deficit to below 5% of GDP in 2004 is viewed positively by Fitch and should ease concerns over the sizeable twin deficits that the country has generated over the last three years. However, large debt-fuelled balance of payments surpluses together with exchange rate effects meant that external indebtedness continued to rise in 2004; net external debt ended the year equivalent to 70% of exports of goods and services, compared with an average for the 'BBB' rating range of 40%. Fitch expects the external debt burden to ease in 2005 as the pace of private credit expansion slows and the government finances a larger portion of its needs from the local debt market. However, at around 4.5%-5% of GDP, the current account deficit will remain sizeable, and with foreign direct investment unlikely to cover more than half of the external shortfall, external debt financing is expected to continue.
The rating balances the worse-than-expected public deficit and debt developments with the country's relatively moderate and low cost near-term financing burden. The rating is further supported by a high GDP per capita relative to many rating peers, a generally sound foreign-owned banking system and reasonable economic diversification. A resolution of the ICTY issue over the short term prompting the start of EU accession talks, together with more government reforms on public finances, could restore the Positive Outlook and eventually support a rating upgrade.