Editor’s note: Moody’s Investors Service released the following statement in conjunction with a ratings action it took on the debt of the government of Croatia.
London, 01 February 2013 — Moody’s Investors Service has today downgraded Croatia’s government bond rating to Ba1 from Baa3. Moody’s has also changed the outlook to stable from negative.
Today’s rating action was prompted by the following factors:
(1) The absence of an economic recovery in Croatia and Moody’s expectation that the situation is unlikely to improve significantly as growth is structurally constrained;
(2) Insufficient fiscal consolidation, which will remain restricted in the medium term by the government’s lack of fiscal flexibility and the challenging economic environment; and
(3) Croatia’s external vulnerability indicators and government financial metrics that compare unfavourably with countries rated Baa3.
Moody’s has assigned a stable outlook to Croatia’s government bond rating as the risk that the government’s fiscal position and debt will materially deteriorate any further is limited.
RATING RATIONALE
The first factor behind Moody’s decision to downgrade Croatia’s government bond rating to Ba1 is the country’s poor growth prospects given the structural challenges of its economy. After registering four years of sluggish growth or recession (CAGR -1.7% 2008-12 in real terms), the Croatian economy continues to lack new sources of growth. Its economic model — which has historically relied heavily on private consumption and construction fueled by external credit — is impaired, while bottlenecks to investment and export-led growth persist.
In particular, the rating agency notes that the government’s capacity to re-balance the economy toward exports is intrinsically limited by (1) the lack of productive investments prior to the crisis; (2) a business environment that is less attractive than its regional peers (as illustrated by the World Bank’s Ease of Doing Business Indicators); (3) an oversized and dated public sector; and (4) the lack of labour flexibility. Demand for Croatia’s exports is unlikely to resume in line with Moody’s economic forecast for the EU.
Moody’s says that the country’s expected forthcoming EU accession in July 2013 is a positive development; however, the European economic environment and the government’s reform inertia are likely to limit the benefits normally expected to arise from EU accession (see “Croatia: Reform Inertia Constrains Growth, Limiting EU Accession Benefits”). In particular, Moody’s notes that the authorities’ ability to absorb EU funds is limited, and that the fiscal space for co-financing is, for now, almost non-existent.
The second driver underpinning the downgrade are the headwinds to fiscal consolidation, namely the unfavourable economic environment and the government’s lack of fiscal flexibility alongside a relatively high debt level (54% of GDP as of year-end 2012). Moody’s notes that the Croatian budget is structurally constrained by (1) the high level of compulsory contributions (taxes and social security contributions represent around a third of the GDP), and the need to boost the economy’s competitiveness; (2) increasing interest costs; and (3) extensive support through subsidies to some non-profitable sectors, such as the shipyards. In this context, Moody’s sees Croatia’s efforts at consolidating its public finances — including through improvements in tax collection efficiency and cuts in capital expenditure — as insufficient to ensure a reversal in debt ratio in the medium term.
The third driver informing Moody’s decision to downgrade the rating is the weakness of its credit metrics relative to those of its peers, particularly its external vulnerability and fiscal position. Although the country’s current account deficit has narrowed significantly as a result of the economic recession, its external debt (at around 95% of GDP) and Moody’s External Vulnerability Indicator (at 215%, or 140% excluding intra-group operations) are well above the median for the Baa3 rating category. The government’s fiscal metrics are also weaker, with general government debt exceeding those of Baa3-rated countries (38% of GDP in 2012), and close to that of Ba1 rated countries (58% of GDP in 2012).
RATIONALE FOR STABLE OUTLOOK
Moody’s has assigned a stable outlook to Croatia’s government bond rating, as the risk that the government’s fiscal position and debt will materially deteriorate any further is limited. Moody’s anticipates the economic environment to remain sluggish and for the deficit to slowly and gradually reduce, although government debt is likely to continue to increase.
WHAT COULD CHANGE THE RATING DOWN/UP
A robust economic recovery coupled with sustained reductions in government debt levels would exert upwards pressure on the rating. Conversely, a further deterioration in the economic environment resulting in sharp increases in debt levels and/or higher risks stemming from the country’s external vulnerabilities could exert downward pressure on the rating.
COUNTRY CEILINGS
Moody’s has today revised both country ceilings for local-currency debt and deposits to A3 from respectively Aa1 and A1 previously. The ceilings for long-term and short-term foreign-currency bonds have also been reassessed to Baa1 and P-2 from respectively A1 and P-1 previously. Finally, the ceiling for foreign-currency deposits was downgraded to Ba2 form Ba1.
Moody’s Local Currency Country Risk Ceilings determine the maximum credit rating achievable in local currency for a debt issuer domiciled in that country or for a structured note whose cash flows are generated from domestic assets or residents. Moody’s foreign-currency country ceilings generally set the highest rating possible in a given country by denoting the risk that a government would interfere with a domiciled debtor’s repayment of its foreign-currency-denominated bonds (the Foreign Currency Bond Ceiling) and deposits (the Foreign Currency Deposit Ceiling).
METHODOLOGY USED
The principal methodology used in this rating was Sovereign Bond Ratings published in September 2008. Please refer to the Credit Policy page on www.moodys.com for a copy of this methodology.