On September 5, Fitch revised Croatia's outlook to stable from negative while affirming its long-term foreign currency and local currency Issuer Default Ratings at 'BBB-' and 'BBB' respectively.
The recent outlook revision reflects the government's progress in addressing the country's fiscal challenges. "The key challenge facing the government will be to further reduce its deficit and implement structural reforms against a backdrop of prolonged low economic growth," said the report.
In March 2012, Fitch affirmed Croatia's rating at 'BBB-' and took the unusual step of affirming the negative outlook on the rating, the report said, adding that "Fitch typically aims to resolve a rating Outlook within two years and Croatia had been on Negative Outlook since May 2009."
In March, "Fitch decided to give the government the benefit of the doubt as at the time the government had just announced the 2012 budget which set out an array of measures aimed at cutting the budget deficit from 2012 onwards."
"Fitch views positively the government's efforts to improve tax compliance and to fight tax avoidance. Such efforts have been well-targeted and have borne fruit in a short-time frame. Fitch also believes that the changes to the labour laws and collective agreements have the potential to make the public sector wage bill more flexible and responsive to the economic cycle," said the report.
The agency predicts that borrowing needs will be modest in the short-term, and recalls that there are no external bonds maturing until April 2014. "Financing capacity is supported by a domestic market underpinned by pension funds and a liquid banking sector."
"The agency notes that the flipside of such financing flexibility is that domestic banks are becoming increasingly inter-dependent with the sovereign due to their increased holdings of T-Bills and loans to central government. This inter-dependence puts greater emphasis on the government's ability to consolidate the public finances and maintain market confidence. In this respect, the government meeting its budget deficit target and the stabilisation of public debt ratios are key to preserving the investment grade rating."
The agency said the Croatian economy "is facing a growth problem" and that the country "has been unable to return to growth" since 2008.
"On Fitch's latest forecasts, Croatia faces the prospect of a real GDP contraction of 1.7% in 2012, followed by anaemic growth of 1.5% in the medium-term. Weakness in Italy and other key EU export markets are a drag on export growth. This poses a threat to the country's fiscal adjustment and its debt dynamics."
In Fitch's view, "comprehensive labour market reform which tackles rigidities in both the private and public sector is important to improve competitiveness, support medium-term GDP growth potential and preserve Croatia's investment grade rating. The government has carried out changes to the labour laws which tackle the flexibility of wages in the public sector. Nevertheless, in Fitch's view, the low labour participation rate in the economy is a key structural bottleneck."