"The outlook revision reflects our view that Croatia's general government indebtedness, as a share of GDP, will continue to increase to over 90% of GDP in 2016, after doubling since 2008.
"Following the upcoming parliamentary elections that must be held by February 2016, we foresee a marked risk that the policy response to increasing debt and momentum for reform could be insufficient to reverse the mounting indebtedness without robust measures. This would, in turn, cast further doubts on the ability of Croatia's political institutions to implement effective policies that would deliver sustainable
public finances and promote balanced economic growth," the agency says.
It notes that the country's ratings are constrained by its weak growth prospects and the public sector's overbearing and inefficient role in the economy, due to a backlog of unimplemented structural and fiscal reforms. In addition, high and increasing public-sector indebtedness, partially owing to lossmaking state-owned enterprises, jeopardises the long-term sustainability of Croatia's public finances, it says.
The agency notes that the country's ratings are supported by slightly decreasing external indebtedness because of deleveraging in the financial sector, "which somewhat offsets the public sector's increasing external leverage."
S&P analysts believe that Croatia's institutional framework benefits from the country's EU membership, including in particular the EU's deficit monitoring function through its Excessive Deficit Procedure (EDP).
"However, we have seen little progress in terms of fiscal consolidation in Croatia since the beginning of the EDP in 2013, and we think there's a high likelihood that Croatia will not meet its EDP deficit correction deadline in 2016."
After contracting a further 0.4% in 2014, Croatia's economy now seems to have pulled out of recession, the analysts say, estimating that real GDP will grow by 0.2% in 2015, primarily supported by net exports. In the next few years, they expect GDP growth will average 1.2% annually, which, they say, is still significantly lower than in peers with similar income levels.
"Moreover, we see pronounced downside risk to our GDP forecast, mainly owing to a potentially slower rebound than we currently expect in eurozone economies, Croatia's main trading partners. At the same time, high private-sector indebtedness and banks' continued need to deleverage may pose a further drag on investments."
"Croatia's institutions have so far not been able to effectively respond to the mounting economic challenges, and the upcoming parliamentary elections make any near-term reforms unlikely. That said, we anticipate that the new government will aim to address some of the structural issues to improve Croatia's competitiveness," the analysts say.
"Although the EDP should provide Croatia with an important fiscal policy anchor by imposing the goal of a budget deficit of less than 3% of GDP by 2016, we expect the government's fiscal stance will remain loose in 2015," say the analysts who this year expect the general government deficit to be a high 5.6% of GDP and only a gradual decline toward the 3% target beyond 2018.
They also expect that pre-election measures in the first half of 2015, such as changes to the personal income tax and debt relief for the very poor, as well as very slow reforms of state-owned enterprises, will disrupt consolidation plans this year and are likely to have a negative effect on the budget in coming years. "We think meeting the EDP target largely depends on the still-uncertain policy measures that the government may implement following the upcoming elections," they say.
The country's net general government debt is expected to increase to over 87% by 2017.
"The peak could even be higher due to the vulnerable financial situation of state-owned enterprises. Although much of Croatia's quasi-government debt is included under general government debt under the European System of Accounts (ESA) 2010 framework, failed privatizations or further arrears by or guarantees to local and regional government or state-owned enterprises may further increase general government debt. In addition, foreign currency debt currently represents 73% of general government debt, making Croatia vulnerable to changes in global monetary conditions and sentiment, which could push up interest rates on a sustainable basis and result in higher debt servicing costs," S&P says.
In contrast with its fiscal position, Croatia has improved its external balances, the analysts say, estimating a current account surplus of 0.9% of GDP in 2015, aided by lower oil prices and a slight pick-up in exports, particularly tourism.
In their opinion, the current account surplus will peak in 2016 at 1% of GDP, and decline to 0.3% of GDP in 2018 as domestic consumption and imports accelerate.
The Croatian National Bank is committed to the kuna-euro peg, which limits monetary policy flexibility, as does the highly euro-ized economy, the analysts say, noting that more than 70% of loans and 60% of deposits are denominated in or linked to a foreign currency, usually the euro.
Several years of deleveraging continue to hamper the predominantly foreign-owned Croatian banking system. In addition, a temporary, one-year, peg of the kuna-Swiss franc exchange rate at historic rates for outstanding Swiss franc-denominated loans, as well as the unknown final resolution of this issue, weighs on banks' profitability and lending activity. Nonperforming loans, particularly in the Swiss franc-denominated household mortgage book, remain high and have increased to about 18% of total loans due to the Swiss franc's recent appreciation against the kuna, S&P says.
The negative outlook reflects the analysts' view that there is at least a one-in-three possibility that they could lower their ratings on Croatia in the next 12 months.
S&P could lower the ratings if government policies do not robustly counter Croatia's entrenched fiscal and economic challenges after the upcoming election. In addition, it could lower the ratings if it considered that the effectiveness or credibility of the Croatian National Bank was undermined by further increased euro-ization or political influence, the analysts say.
"On the other hand, Croatia's accelerated efforts toward, and meaningful progress in, addressing key structural economic and budgetary challenges, could lead us to revise the outlook to stable, as would an increasingly substantial and sustained return to economic growth."
Croatia's BB foreign currency rating is two levels below the investment grade. Croatia has been given the same rating, but with a stable outlook, by the Fitch ratings agency, while Moody's has kept its ratings at one level below the investment grade Ba1, but with a negative outlook.