The ratings reflect S&P analysts' view that the absence of structural and fiscal reforms continues to drag on economic growth and cast doubts over the long-term sustainability of the country's public finances. Croatia also still lacks economic competitiveness, the analysts say, noting that wage and price rigidities undermine labour flexibility.
On the other hand, the ratings are supported by the medium-term opportunities stemming from Croatia's recent EU accession in terms of addressing key growth areas, improving competitiveness, accessing external funding, and meeting productivity challenges.
"We estimate that Croatia's real GDP contracted by 0.6% in 2014. This will be its sixth year of recession. Output has now diminished by 13.1% from 2008.
"That said, we forecast the recession will end in the second half of 2015. While this would leave real GDP growth at 0% for the year, we expect it to gradually rise to 1.0% in 2016 and 1.8% in 2018. In our view, the recovery in investment would come first before a modest revival in consumption; we foresee Croatia recording its highest growth rate since 2008 during 2015."
"According to our forecasts, at $13,600 Croatian income per capita would barely exceed 2006 levels in 2016, representing a lost decade," the analysts say, warning that Croatian institutions have so far not been able to effectively respond to economic challenges and that upcoming parliamentary elections make any near-term reforms unlikely.
They underline that big budget gaps and the application of Eurostat's new ESA2010 accounting methodology worsen Croatia's debt indicators.
The analysts forecast the general government deficit will remain at 4.9% of GDP in 2015, before gradually shrinking to 3.0% by 2018. This estimate is based on the fact that the current government is unlikely to enforce increased consolidation ahead of elections, amid an ongoing recession, they say.
However, they underline that from 2016 on revived economic growth and a new political mandate should pave the way for more-rapid fiscal deficit reduction.
"Net general government debt will likely peak at 81% in 2017. This is higher than we had previously forecast but takes account of quasi-government debt included under general government under ESA2010."
"In contrast to the fiscal account, Croatia has experienced an improvement in its external balances. We estimate a current account surplus of 1.0% of GDP in 2014, even higher than in 2013.
"However, given that import compression (a consistent drop in import demand) has contributed to the unusual surplus, we expect the recovery in domestic demand from 2016 onward to nudge the current account back into negative territory. For 2016-2018, we forecast average current account deficits of 0.9% of GDP."
In a comment on the central bank, S&P notes that the Croatian National Bank is committed to an informal kuna-euro peg, "which limits monetary policy flexibility as does the highly euroized economy (more than 70% of loans and more than 60% of deposits are denominated in or linked to a foreign currency).
"The predominantly foreign-owned Croatian banking system is still hampered by years of deleveraging, and the recent appreciation shock of the Swiss franc will further shrink profitability as the nonperforming loan ratio on Swiss franc-denominated household loans in Croatia (about 7% of GDP) rises from 17.4% currently," the ratings agency says.
"The stable outlook reflects our view that risks to the ratings are broadly balanced. It balances our expectations of medium-term benefits from EU accession against our view of currently-limited prospects for significant economic-growth-enhancing reforms."
Croatia's foreign currency rating by S&P is similar to that by the Fitch ratings agency, with its outlook being stable in both ratings. Its rating by Moody's is Ba1, with a negative outlook. All three agencies have given Croatia's rating a non-investment grade.