Explaining its decision, Fitch Ratings says that last year's debt and deficit growth was expected considering the application of new ESA 2010 accounting rules to Croatia's headline deficits and debt and that these have had only a marginal impact on deficits.
"However, the inclusion of two major state-owned enterprises in general government accounts has added an average 7.8 percentage points to gross general government debt (GGGD)/GDP over the period 2008-2013. Thus, GGGD rose to 75.7% of GDP from 67.1% at end-2013."
The latest data indicates that more buoyant revenues, chiefly higher VAT receipts, more than offset upward pressure on expenditure and delivered an estimated general government deficit (GGD) of 5% of GDP for 2014, marginally down from 5.2% in 2013, but above the Excessive Deficit Procedure (EDP) target of 4.6%, says the credit rating agency.
It notes that the fiscal policy framework for 2015-2017 is based on more realistic macroeconomic assumptions than in past years - growth is expected to turn positive in 2015 (+0.5%), rising to 1.5% by 2017 - and envisages an appreciable reduction in the GGD to 3.8% of GDP in 2015, 3.6% in 2016 and 2.3% in 2017. These projected outcomes will continue to exceed EDP targets, the agency notes.
"The authorities plan cuts in expenditure on pensions, public sector pay, healthcare and education to fulfil their commitments under the EDP. However, measures to attain these goals have yet to be specified in detail, and may be tempered by the forthcoming elections and the authorities' fear of derailing a weak economic recovery. Fitch therefore expects headline GGDs to fall only modestly to 4.5% of GDP in 2015 and 3.9% in 2016."
Concerted fiscal consolidation and accelerated structural reforms would enhance sovereign creditworthiness and help free up fiscal space for better utilising EUR 12.5bn of pre-committed EU structural, cohesion and other funds technically available to Croatia in 2014-2020. At present, Croatia's absorption rate of such funds remains at the bottom of the league table for EU member states, while the approach of parliamentary elections in early 2016 suggests that the pace of structural reforms is likely to remain gradual in the near term, says the agency.
Prolonged recession continues to impair the prospects for fiscal consolidation and public debt sustainability. Last year marked Croatia's sixth consecutive year of recession, albeit shallower (-0.5%) than 2013 (-1%), as the economy laboured under the twin pressures of private sector deleveraging and fiscal consolidation.
More buoyant industrial production and retail sales coupled with an upturn in productivity point to a weak recovery in 2015 (+0.5%), with net exports providing most of the impetus. However, the onset of mild deflation (Fitch is projecting minus 0.5% for 2015), suggests that nominal GDP will remain virtually unchanged in 2015.
Taking account of ESA 2010 revisions, Fitch Ratings estimates that Croatia's GGGD ended 2014 at 81% of GDP.
Fiscal financing needs are high at 20% of GDP but so, too, is fiscal financing flexibility.
"The bulk of fiscal financing needs are met from the domestic market, domestic borrowing costs have fallen to historical lows and cash reserves stand at 6.5% of GDP. Nonetheless, public debt sustainability is far from secure: debt/GDP is unlikely to peak until 2016, when Fitch estimates that it will be 88%, while weak fiscal outcomes and/or continued recession could easily undermine our base case."
"The government has sought to alleviate the recent appreciation of the Swiss franc and its adverse impact on some HRK 23.8bn (7% of GDP) of CHF-pegged loans held by households, fixing the HRK-CHF exchange rate at historical levels for one year and leaving the banks to bear the cost. While this move will support the household sector and potentially forestall more intense deleveraging, it will dent the profitability of the mainly foreign-owned banking sector."
Croatia's per capita income is high relative to 'BBB' and 'BB' peers, contributing to greater debt tolerance, while the current account has swung into surplus to the tune of over 1% of GDP since 2013. These factors are important supports for the ratings. Still, Croatia remains highly leveraged relative to peers: net external debt stood at over 60% of GDP at end-2014, giving rise to large gross external financing needs.
Household, corporate and bank deleveraging have begun to make inroads into this debt stock, but public external borrowing remains significant, says Fitch Ratings.
It also notes that the stable outlook reflects its view that upside and downside risks to the rating are evenly balanced.
The main risk factors that could, individually or collectively, trigger negative rating action are: significant fiscal slippage leading to escalating public debt/GDP ratios; prolonged recession, potentially accompanied by deflationary pressures, which would further weaken the prospects of securing public debt sustainability; increased contingent liabilities, or further crystallisation of these liabilities on the government's balance sheet. Government-guaranteed debt currently amounts to around 9% of GDP.
Conversely, the factors that could, individually or collectively, result in positive rating action are: greater progress on deficit reduction in line with the EDP, leading to a declining public debt/GDP ratio over the medium term; and clear signs of economic recovery, underpinned by further structural reforms, says the agency.
Fitch's foreign currency rating for Croatia is the same as that by Standard & Poor's, with outlooks being stable in both ratings, while its rating by Moody's is one level higher, at Ba1, but with a negative outlook. All three agencies have given Croatia's rating a non-investment grade.