Until now, the rating was investment-grade, whereas now it has been downgraded to speculative or junk level.
"In our opinion, the Croatian government's reforms have so far been insufficient to eliminate the structural rigidities that hamper the country's growth potential," the agency said in a press release.
"We believe that the government's fiscal resolve has weakened, leaving structural budgetary weaknesses, such as high personnel and social expenditures, which together make up just under three quarters of central government spending, unaddressed."
"We are therefore lowering our long- and short-term sovereign credit ratings on Croatia to 'BB+/B' from 'BBB-/A-3'. The outlook is stable, reflecting our view that Croatia's wealth levels, relatively diversified economy, and future receipt of EU funds could help stabilize external imbalances and government finances while improving growth prospects," the agency said.
The downgrade reflects the agency's view that structural and fiscal reforms implemented so far have been insufficient to foster economic growth and place public finances on a more-sustainable path.
"In our opinion, labor and product market flexibility in Croatia is lacking. Policy inertia and opposition from vested interests that benefit from long-entrenched entitlements have contributed to wage and price rigidities, the low participation rate, and loss of economic competitiveness," said the press release.
"Croatia's public sector employs about one-third of the workforce. The budget is dominated by personnel and social expenditure: together nearly three-quarters of central government spending, leaving little room for public investment. Given the strength of incumbents inside and outside the public sector, Croatia's unsustainably high entitlement spending -- in light of economic drift, low labor participation, and population aging -- will be politically challenging to cut back, in our view. As a consequence, we no longer consider Croatia to possess the economic flexibility and policy resolve of an investment-grade sovereign," said the press release.
"Revenue-based fiscal consolidation, driven by a 2% increase in the VAT rate and improved tax collection, saw the fiscal position improve modestly in 2012 compared to 2011. Nevertheless, the recently adopted supplementary budget for 2012 underlines the challenge the government faces in adhering to its own spending plans for the wage bill, subsidies, and social transfers: all were revised upward," the agency said.
"The government's medium-term fiscal framework indicates a continued preference for revenue-based budgetary consolidation rather than current expenditure cuts to meet what we view as unambitious fiscal goals. This includes the widening deficit in 2013, a deviation from the previous government plans and from our expectations, and growing nominal expenditure, based on what we believe to be overly optimistic growth assumptions."
The agency estimates "a 2% contraction for 2012, despite a strong tourism season."
"Private-sector deleveraging, high unemployment, rising inflation, low credit growth, and a VAT increase are all weighing on domestic demand. During 2013, we expect the economy to stagnate, and then recover only gradually to trend growth of 2% by 2015, well below the pre-crisis average."
The agency went on to say that the government's growth program -- mainly increasing investment by state-owned enterprises might temporarily boost domestic demand, but that "this will be offset by weak private demand, given high unemployment and unfavorable credit conditions."
The growth program is also likely to exacerbate high external vulnerabilities, pushing up investment and external debt, said the press release.
"Strong progress in reducing economic imbalances, particularly the reliance on external financing, and the implementation of growth-enhancing structural reforms could lead us to consider raising the ratings", the agency said.
"Conversely, we could consider lowering the ratings if the government fails to reduce the structural rigidities in the economy, external imbalances widen, or there is significant deviation from budgetary targets, which could increase the risk of sudden deterioration in the economy's funding position."