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Rating Action:

Moody's upgrades Croatia's ratings to Baa2 and changes outlook to stable, concluding review for upgrade

15 Jul 2022

Paris, July 15, 2022 -- Moody's Investors Service ("Moody's") has today upgraded the Government of Croatia's foreign- and domestic-currency long-term issuer ratings and foreign-currency senior unsecured debt ratings to Baa2 from Ba1. The outlook has been changed to stable from ratings under review. This concludes the review for upgrade that was initiated on 24 June 2022.

The upgrade of the ratings to Baa2 is driven by the adoption of the legal acts formalizing Croatia's adoption of the euro by the EU Economic and Financial Affairs Council (ECOFIN) on 12 July 2022. Croatia will adopt the euro as its domestic currency on 1 January 2023, thereby eliminating any foreign currency risk for the government's largely euro-denominated debt burden and reducing government liquidity risk.

Moody's also sees euro adoption as credit positive for Croatia's economic strength as it will remove foreign currency risk and transaction costs also for the private sector, spurring further economic integration of Croatia with the euro area. Furthermore, the ability of the country's institutions to complete the rigorous process towards euro adoption within the planned time frame also supports Moody's assessment of the strength of Croatia's institutions and governance.

The stable outlook balances the continued strength of Croatia's economic and fiscal recovery from the initial shock of the coronavirus pandemic against risks to the macroeconomic and geopolitical environment in Europe stemming from rapidly rising inflation, concerns around the stability of the EU's energy supply and the Russian invasion of Ukraine (Caa3 negative).

The long-term country ceilings of Croatia for local and foreign currency bonds have been raised to Aa2 from A2. This reflects the fact that for euro area countries, as Croatia will be from 1 January 2023 on, a six-notch gap between the local currency ceiling and the local currency rating, as well as a zero-notch gap between the local currency ceiling and foreign currency ceiling, is typical, reflecting benefits from the euro area's strong common institutional, legal and regulatory framework, as well as liquidity support and other crisis management mechanisms. It also is in line with our view of de minimis exit risk from the euro area.

RATINGS RATIONALE

RATIONALE FOR UPGRADING CROATIA'S RATINGS TO Baa2

The EU's Economic and Financial Affairs Council (ECOFIN) on 12 July 2022 adopted a set of legal acts formalizing Croatia's adoption of the euro on 1 January 2023[1]. The adoption of the euro has significant positive implications for Croatia's credit profile.

Most notably, the adoption of the euro reduces Croatia's share of government debt denominated in foreign currency from over 70% at present to close to zero, as this debt is almost wholly denominated in euros. This, in turn, has a significant positive impact on Moody's assessment of the government's fiscal strength as it eliminates the risk of a sudden and potentially significant increase in the local currency value of government debt relative to GDP in the event of a devaluation of the local currency relative to the euro. Fiscal strength is one of the four factors of Moody's assessment of a sovereign's creditworthiness.

Croatia's economy is already highly integrated with that of the euro area, and the country has maintained a managed float of its domestic currency in a narrow band against the euro since 1999. Nevertheless, we expect that euro adoption will have additional positive effects on Croatia's economic strength over the medium to long term by reducing transaction costs and eliminating any remaining foreign currency risks for transactions between Croatia and the euro area, which already accounts for more than half of all of Croatia's imports and exports. This is likely to spur further economic integration and foreign direct investment into Croatia, supporting its longer term growth potential.

Furthermore, Croatia's adoption of the euro will also reduce foreign currency risks for the banking sector, and will also have a positive impact on our assessment of government liquidity and external vulnerability risks. As a euro area member, Croatia would in a future crisis stand to benefit from potential European Central Bank (ECB) support programmes such as the asset purchase programmes that were first introduced in 2015, while membership of the European Stability Mechanism (ESM, Aaa stable) will also support the government's ability to fund itself in a crisis situation.

Lastly, the ability of the Croatian institutions to steer the country into the euro only two years after joining ERM II - the antechamber of the currency bloc - supports our assessment of the effectiveness and strength of the country's institutions and governance.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook balances the continued strength of Croatia's economic and fiscal recovery from the initial shock of the coronavirus pandemic against risks to the macroeconomic and geopolitical environment in Europe over the coming 12 to 18 months as well as country-specific challenges that include the effective absorption of EU funds and adverse demographic trends.

The Croatian economy has continued to recover strongly from the sharply negative impact of the coronavirus pandemic on the country's tourism sector and overall economy in 2020. In our baseline scenario, we expect GDP growth to remain robust at 3% in 2022 while the debt burden will continue to decline at a more moderate pace, although the continued strength of the tourism sector's rebound from the pandemic could produce outcomes that are stronger than our baseline forecast this year.

However, there are prominent risks to the economic and fiscal outlook for Croatia stemming from a deteriorating macroeconomic environment in Europe. Such risks tied to rapidly rising inflation and concerns about the stability of the energy supply of several EU member states are in large part also linked to geopolitical risks and heightened uncertainty stemming from Russia's invasion of Ukraine and the on-going military conflict. Although the direct risks of a potential energy supply shock are limited for Croatia, in an adverse scenario, the euro area could enter a recession over the next 12 to 18 months, which would also have material negative implications for the economic and fiscal outlook for Croatia.

Moreover, Croatia's relatively weak track record of absorbing EU investment funds raises question marks around whether the country's economy will be able to derive the full benefits of the very substantial funding available for Croatia under NGEU and the EU's regular budget for 2021-2027. Croatia's medium to long term growth potential also continues to face significant challenges from the projected decline of the country's working age population.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Croatia's ESG Credit Impact Score is neutral to low (CIS-2), reflecting low exposure to environmental and moderate social risks, while European integration is further enhancing institutional and governance capacity.

Croatia's exposure to environmental risks is neutral-to-low for all the sub-factors of our assessment such as physical climate and carbon transition risks, resulting in an overall E issuer profile score of (E-2) - neutral to low.

Croatia's social risks include adverse demographics, net migration outflows and relatively high youth unemployment. Access to basic services is satisfactory. Overall, we assess Croatia's S issuer profile score as moderately negative (S-3).

Croatia's solid institutions and governance strength is reflected in a positive G issuer profile score (G-1). Although concerns around the control of corruption persist, the effectiveness of the country's institutions has been demonstrated by their ability to successfully steer Croatia towards euro adoption within the government's set time frame.

The publication of this rating action deviates from the previously scheduled release dates in the EU sovereign calendar published on https://ratings.moodys.com. This action was prompted by the adoption of the legal acts on 12 July formalizing Croatia's adoption of the euro on 1 January 2023.

GDP per capita (PPP basis, US$): [not available] (also known as Per Capita Income)

Real GDP growth (% change): 3% (2022) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 8% (2022)

Gen. Gov. Financial Balance/GDP: -2.8% (2022) (also known as Fiscal Balance)

Current Account Balance/GDP: 5.9% (2022) (also known as External Balance)

External debt/GDP: 69.7% (2022)

Economic resiliency: baa1

Default history: No default events (on bonds or loans) have been recorded since independence in 1991.

On 12 July 2022, a rating committee was called to discuss the rating of Croatia, Government of. The main points raised during the discussion were: The issuer's fiscal or financial strength, including its debt profile, has materially increased. Other views raised included: The issuer's economic fundamentals, including its economic strength, have materially increased. The issuer's institutions and governance strength have not materially changed. The issuer's susceptibility to event risks has not materially changed.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

FACTORS THAT COULD LEAD TO AN UPGRADE OF CROATIA'S RATINGS

Upward pressure could build on the ratings if Croatia manages to maintain a strong economic performance and growth potential as well as a continued reduction of the government debt burden over the coming years. This would notably be supported by evidence of effective implementation of the investments and reforms tied to the EU's post-pandemic recovery fund Next Generation EU, which would support economic growth in the near term but also growth potential over the longer term.

FACTORS THAT COULD LEAD TO A DOWNGRADE OF CROATIA'S RATINGS

Negative pressure could build on the ratings in the event of a sharp deterioration of Croatia's growth potential relative to Moody's expectations, most likely tied either to a resurgence of pandemic-related complications for the tourism industry or to the economic and political spillover effects from the Russian invasion of Ukraine. A failure to effectively implement the investments and reforms of Next Generation EU would also weigh negatively on Moody's assessment of Croatia's growth potential and the strength of its institutions and governance.

The principal methodology used in these ratings was Sovereign Ratings Methodology published in November 2019 and available at https://ratings.moodys.com/api/rmc-documents/63168. Alternatively, please see the Rating Methodologies page on https://ratings.moodys.com for a copy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

REGULATORY DISCLOSURES

For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found on https://ratings.moodys.com/rating-definitions.

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the issuer/deal page for the respective issuer on https://ratings.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.

These ratings are solicited. Please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website https://ratings.moodys.com.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at https://ratings.moodys.com/documents/PBC_1288235.

The Global Scale Credit Rating on this Credit Rating Announcement was issued by one of Moody's affiliates outside the UK and is endorsed by Moody's Investors Service Limited, One Canada Square, Canary Wharf, London E14 5FA under the law applicable to credit rating agencies in the UK. Further information on the UK endorsement status and on the Moody's office that issued the credit rating is available on https://ratings.moodys.com.

REFERENCES/CITATIONS

[1] Council of the European Union 12-Jul-2022

Please see https://ratings.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the issuer/deal page on https://ratings.moodys.com for additional regulatory disclosures for each credit rating.

Petter Bryman
Vice President - Senior Analyst
Sovereign Risk Group
Moody's France SAS
96 Boulevard Haussmann
Paris, 75008
France
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Alejandro Olivo
MD-Sovereign/Sub Sovereign
Sovereign Risk Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's France SAS
96 Boulevard Haussmann
Paris, 75008
France
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
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