OREANDA-NEWS. The agreement by Croatia's Croatian Democratic Union (HDZ) and the smaller Most party to form a coalition government reduces near-term uncertainty and suggests that attempts to reform the economy and reduce debt will continue, Fitch Ratings says. But recent history suggests political risks to policy implementation will persist.

Croatia's president nominated HDZ leader Andrej Plenkovic as prime minister-designate on Monday, after Plenkovic said HDZ and Most had agreed to form "a stable and efficient government." The combined parties fall just short of a majority in the 151-seat parliament, but the president said that 91 deputies back the coalition. These include eight deputies representing ethnic minorities, and some smaller parties.

The formation of a government after last month's election follows several rounds of talks between the centre-right HDZ and Most, which advocates economic reform. It means Croatia has avoided extended political wrangling that could have seriously disrupted policymaking.

It also suggests that the economic reform agenda established by the previous government, a diverse

Coalition led by the technocrat Tihomir Oreskovic and also relying on support from HDZ and Most, will be maintained. The European Union described the National Reform Programme submitted in April, which included measures to improve the business environment and governance in state-owned enterprises, as "fairly ambitious". Weak potential growth of 1%-2% is a ratings weakness.

The previous government also appeared committed to fiscal tightening after years of wide deficits (averaging 5.4% of GDP in 2011-2014), while Plenkovic has said that HDZ would aim to reduce the deficit to 2% of GDP.

A return to growth, better tax compliance, and under-execution of capital spending meant the deficit narrowed to 3.2% in 2015, and we forecast a fall to 2.6% this year. But this is partly due to expenditure freezing after the fall of the previous government in June, and we forecast little further improvement in 2017 or 2018. The fiscal picture therefore remains a source of vulnerability for the sovereign rating.

We assumed a degree of post-election policy continuity when we affirmed Croatia at 'BB'/Negative in July. But it is not yet clear that the HDZ-Most agreement heralds a lasting improvement in stability. The fall of the previous coalition followed disagreement between HDZ and Most, although this was occasioned more by conflict of interest allegations against the previous HDZ leader than by economic policy.

Agreeing unpopular measures, such as cuts to social spending, and overcoming vested interests in areas such as state-owned enterprise reform, may prove challenging. We think the prospect of regional elections in May next year will delay politically difficult reforms until 2H17.

Croatia's debt/GDP ratio is nearly double the 'BB' category median, at close to 90%. Failure to put the ratio on a sustained downward path, whether due to policy direction, fiscal underperformance, rising financing costs, or weak nominal GDP growth, could result in a downgrade.