OREANDA-NEWS. August 04, 2015. Fitch Ratings, London, 31 July 2015: Fitch Ratings has revised the Outlooks on Croatia's Long-term foreign and local currency Issuer Default Ratings (IDR) to Negative from Stable and affirmed the IDRs at 'BB' and 'BB+', respectively. The issue ratings on Croatia's senior unsecured foreign- and local-currency bonds have also been affirmed at 'BB' and 'BB+', respectively. The Country Ceiling has been affirmed at 'BBB-' and the Short-term foreign currency IDR at 'B'.

KEY RATING DRIVERS
The revision of the Outlooks to Negative reflects the following key rating drivers and their relative weights:

HIGH
The general government deficit reached 5.7% of GDP in 2014, 0.3% above its 2013 level and 1.3% above the target set in the government's April 2014 Convergence Programme. Most of the slippage stemmed from weaker revenues due to lower than forecast inflation and GDP growth. The government has revised up its target for the 2015 budget deficit to 5.0% of GDP compared with an original target of 3.5% in the previous year. Fitch has revised its 2015 forecast budget deficit to 5.5% of GDP (previously 4.5%).

The government's latest Convergence Programme envisages a reduction of the budget deficit to 2.7% in 2017, but in our view, implementation risks are high. The government's track record of restructuring state-owned enterprises (SOEs) suggests that budgeted savings in this area may underperform. Forthcoming parliamentary elections expected in early 2016 are also likely to forestall consolidation efforts until a new government has been formed.

Gross general government debt (GGGD) grew to 85% of GDP at end-2014, the second highest in the 'BB' category, and up from 39% of GDP at end-2008. Fitch expects GGGD to rise to 90% of GDP in 2015 and peak at 94.4% of GDP in 2017. Funding conditions remain favourable, but high fiscal financing needs of approximately 20% of GDP pose a risk to public debt sustainability in the event of an unexpected rise in funding costs.

GGGD for 2013 was revised up by 4.9% of GDP in April 2015 following a recent round of ESA2010 statistical reclassifications aimed at providing a more complete and standardised picture of government debt levels. In total, GGGD has been revised up by approximately 13% of GDP since the first round of reclassifications was introduced in October 2014. Any future reclassifications are likely to have only a modest impact on GGGD as the bulk of SOE liabilities are now included in the general government sector.

Croatia's 'BB' foreign currency IDR also reflects the following key rating drivers:

The Croatian economy suffers from high public and external debt ratios, high euroisation, and weak economic performance since 2009. These factors create an unfavourable background for debt dynamics, making Croatia vulnerable to adverse shocks. However, structural features including per capita income, human development, and governance indicators score well above the 'BB' and 'BBB' category medians, and support the rating.

Economic growth has performed significantly below peers following six protracted years of recession. Real GDP growth contracted by 0.4% in 2014 and has grown at an average of -1.1% on a five-year look-back basis versus 3.9% for the 'BB' median and 3.2% for the 'BBB' median.

Fitch expects the economy to exit recession this year and for real GDP to grow by 0.5% in 2015 and 1.0% in 2016. The improved growth outlook is largely driven by net exports, lower oil prices, and a general pick-up in eurozone economic activity, as internal demand is not expected to contribute positively to growth until 2016.

Croatia posted a current account surplus of 0.7% of GDP in 2014 and 0.8% in 2013, after nearly 20 consecutive years of deficits. Fitch forecasts the surplus to grow to 1.9% of GDP in 2015 driven by tourism receipts and a narrowing of the goods deficit due to lower oil prices. Better absorption of EU funds would improve the balance of payments through higher transfers.

Net external debt is high, at approximately 63% of GDP at end-2014, a significant outlier relative to the 'BB' and 'BBB' category medians of 7.1% of GDP and 6.9% of GDP, respectively. External indebtedness is largely accounted for by the private sector, although public external borrowing has grown substantially in recent years.

Fitch views the banking sector's profitability as weak but the sector is sufficiently capitalised with an average capital adequacy ratio of 21%. Non-performing loans are high at 17% at end-2014, but provisioning levels exceed 50%. Unresolved issues pertaining to roughly HRK23.8bn (7% of GDP) in CHF-pegged household loans weigh on confidence but do not pose a systemic risk to the financial system. High foreign ownership of the banking sector (about 90% by assets) also mitigates contingent liabilities to the sovereign balance sheet.

RATING SENSITIVITIES
The Negative Outlook reflects the following risk factors that may, individually or collectively, result in a downgrade:
-Continued escalation of the public debt/GDP ratio, whether through fiscal underperformance, rising financing costs, or weaker nominal GDP growth.

Future developments that may, individually or collectively, result in a revision of the Outlook to Stable include:
-Fiscal deficit reduction broadly in line with the latest Convergence Programme targets, which would increase confidence that public debt/GDP will be stabilised over the medium term.
-Strengthening growth prospects and competitiveness, particularly through the implementation of structural reforms.

KEY ASSUMPTIONS
Croatia's track record of monetary and exchange rate stability remains intact, lowering the risks to household, corporate, and public sector balance sheets, all of which are heavily euroised.

Fitch expects the reclassification of local utilities to drive one further round of public debt revisions by end-2015, although we expect the net impact to be modest at roughly 1% of GDP.