Risk drivers and outlook

Croatia has been stuck in recession since 2009. The private sector (corporates and households) is deleveraging, the public authorities are struggling to contain their mounting debt and exports provide insufficient counterweigh as they are being affected by the crisis in the euro area and by structural weaknesses. Many uncertainties remain as to when recovery will take place. Along with significant corruption, this makes for a high commercial risk. Nonetheless, the short-term political risk rating has recently been upgraded to reflect the positive evolution of foreign exchange liquidity and the prospect of stability provided by accession to the European Union (EU) on 1 July, in particular thanks to the adhesion to the single market and the freedom of goods and capital movement that comes with it.

In the medium to long run, the country’s solvency remains a concern, as public and external debt levels  are high. However, the share of short-term debt in total external debt has overall been decreasing in recent years, which improves the risk prospect related to a sudden reversal of confidence from investors. A  further threat relates to the large degree of euroization of domestic loans and bank deposits, increasing the exchange rate risk. Nonetheless, the objective of broad stabilization of the exchange rate, administered through a managed float by the central bank, has always been met and can anchor expectations of further stability. Finally, foreign investment is expected to regain momentum, spurred by the better framework provided by the alignment of Croat legislation with the acquis communautaire and the confidence framework that EU membership can offer. This should boost the growth potential of the country.

Facts & figures

Pros

  • EU accession should increase the growth potential
  • Resilient banking sector
  • Satisfactory foreign exchange reserves level
  • Stable ruling coalition

Cons

  • High external debt
  • Significant euroization of the economy makes it subject to exchange rate risk
  • Structural lack of competitiveness
  • Weak export base

Main export products

  • Tourism (31.2% of total current account receipts), manufactured goods (28.2%)

Income group

  • High income

Per capita Income (USD)

  • 13,530

Population

  • 4.4 million

Next presidential elections (every 5 years)

  • December 2015

Next parliamentary elections (every 4 years)

  • Due by February 2016

Head of government

  • Zoran Milanovic

Head of State

  • Ivo Josipovic

Country risk assessment

Since independence, from authoritarianism to full democracy

From its secession from the Socialist Federal Republic of Yugoslavia in 1991 until the last legislative elections in 2011, Croatia’s political system was dominated by right-wing party Croatian Democratic Union (CDU). Its then leader and President of the Republic of Croatia, Franjo Tudjman, brought the country to independence and led the conflict that opposed Croatian independentists against Croatian Serbs, until the conflict was resolved in 1995.

After the war, authoritarian nationalist President Tudjman kept the country isolated from the rest of the world, refraining from membership in international organizations. After his death in 1999, first under the newly-elected Social Democratic Party (SDP) and then the reformed CDU from 2003, Zagreb went on to embrace democracy and opened up to the outside world. The SDP introduced constitutional reforms, curbing presidential powers to the benefit of parliament, and unlocking the country by allowing the return of refugees and allowing political representation of minorities in parliament. To the dismay of the population, it agreed to let the International Criminal Tribunal for the Former Yugoslavia (ICTY) to conduct enquiries  over war crimes committed against Serbs inside Croatia during the 1991-95 conflict. Following the 2003 legislative elections, the CDU, under the helm of PM Ivo Sanader, continued to cooperate with the ICTY. EU accession talks were started in 2005 and the country was allowed to join NATO in April 2009. The sudden resignation of Sanader as prime minister and CDU leader in July 2009 was followed by a difficult period for the party, as several corruption affairs involving its members were revealed. Sanader himself  was suspected and finally sentenced to ten years imprisonment in November 2012.

The legislative elections held in December 2011 brought the necessary change of leadership when the centre-left Kukuriku coalition under SDP chief Milanovic achieved victory. Since then, the country has been considered as politically stabilized, with the ruling coalition and opposition parties united in fully supporting the EU membership project.

A lengthy EU accession process

Following Croatia’s application for EU membership in 2003, accession talks officially started in October 2005 after the main obstacle for opposing the country’s EU application was removed, i.e. the lack of co-operation of the authorities with the ICTY to track down and extradite the fugitive Croat general Gotovina. From that date, substantial domestic reforms have been implemented to align Croatian legislation with the acquis communautaire and to bring competition policy, the judiciary and fundamental rights and security to European standards.

However, the path to accession was full of pitfalls, most of them coming from neighbouring EU-member Slovenia. The major stumbling block was the long-standing border dispute over the Piran Bay in Istria, which has poisoned relations between the two neighbours since their independence in 1991. With direct access to international waters at stake for Slovenia, the country requested the dispute be resolved as a precondition for Croatia’s adhesion, blocking accession talks for many months. Tensions were defused when both countries agreed in 2010 to submit the issue to binding international settlement, the ruling of which is still pending. Croatia finally signed the EU Accession Treaty end 2011 and a binding national referendum held in January 2012 endorsed it. After that, it was still subject to the ratification by the 27 Member states.

Slovenia’s ratification was one of the last hurdles, as Ljubljana had pushed for one more pending issue to be settled before it would sign Croatia’s Accession Treaty. The dispute involved the Slovenian bank Ljubljanska Banka (LB), which went bankrupt in 1991 without repaying its Croatian depositors. Croatia agreed last March to drop the lawsuit aimed to obtain reimbursement from Slovenia, as further talks on the LB issue would be held under the auspices of the Bank for International Settlement. Slovenia eventually ratified Croatia’s accession last April, so that Croatia will become the 28th member of the EU on 1 July 2013.

Unable to shake off recession

Ravaged by five years of war, the economy missed the first wave of investment in Central and Eastern Europe that followed the fall of the Iron Curtain. However, during most of the last decade, Croatia has had solid growth fuelled by external funds as the mostly foreign-owned (i.e. Austrian and Italian) banking sector tapped into international markets, feeding cheap credit to households and corporates. The SDP government also boosted the economy with a large road-building infrastructure project. In spite of the trade surplus in services thanks to the recovery of tourism, large current account deficits were the rule as  surging imports of goods exceeded exports. Over that period, inflation remained in check and the currency (kuna) was stable.

Expansion came to a sudden halt when the global crisis hit the Croatian economy. With large current account deficits, a high level of external debt, and significant exposure to interest and exchange rate risks due to the large degree of euroization of bank credit and bank deposits, market confidence in Croatia deteriorated and credit conditions tightened.

Even though the financial system has remained globally stable thanks to sustained support from parent banks to their subsidiaries and despite the prompt monetary policy reaction from the authorities to sustain the activity, recession was unavoidable. Since the eruption of the crisis, the economy has not managed to recover as real GDP, after having shrunk by almost 7% in 2009, fell by another 2.3% in 2010, stagnated in 2011 and should have contracted by another 2% in 2012. Since 2010, the recession is mostly due to diminishing domestic demand, as private consumption and mostly investment fell sharply. Private consumption is being affected by the erosion of disposable income of households due to austerity measures, by the diminishing credit supply, by the efforts of households to deleverage and by the rising unemployment rate (from 8.3 % in 2008 to an estimated 14.2% in 2012). Corporate investment has crashed as the sector wants to reduce its high level of indebtedness and as credit conditions have been tightened. Export volumes have maintained a slightly positive growth since 2010, while imports volumes have globally decreased over the same period, allowing the external balance of goods and services to become positive in 2011. This year should see the recession continue (with a real GDP forecast to contract slightly by 0.2% according to the IMF). After all, household consumption and corporate investment are expected to still be influenced by the same negative factors as in previous years, while external trade support should remain insufficient to bring back growth. The realization of large announced investment plans by state-owned enterprises and the implementation of the law on strategic investment aimed at decreasing the barriers for large investments are the main factors that are likely to have a positive  influence on the activity in the near future. The difficulty to shake off the recession has shed light on Croatia’s structural economic weaknesses.

Structural weaknesses prevent recovery

In their efforts to reduce mounted debts, public and private sectors are stifling domestic economic growth, and the export base of the small country proves insufficient to boost economic activity, especially with some 50% of exports bound for the crisis-stricken euro area. Tourism revenues represent about one third of goods and (non-factor) services exports (15% of GDP) but their potential for further expansion remains limited, although renovation works of hotel infrastructure are in process. In addition, the industry is lacking competitiveness due to wage levels remaining higher than average in peer countries and significant when compared to productivity levels. Also, deficiencies in non-price competitiveness, such as rigidities in the labor market and obstacles for starting or conducting a business explain Croatia’s market share losses in global exports experienced since 2008. The World Bank ranked Croatia 84th according to the ‘ease of doing business’ criteria in 2012, behind poorer Balkan neighbors Macedonia and Montenegro.

In spite of the slow privatization process, one of the requirements for EU accession, Croatia still has a high number of state-owned or -controlled companies, which also affects competition and productivity levels.

Croatia_Graph1EN

Source: Eurostat

Croatia_Graph2EN

Source: Eurostat

High public and external debts

Managing public debt was already a concern for Croatia even before the eruption of the financial crisis in 2008. Public debt went on to rise from less than 30% of GDP in 2008 to an estimated 54% of GDP in 2012 (or almost 70% of GDP including publicly guaranteed debt) due to the persisting recession. Public deficits, which were brought back in check in 2008 (-1.3% of GDP), have largely exceeded the 4% of GDP since then. The target of a 4% public deficit in 2012 was nonetheless achieved thanks to fiscal consolidation progressively implemented since 2009. In spite of further austerity measures announced in the 2013 budget, fiscal deficit is projected to widen again this year, mainly reflecting the weak activity, and leading the general government debt to exceed 60% of GDP in 2014.

While in the first half of the last decade public debt was mostly foreign-held, the government took measures to redirect public debt to local financing sources so that it has now become predominantly domestic. However, the shift in public debt did not prevent the total external debt from inflating in the years of boom, through fault of the private sector. This was partly due to the mainly foreign-owned banks, which had continued to draw funds from their parent banks to back the rapidly growing demand for credit. However, in recent years and after peaking in 2009, external debt has settled in relative terms, although remaining at a high level (about 100% of GDP). Also, the share of short-term debt in total external debt has been globally decreasing in the latest years.

Despite significantly lower capital inflows (particularly foreign direct investments), the country’s external liquidity, as reflected by the foreign exchange reserves level, has gradually improved compared to pre-crisis years, which is mainly thanks to tourism revenues and a smaller current account deficit. Reserves currently cover more than six months of imports.

The objective of a broad stabilization of the exchange rate, administered through a managed float, has been met from the start of the financial crisis through interventions of the central bank and adjustments of reserve requirements, even though it has progressively allowed more flexibility to absorb external shocks. Overall, the exchange rate policy, combined with the weak activity, has helped to keep inflation in check since 2009, in spite of a hike in food prices in 2012 due to a VAT tax rise.

Croatia_Graph3EN

Source: IMF and Eurostat

Croatia_Graph4EN

Source: IMF

The banking sector remains stable and well-capitalized

More than 90% of the assets of the Croatian banking sector are held by foreign banks of EU member states (mainly Austria and Italy). As the sector relies highly on funding from foreign parent banks*,  potential difficulties in a parent bank or a reassessment of Croatia’s growth potential could translate into liquidity constraints through lessened support or higher financing costs. However, foreign banks have maintained their exposure to Croatian subsidiaries the last few years, allowing the system to remain stable and well-capitalized. Due to the recession, the share of non-performing loans (NPLs) is increasing, but is still at a reasonable level (13.2% of all loans in June 2012) in comparison to peer countries. The low coverage requirement of NPLs poses also some level of risk in terms of capital adequacy if the deterioration of loan quality continues but, combined with the moderate share of NPL’s, leaves the sector highly profitable.

* According to the IMF, “liabilities to nonresidents represent a quarter of total bank liabilities, 90 percent of which are to parent banks, mainly from Italy and Austria."

EU accession should boost growth potential

Croatia has completed a rigorous reform process since it applied for EU membership ten years ago. These efforts have led to substantial progress in the fields of competition policy, judiciary and fundamental rights, justice, freedom and security. The imminent EU accession is seen more as an incentive to pursue reforms as the European Commission stated last March that Croatia was expected to continue to improve its track record, especially in the area of the rule of law and the fight against corruption.

On the macroeconomic side, one of the main advantages of EU membership are the structural and cohesion funds to which Croatia will be entitled. While the EU has already provided a total of € 998 million in financial support to Croatia under pre-accession aid since 2007, total EU funds approved for Croatia for the second half of 2013 amount to € 687.5 million. According to a draft multiannual financial framework for the 2014-2020 period, total funds allocated for Croatia would amount to € 13.7 billion (representing on average more than 4% of GDP per year). Moreover, foreign investment is expected to regain momentum, spurred by the better framework offered by the alignment of Croatian legislation with the acquis communautaire and the confidence framework that EU membership can offer. These elements should boost the country’s growth potential

Analyst: Florence Thiéry, f.thiery@credendogroup.com