Moody s Ba2 / S&P BB / Fitch BB 1 Economy: Agriculture 4%, Industry 27%, Services 69%

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1 Croatia Summary Moody s Ba2 / S&P BB / Fitch BB 1 Economy: Agriculture 4%, Industry 27%, Services 69% Croatia emerged from a six-year recession in 2015, although the economic recovery has been tepid due to competitiveness challenges, including a labor market with high nominal wages and low participation. Years of low growth curbed government revenues, and an inefficient public sector hindered attempts to reduce expenditures. These factors contributed to a deterioration of public finances and rising public debt levels, however, this trend is beginning to reverse. Although debt levels remain elevated, liquidity and rollover risk are limited because most of Croatia s public debt is local currencydenominated, with a captive local investor base of banks and the pension system. Other strengths include a strong external position and EU membership, which should provide a policy anchor. An additional risk is the potential contingent liability of the country s largest food producing company, which is currently being restructured. Economic Indicators F 2018F Population (Millions) GDP per Capita (USD) 13,570 13,451 11,640 12,145 11,970 12,365 Nominal GDP (USD Billions) Real GDP (%) Year-End CPI (%) Fiscal Balance (% of GDP) Interest (% of Revenues) FC Debt/Public Debt (%) Government Debt (% of GDP) Government Debt (% of Revenue) Current Account (% of GDP) FDI (% of GDP) External Debt (% of GDP) Foreign Reserves/External Debt (%) Foreign Reserves (Mo. of imports) Foreign Reserves (% of GDP) As of November 2017 Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Lazard, Bloomberg, Croatian Bureau of Statistics, Croatian National Bank, IMF 183

2 Lazard Emerging Markets Debt Rating History Below is a history of the country s foreign and local currency ratings by the major agencies dating back to We have also included a chart of the country s hard currency external debt spread and the JP Morgan EMBI Global Diversified Index spread for comparison. Rating History Hard Currency BBB+ BBB BBB- BB+ BB Local Currency A- BBB+ BBB BBB- BB+ BB BB BB Moody s S&P Fitch Moody s S&P Fitch As of December 2017 Performance represents past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg, Fitch, Moody s, Standard and Poor s Bond Spreads Croatia 2012 EMBIGD 2017 As of December 2017 Performance represents past performance. Past performance is not a reliable indicator of future results. Source: JP Morgan 184

3 Croatia Strengths EU Accession Croatia joined the EU in July 2013, unlocking financial assistance and monitoring that could strengthen the country s institutions and generate new investor interest and foreign direct investment. Accession provides an opportunity to rebalance the economy from a consumption-oriented model financed by external debt to one based on net exports and investment. Under the EU s Partnership Agreement, Croatia is eligible to receive 8.6 billion in structural funds between 2014 and The authorities are hoping this assistance will ultimately help diversify Croatia s narrow goods export base, which is currently limited to shipbuilding and refined oil. However, in the short term, EU accession is unlikely to generate the same economic dividends for Croatia as received by countries in previous EU enlargement rounds, owing to the country s low export competitiveness, which is due to high labor costs and a large public sector. In addition, the country s membership in the Central European Free Trade Area (CEFTA), which encompasses the countries of the western Balkans outside the EU and is a major export market for Croatian goods, came to an end upon accession to the EU. Croatian goods now face the same tariffs as other EU goods in the CEFTA area. Finally, even though Croatia is eligible to receive large amounts of EU funds, the ability of the Croatian authorities particularly at the local level to absorb and administer these funds is limited. Moreover, Croatia s expenditures are likely to grow in the short term due to the country s financial obligations pertaining to EU membership. External Liquidity Croatia s current account balance has registered a substantial improvement, going from a deficit equal to 10% of GDP in 2008 to a surplus of nearly 5% in However, nearly half of the improvement that year was the result of a one-off drop in foreign bank profits resulting from the conversion of Swiss franc-denominated mortgages. 3 Nevertheless, the current account surplus is projected to diminish but remain positive over the forecast horizon, owing to increased tourism revenues and reduced remittances of foreign-owned firms due to lower profitability. Croatia s high gross external debt burden, which currently amounts to about 90% of GDP, is offset by foreign currency reserve coverage equal to about one-third of the total external debt stock. Approximately 62% of the external debt is owed by corporates and banks, with around 15% in intra-company lending. 4 The relatively low sovereign portion of external debt, about 38% of GDP, partly offsets a key vulnerability for Croatia: a very high euroization ratio of 70% to 75% for both loans and deposits, hence the need to limit currency volatility. 5 Exchange-rate vulnerability became more pronounced in early 2015, when the Swiss monetary authorities abruptly allowed the franc to appreciate, exposing Croatian borrowers to heightened currency risk since franc-denominated loans amounted to more than 7% of GDP. The government responded by temporarily freezing the exchange rate applied to these loans before ordering banks in September 2015 to retroactively convert their clients francdenominated loans to euros. The cost to banks amounted to about 2% of GDP, and the subsequent decline in profit remittances from foreign banks operating in Croatia contributed to the country s large current account surplus that year. 185

4 Lazard Emerging Markets Debt Low Rollover Risk About 60% of Croatia s public debt is denominated in local currency, with a captive local funding source in its banks, insurance companies, and pension system. There is ample liquidity in the financial system. These factors have enabled the government to issue large amounts of local currency- and euro-denominated debt at low rates, and the government is able to meet more than 80% of its funding needs in local markets. Foreign investors are not active in Croatia s domestic market, reducing the risk of rapid outflows or currency fluctuations. Weaknesses Poor Growth Prospects Croatia s growth fundamentals are poor, owing to a large and inefficient public sector that has weighed on activity and discourages foreign investment. Persistent fiscal deficits also limit the government s ability to stimulate economic activity. Monetary policy flexibility is also constrained by the Croatian kuna s peg to the euro, as well as the high euroization rate of Croatia s financial system. The country s nominal GDP has only recently recovered to its pre financial crisis level. 6 This prolonged economic contraction can be traced to a lack of an industrial base because Croatia s main industry shipyards is considered a sunset industry. In addition, Croatia is burdened by low competitiveness relative to peers, a poor business environment, widespread corruption, an inefficient public sector, and an inflexible labor market. The International Monetary Fund estimates long-term potential growth of less than 2%. 7 Exports have been hurt by the ongoing restructuring of the shipbuilding sector, and by the economic slowdown in neighboring European countries, in particular, Italy, which is Croatia s largest trading partner. In addition, Croatia is not integrated into the eurozone manufacturing chain and faces steep competition to its manufactured base. Croatia s poor competitiveness is reflected in its loss of world export market share compared to its peers, both before and after the financial collapse. However, a bright spot is the focus on non-tradeables, the most promising of which is tourism, whose total contribution to the economy amounts to more than 25% of GDP. 8 Croatia also has among the highest tax burdens in the world and ranks poorly on several fronts in terms of its business environment, based on the World Bank Ease of Doing Business and the World Economic Forum Global Competitiveness Report. Generous benefits and the highest nominal wages in the region have resulted in one of the lowest labor participation rates in emerging markets and the lowest participation rate for countries with similar levels of GDP per capita. Such a low labor participation rate has consequences not only for medium-term potential GDP growth, but also for fiscal dynamics and for the external debt position. Unemployment is easing, but is still high at 10.9%

5 Croatia A Large Debt Burden Croatia s public debt has risen sharply from below 40% of GDP in 2008 to 82% currently. 10 About 61% of public sector debt is internal, and as mentioned previously, the government is able to roll over this debt without difficulty due to the captive local funding base. The government also faces contingent liabilities associated with the central government s guarantees of Croatia s many unprofitable state-owned enterprises, some of which have foreign currency-denominated debt. Public debt levels are likely to remain high in the near term due to low real GDP growth of less than 3% in a best-case scenario, negligible inflation, an average interest rate on government debt of 4% to 5%, and the risk of external shocks, such as a sharp slowdown in European growth or rising global borrowing costs. 11 In 2014, Croatia came under the EU s Excessive Deficit and Macroeconomic Imbalances Procedures (EDP and MIP, respectively), which subjected the country to EU guidance and monitoring to reduce imbalances. However, the country exited the EDP now that the fiscal deficit has dropped below 3%. Potential Contingent Liabilities Croatia s food and retail company Agrokor employs 60,000 workers in more than 70 companies throughout Eastern and Western Europe. The company accounts for an estimated 2% of Croatia s GDP and employs about 2% of the country s workforce. Agrokor began to experience financial difficulties in early 2017 and defaulted in May, despite capital injections from a consortium of foreign banks. Independent administrators have been appointed to manage Agrokor s restructuring, and this process is scheduled to be completed in the second quarter of The government has said it will not intervene to support the company, but it may be forced to reconsider given the importance of the company to the Croatian economy. Moreover, government officials have faced accusations of complicity and failure of oversight, which has increased political uncertainty. 187

6 Lazard Emerging Markets Debt Country Background Size Capital Population 56,594 KM 2 (128th) Zagreb 4.3 Million Religion Roman Catholic 86.3%, Orthodox 4.4%, Other 9.3% Median Age 43.0 Years Literacy Rate 99.3% Independence 25 June 1991 Political System Government Leadership Legislative Election 2020 Legislative Branch Parliamentary Democracy President Kolinda Grabar-Kitarovic; PM Andrej Plenkovic Unicameral Assembly Economy Agriculture 4.1%, Industry 26.5%, Services 69.4% Labor Force Agriculture 1.9%, Industry 27.6%, Services 70.4% Merchandise Exports Export Partners Currency As of November 2017 Source: CIA Transport Equipment, Machinery, Textiles, Chemicals, Foodstuffs, Fuels Italy 13.5%, Slovenia 12.3%, Germany 11.6%, Bosnia and Herzegovina 9.2%, Austria 6.3%, Serbia 4.2% Croatian Kuna (HRK) 188

7 Croatia Country Timeline 2004 EU agrees to start accession talks with Croatia in March Green light given for EU accession talks to go ahead again even though Gen Gotovina remains at large. Croatia calls for international mediation after Slovene parliament declares ecological zone in the Adriatic with rights to protect and use sea bed European Commission says Croatia is likely to end accession talks by 2009 and become a member by 2011, but demands tougher action against corruption and organized crime Croatia officially joins NATO. Slovenia lifts block on Croatia's EU membership talks after the two countries sign deal allowing international mediators to resolve their border dispute. Croatian EU membership talks resume Croatia successfully completes EU accession negotiations, putting it on track to become the 28th member state in mid Croatian voters back joining the European Union in a referendum by a margin of two to one, albeit on a low turnout of about 44% Croatia takes its place as the 28th member of the EU EU finance ministers launch proceedings to force Croatia to halve its budget deficit and bring it under the bloc's permitted limit. Source: BBC Notes 1 As of December Corina Cretu, Helping Croatia make the most out of EU Structural Funds, European Commission, Blog Post, 30 January 2015, accessed on 29 October 2015, blog/helping-croatia-make-most-out-eu-structural-funds_en. 3 Croatia: 2016 Article IV Consultation, IMF Country Report No. 16/187, IMF, June 2016, org/external/pubs/ft/scr/2016/cr16187.pdf. 4 As of 30 June Source: Croatian National Bank. 5 Euroization refers to the process of a country adopting the euro as its primary currency or linking its currency to the euro. 6 As of December Source: Croatian National Bank. 7 Croatia: 2016 Article IV Consultation, IMF Country Report No. 16/187, IMF, June 2016, org/external/pubs/ft/scr/2016/cr16187.pdf. 8 As of December Source: Economic Impact 2017: Croatia, World Travel and Tourism Council, As of August Source: Croatian Bureau of Statistics. 10 As of June Source: Croatian National Bank 11 As of October Source: IMF, Croatian National Bank, and Lazard. 12 Monthly report on economic and financial state and the implementation of the measures of extraordinary administration of Agrokor D.D., Agrokor Izvanredna Uprava, 10 April to 10 May 2017, hr/file/749/agrokor+extraordinary+administration+report+april+-+public.pdf/. 189

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