Croatia Battles EU ‘Basket Case’ Label After Downgrade

Croatia Battles to Avoid EU ‘Basket Case’ Label on Downgrade
The economy of Croatia, set to join the EU in July, is in its second recession in two years after contracting for four quarters. Photographer: Oliver Bunic/Bloomberg

A year after winning office vowing to boost Croatia’s economy as it enters the European Union, Premier Zoran Milanovic is struggling to overcome a recession and opposition to austerity after a credit-rating downgrade.

The prime minister and senior officials publicly disagreed over how to respond after Standard & Poor’s cut Croatia’s sovereign debt rating to junk Dec. 14. The government’s structural and fiscal overhaul isn’t enough to spur growth and render public finances sustainable, S&P said.

“Croatia can still manage in the short-term, but it needs someone with a vision and a long-term plan to solve its deeply rooted structural problems,” Timothy Ash, head of emerging-market research at Standard Bank Group Ltd, said in an interview in Zagreb. “Otherwise, it will be facing a slow death.”

The economy of Croatia, set to join the EU in July, is in its second recession in two years after contracting for four quarters. Next year’s budget deficit will widen more than first estimated as the government, which forecasts a 1.1 percent economic contraction in 2012, pays debts and begins contributing to the bloc’s coffers.

The yield on dollar-denominated notes due in March 2021 rose after the downgrade before easing today to 4.403 percent. The kuna has declined 0.3 percent against the euro since the rating announcement, trading at 7.535 at 1:20 p.m. in Zagreb, according to data compiled by Bloomberg.

Different Responses

S&P’s move prompted a range of responses from officials. Milanovic said Croatia won’t cut public wages and pensions or seek aid from the International Monetary Fund as the country “can do it alone.” Finance Minister Slavko Linic said the nation may abandon debt sales abroad and cooperate with the IMF.

Central bank Governor Boris Vujcic on Dec. 16 said Croatia should continue to borrow both abroad and domestically and find the “strength” to carry out reforms. Vujcic also declined to release foreign-currency reserves to aid government borrowing.

Milanovic’s Social Democrats led a four-party coalition to victory in December 2011, dethroning the Croatian Democratic Union that was tainted by graft scandals after governing for eight years. With investment drying up and unemployment rising, Fitch Ratings advised the government as it was coming to power to make “unpopular” spending cuts to revive growth and boost fiscal credibility.

The 2012 budget included 4 billion kuna ($700 million) in proposed cuts to narrow the deficit to 3 percent of gross domestic product this year from 4.2 percent in 2011, prompting Fitch in September to lift its outlook to stable from negative.

Outlook Switch

While Linic has boosted revenue through improved tax collection, the 2013 budget submitted in November sees the fiscal deficit widening to 3.5 percent of GDP as expenditures rose. In response, Fitch changed its outlook back to negative.

“Croatia was the recipient of plentiful goodwill, with the new coalition government being widely praised,” said Abbas Ameli-Renani, an emerging-markets strategist in London at Royal Bank of Scotland Group Plc. “The nail in the coffin was the 2013 budget, which abandoned the government’s commitment to the fiscal responsibility law.”

S&P’s downgrade to BB+, the first time Croatia lost its investment grade by any of the three major rating companies since 1999, put its creditworthiness on par with Romania and Indonesia.

“Policy inertia and opposition from vested interests that benefit from long-entrenched entitlements have contributed to wage and price rigidities, the low participation rate, and loss of economic competitiveness,” S&P said in the statement.

Bond Markets

The global bond market disagreed with S&P and Moody’s Investors Service more often than not this year when the companies told investors that governments were becoming safer or more risky. Yields on sovereign debt moved in the opposite direction from what ratings suggested in 53 percent of the 32 upgrades, downgrades and changes in credit outlook, according to data compiled by Bloomberg.

That’s worse than the longer-term average of 47 percent, based on more than 300 changes since 1974. This year, investors ignored 56 percent of Moody’s rating and outlook changes and 50 percent of those by S&P.

Public Debt

Croatian public debt, estimated at 172 billion kuna at the end of June, will rise to 55 percent of GDP next year, when state borrowing will total 27 billion kuna, according to government data. The government expected to sell about $2.5 billion of debt in January on the U.S. and European markets, with a second round later in 2013 on Asian markets.

Croatia can probably finance itself next year without a foreign-currency debt sale even without IMF aid as there are no external bonds maturing, analysts from London to Moscow said.

“A country with a liquid banking system and neutral current account with limited repayments in 2013 can perfectly cope on its own even after the downgrade,” Petr Grishin, a chief economic analyst at VTB Capital in Moscow, said by e-mail.

The economy will contract 2 percent this year and stagnate in 2013, according to S&P. Unemployment in the nation of 4.2 million reached 19.6 percent in October, while the public sector, which employs 17 percent of workers, has seen no reductions amid opposition from powerful labor unions.

Without a change in direction, Croatia “will enter the EU not as a serious country capable of managing its own economy and finances, but as a typical southern European basket case,” Velimir Sonje, an economist at Zagreb School of Economics and Management, said by phone.

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