Croatian Debt Misses EU-Entry Premium as Economy Stumbles

Croatia’s accession to the European Union on July 1 isn’t being celebrated on the debt market as the ex-Yugoslav republic’s borrowing costs rise relative to peers.

The extra yield on Croatia’s dollar bonds over those of other developing countries in JPMorgan Chase & Co.’s EMBI Global index increased to 86 basis points yesterday, the most since April 2, before falling to 50 today, according to data compiled by Bloomberg. The yield on Croatia’s 2023 dollar note fell 8 basis points to 5.985 percent, after jumping to 6.40 percent this week, 62 basis points more than similar securities from Romania, an EU member with the same BB+ junk-rating from Standard & Poor’s.

Unlike its former-communist peers that became EU members last decade, Croatia is entering a bloc in the midst of its longest recession. While nations from Estonia to Bulgaria benefited from joining the world’s biggest trading bloc, Croatia won’t get a similar boost as it depends on tourism for about one-fifth of gross domestic product and as rising labor costs make it harder to attract investment into export industries.

“Although EU entry represents a very important development for the country in the long run, it should not bring in any very relevant short-term advantages,” Emanuele Del Monte, who helps manage $2.3 billion of bonds at Fideuram Asset Management in Dublin, said in an e-mail on June 24. “For yields to converge with eastern European peers, Croatia must deliver structural reforms and a serious attempt to tackle the fiscal deficit.”

‘Bitter Pill’

The Adriatic nation’s $63 billion economy hasn’t grown since 2008 as the crisis in Europe caused foreign direct investment to plummet to almost one fifth of the $4.2 billion in the last pre-crisis year. GDP fell 1.5 percent from a year earlier between January and March, government data show.

Croatian unit labor costs rose 7.5 percent over the past four years even as the economy shrank by a combined 10.9 percent, according to Eurostat data compiled by Bloomberg. This compares with a 6.1 percent increase for the 27-member EU, where output dropped 1 percent in the period, the data show. By contrast, labor costs have declined since 2008 in EU members Latvia, Lithuania, Estonia, Ireland, Greece, Portugal and Spain.

“Unfortunately Croatia didn’t swallow the bitter pill of structural reform during the window of opportunity that it had pre-accession,” Abbas Ameli-Renani, an emerging-markets strategist at Royal Bank of Scotland Group Plc, said.

Prime Minister Zoran Milanovic’s government on Feb. 20 reduced its 2013 economic growth forecast to 0.7 percent from 1.8 percent, citing declining consumption and low investment.

Kia Exports

Croatia’s economy will contract 1 percent this year and grow 0.2 percent in 2014, with net exports providing “limited support,” the European Commission said in a May 3 report.

Growth in Slovakia, which joined the EU in 2004 with seven other former communist countries, doubled to a record 10.4 percent in 2007, fueled by exports from newly built assembly plants such as the one by South Korea’s carmaker Kia Motors Corp. Romania’s economy advanced 6.3 percent when it became a member in 2007, double the EU’s pace in the period, and accelerated to 7.3 percent the following year.

Croatia’s lingering recession combined with a lack of budget discipline and vulnerability to external shocks prompted Moody’s Investors Service to cut the country’s credit rating to junk in February, following a similar move by Standard & Poor’s in December. Fitch Ratings has the nation at BBB-, its lowest investment grade, data compiled by Bloomberg show.

Market ‘Hostage’

“The downgrade, as well as the continuing growth of public debt make Croatia a hostage to sentiment on international markets,” Nikolay Gueorguiev, the former head of the International Monetary Fund’s mission to Zagreb, said in an interview in Dubrovnik, Croatia, on June 17. “The key is to find a balance between continuing with the fiscal adjustment and not hurting the growth at the same time.”

Croatia, a nation of 4.2 million which emerged as an independent country from a violent break-up of Yugoslavia in 1991, has the equivalent of 25 billion euros ($32.5 billion) of outstanding debt, including 6.1 billion euros in loans, according to data compiled by Bloomberg. As much as 7.6 billion euros is due by next year, the data show.

The country’s budget deficit is set to widen to 5.6 percent of GDP in 2014 from 3.8 percent last year and this year’s 4.7 forecast, according to the European Commission. Public debt will swell to 62.5 percent of GDP next year from 53.7 percent in 2012, the EU’s executive said on May 3.

‘Rational’ Policy

EU membership will help encourage foreign investment, which will get a further boost from a draft bill that streamlines Croatia’s administration, Premier Milanovic said in an interview yesterday. The country needs a “rational approach” to budget policy to avoid choking growth while maintaining control over spending, he said from his office in central Zagreb.

“The economic prospects for Croatia are certainly not rosy, but the government is well aware that it needs to deliver,” Stanislav Petrov, a London-based fixed-income strategist at BNP Paribas SA, said in an e-mailed comment on June 18. BNP Paribas has a buy recommendation for Croatia’s 2023 dollar bonds, which “offer value,” especially when compared with Romania, he said.

The costs of insuring Croatia’s debt against non-payment for five-years with credit default swaps fell 11 basis points to 334 basis, still a 52 basis-point increase from May 6. This compares with 211 for Romania, 336 for Slovenia and 324 for Hungary, data compiled by Bloomberg show.

Fed Effect

Croat bond yields surged along with the country’s debt-insurance costs in past weeks because of speculation the U.S. Federal Reserve will trim its unprecedented asset-purchase program. The stimulus has kept Treasury yields near record lows and fed a global hunt for higher-yielding assets, cutting the borrowing costs of riskier sovereigns including Croatia.

“Croatia is entering at a demanding time for both the EU and itself,” said Brigit Niesser, an economist at Erste Group Bank AG in Vienna. “We are facing optimistic expectations when it comes to EU membership, even though the success of previous enlargement rounds seems to be a demanding target to match.”

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