Croatia: Risk Assessment

Country Rating¹

Rating: A4

Business Climate Rating¹

Rating: A3

Risk Assessment²

A lagging and moderate recovery
The slight recovery that emerged late in 2010 is expected to continue in 2011, albeit at a low level. After a near 7% overall contraction of GDP in 2009-2010 that sanctioned the bursting of the housing bubble, the recovery of domestic demand has been very weak. With households indebted in foreign currency, their consumption will be constrained by the increase in debt service (associated with the weakness of the kuna) and then by the high-level of unemployment: 12% compared to 9% before the crisis. Corporate investment will be limited by a weak expansion of credit in the context of bank assets deterioration in the wake of the downturn in the housing market. And Croatian banks will be all the more prudent in 2011 with their Greek parent companies directly exposed to the sovereign risk crisis. Despite privatization projects, foreign direct investment will furthermore be unlikely to recover to pre-crisis levels due to the very high level of corruption. . The recovery of foreign demand is also expected to be limited due to the sluggishness of demand from Italy (17% of exports) and the Balkans. A range of sectors including chemicals/agrochemicals, automotives, electrical equipment, capital goods and naval shipyards will suffer from the weak return of foreign demand. However, tourism (10% of GDP) will be likely to post its strong performance.

Substantial deterioration in public finances and persistent liquidity crisis risk
The public debt will remain relatively moderate at 40% of GDP (or 55% if all public guarantees are included). But its medium-term solvability will only be secure if the government undertakes structural reforms (privatizations, health and pension sectors reforms, contraction of the public sector). Although the current account deficit narrowed during the crisis with the decline in household demand, external financing needs will remain substantial in 2011 due to the scale of the debt service. Refinancing the foreign debt could thus run into some turbulence in case of sudden crisis of investor confidence.  And foreign exchange reserves remain inadequate.

On track for European Union membership but major challenges to be taken up by the ruling party
Under the leadership of the conservative HDZ party, the government has major challenges to take up. In October 2009, Croatia resumed negotiations with the European Union on membership after Slovenia withdrew its veto: the two governments agreed to submit their dispute to international arbitration for resolution of the differences over demarcation of the maritime and land border in the Gulf of Piran. European Union accession nonetheless continues to depend on implementation of several measures intended to strengthen law enforcement and anti-corruption strategy. The ruling party, fully committed to joining the Union, must take pains to preserve the cohesiveness of the government coalition while some of its members, like former Prime Minister Ivo Sanader, are the object of an international arrest warrant for abuse of power.

Strengths

• Growth prospects enhanced by the European Union integration process
• Substantial economic convergence with the EU already achieved
• High standard of living; improved infrastructure
• Tourist potential

Weaknesses

• Large current account deficits and dependence on foreign capital
• High corporate and household debt with borrowers highly exposed to exchange rate risk
• Lack of progress in combating corruption and modernizing the civil service and the judiciary