Croatia's conundrum - spending cuts or rating cuts?

By bne IntelliNews June 18, 2012

Guy Norton in Zagreb -

In recent times, the economic news out of Croatia has been as changeable as the country's weather, with bright blue skies and scorching sunshine one minute, only to be followed by coal black clouds and torrential downpours the next.

Looking on the bright side, Moody's Investors Service at the end of May became the last of the three major global rating agencies to confirm that Croatia had maintained its investment grade position. Given that more than a few observers had seen Croatia as a shoo-in for a downgrade to junk status this year, the centre-left coalition that came to power just before Christmas has notched up a noteworthy hat-trick in retaining the country's prized investment grade status. For the moment at least. For while Moody's kept Croatia's rating at 'Baa3', it did revise the outlook on it from stable to negative, citing concerns about the sustainability of the country's current economic model and doubts over whether the government can push through fiscal reforms.

With the Croatian economy more or less continually mired in recession since 2008, Moody's is skeptical about whether the country's leaders can implement the structural reforms that will be necessary to return Croatia to a sustainable growth path. "Croatia's future growth prospects face significant risks, in part because of uncertainties regarding the pace and scope of the structural reforms being undertaken by the authorities to re-orient the economic model towards exports and foreign direct investment-financed investments," notes Moody's sovereign risk analyst Lucie Villa. "The unfavourable external environment will also present significant challenges to these efforts. As a small and open economy, Croatia is being negatively affected by the weak economic conditions in the euro area and other EU countries, which are its main trading partners and sources of foreign credit and investment."

Lack of industry

Recent data also have given rise to concerns over Croatia's economic outlook. Although the government is sticking to its forecast that the economy will emerge from recession this year - it is looking for GDP to expand by 0.8% - that looks an increasingly tall order after the Central Bureau of Statistics announced that GDP in the first quarter had in fact fallen by 1.3%, which was better than the consensus estimate of a 2% decline by local analysts, but confirming the fact that after two quarters of mildly positive growth in the third and fourth quarters of 2011, Croatia is once again on the brink of recession.

Another troubling statistic concerns the fall in industrial production, which fell by 9.4% on year in April. That is the biggest drop since November 2009 when industrial production sank by 9.9% and was almost twice the 5% consensus forecast expected by local analysts. With industrial production having fallen a total of 7.1% in the first four months of this year, hopes of an industry-led economic recovery this year are looking increasingly forlorn given the toxic combination of both weak domestic and foreign demand.

Zrinka Zivkovic Matijevic, head of research at Raiffeisen Bank in Zagreb, says the recent poor industrial production numbers reflect the extremely low competitiveness of Croatian industry. "For this year as a whole, we expect industrial production to fall around 5% year on year."

Similarly, Croatian consumers seem an equally unlikely source of help for the country's financial fortunes, with retail sales in April slumping by 7.3% on an annual basis. That figure was also much weaker than expected, with local analysts having forecast a drop of just 1.9%. The last time retail sales recorded such a large drop was in April 2010 when they fell by 8% on an annualized basis. "This was really a negative surprise," says Alen Kovac, chief economist at Erste Bank in Zagreb, adding that while he expects some rebound in spending in the summer holiday season, for the year as a whole he expects consumption to shrink compared to 2011 as a result of falling disposable income levels attributable to increases in VAT and utility prices.

The recent set of downbeat data mean the consensus estimate among economists in Zagreb is that GDP could decline by as much as 2% this year. Commenting on the economic prospects for the rest of the year, Ljubo Jurcic, a professor at the economics faculty of Zagreb University, told state broadcaster HRT: "We need to pray to god for warm weather so that the agriculture and tourism sectors grow by 10% so that the drop in GDP would be just 1%, which would be a good result for 2012."

Cutting the fat

Given the weakness of the real economy in Croatia, the onus is now firmly on the government to act quickly and decisively to shore up the public sector's finances to ensure that the country retains its investment grade ratings and attracts much-needed foreign direct investment to kickstart the economy.

One of the thorniest issues that the government is looking to address is the level of staffing at a number of leading state-owned enterprises such as power company HEP, rail firm HZ and motorways operator HAC. Finance minister Slavko Linic has announced that at least 15,000 employees will be laid off from these and other firms by 2015. While the private sector has shed over 150,000 since 2008 and many employees have had to accept pay cuts, the public sector has so far been spared any redundancies and workers in state companies have actually seen their salaries rise by an average of HRK350 (€46.60).

Unsurprisingly, public sector union leaders firmly oppose the idea that their members should pay the price for past governments' economic failures and have already threatened to stage a series of nationwide strikes if the government seeks to push through radical changes to existing collective bargaining agreements which expire at the end of July.

Whether the government displays the required mettle to face down any labour unrest will be a key test of its economic credibility. According to Raiffeisen, "the government has no alternative but to continue down the road of cutting expenditures."

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