Guy Norton in Zagreb -

The Croatian government won the first round in the battle to retain the country's investment grade rating when Fitch Ratings, the first of the big three rating agencies to visit this year, said March 5 it has kept Croatia at 'BBB-', one notch above so-called junk status. The decision was welcomed with relief in Croatia, especially given Zagreb is set to kick off a new round of international borrowing in April with plans for a US dollar-denominated Eurobond worth at least $1.5bn.

Fitch, however, has retained the negative outlook on the rating, commenting that Croatia needs to continue with fiscal consolidation if it is to retain its prized investment grade rating. "Despite some positive initial policy steps by the new government, further fiscal consolidation measures and structural reforms will be required to boost economic growth and stabilise the public finances," said Michele Napolitano, associate director in Fitch's Emerging Europe Sovereigns team. "Meanwhile, Croatia's sizeable budget deficit, relatively high public and external debt ratios, and the difficult external financing environment mean that risks to creditworthiness remain on the downside."

Having announced spending cuts of HRK3.4 bn (€453m) in February, the Croatian government is looking to shave its budget deficit from 5.5% of GDP in 2011 to 3.8% at the end of this year. However, Fitch claimed that the revenue projections included in this year's budget are too optimistic and the government will have to identify additional expenditure cuts to meet the deficit target. "Failure to act and significant slippage against fiscal targets would be likely to lead to a downgrade," warned Fitch.

Tim Ash of Royal Bank of Scotland notes that the new government has not come up with much aside from a fiscal consolidation programme. "I guess Fitch are giving them the benefit of the doubt because of the fiscal plans, but the fact that the negative outlook has been retained suggests that Croatia is not out of the woods, and unless the govt can come up with growth enhancing reforms, they will end up with junk bond status."

Labour reforms

On a more positive note, the agency said that the substantive labour market reforms that the government has said it will introduce by the middle of this year will be important to preserving Croatia's investment grade rating.

Commenting on Fitch's decision, Croatia's finance minister, Slavko Linic, told state news agency Hina that the affirmation of the rating was an important step forward in the fight to retain investor confidence and was "supportive of the economic measures the government has taken and intends to take."

With regard to the reforms that the government intends to implement, Linic said that the labour and pensions minister, Mirando Mrsic, had already begun discussions with trade unionists and other social partners about the preparation of new legislation that should ensure greater flexibility in the country's labour market.

Even so, there's considerable doubt about whether the growth predictions on which the current budget is based will be achievable. According to the government's own forecast, GDP will grow by just 0.8% this year, after it crept up by an estimated 0.2% in 2011. Its forecast is much more optimistic than those from the World Bank and the International Monetary Fund, which predict that GDP will shrink by up to 1%, while Hypo-Alpe-Adria Bank analyst Hrvoje Stojic in a recent report warned that economic growth could decline by as much as 2% this year, before expanding by 1% in 2013.