bne -

Moody's Investors Service cut Croatia's sovereign rating to a junk on January 31, downgrading to "Ba1' from 'Baa3' due to a stalled recovery, lack of budget discipline and the economy's vulnerability to external shocks.

The only solace offered was that the rating agency changed its outlook to stable from negative, saying that the risk that the government's fiscal position and debt will "materially deteriorate any further" is limited.

Croatia, due to join the EU on July 1, joins two of the bloc's fellow strugglers, Hungary and Ireland, at junk level. Normally EU accession is a boost for the economy, but Moody's said "the European environment and the government's reform inertia are likely to limit the benefits normally expected to arise."

In fact, with its finances so stretched, joining could make things worse for Croatia. The government said on December 19 that the budget deficit will widen this year to 3.1% of GDP as the country repays debt and begins contributing to EU's coffers.

Moody's, which joins Standard & Poor's in removing Croatia's investment grade, noted the country is in its second recession in two years amid austerity measures and an investment drought sparked by Europe's debt crisis. "The second driver underpinning the downgrade are the headwinds to fiscal consolidation, namely the unfavourable economic environment and the government's lack of fiscal flexibility alongside a relatively high debt level," Moody's said.

Prime Minister Zoran Milanovic's cabinet, which has vowed to reduce public spending and remove obstacles to investment, forecasts the economy will grow 1.8% this year as it hopes to see an expected €10bn in EU grants through 2020 boost investment. The International Monetary Fund forecast in November that the economy will grow 0.75% this year, after shrinking 1.5% in 2012.

"The third driver informing Moody's decision to downgrade the rating is the weakness of its credit metrics relative to those of its peers, particularly its external vulnerability and fiscal position," Moody's added. "The government's fiscal metrics are also weaker, with general government debt exceeding those of Baa3-rated countries."