OUTLOOK 2020 Croatia

OUTLOOK 2020 Croatia
By bne IntelliNews January 9, 2020

Croatia had an eventful start to 2020, with the second round of the presidential election on January 5, that saw the country’s first female President Kolinda Grabar-Kitarovic ousted by Zoran Milanovic, the candidate of the opposition Social Democratic Party. 

Given the presidency is a largely ceremonial role, some of its main significance will be as a precursor to the next parliamentary elections, which must be held by December 23, 2020. 

Grabar-Kitarovic’s failure to secure reelection was a blow to the ruling Croatian Democratic Union (HDZ) that is backing her candidacy, and a boost for the SDP that hopes to regain power. 

Recent opinion polls show the HDZ and SDP are relatively close, with most giving an edge of a few percentage points to the HDZ. A hung parliament following the vote can’t be ruled out. 

The first half of 2020 saw Croatia, the EU’s newest member state, take over the rotating presidency of the European Council. 

Zagreb sees this as a chance to further its ambitions of deeper integration into the European Union. The country is also pursuing entry to the Eurozone. 

The government, under Prime Minister Andrej Plenkovic, has drawn up a detailed programme for its presidency, that has been aligned with the EU's new strategic programme for the period 2019-2024, as reported by state news agency Hina.

Three major upcoming events during the Croatian presidency are the EU-Western Balkan informal summit in Zagreb in May, agreement on the next seven-year EU budget, and a conference on the future of Europe.

Croatia’s slogan for its presidency is "A strong Europe in a world of challenges”, and its programme is based on four themes: “A Europe that develops; A Europe that connects; A Europe that protects; and an influential Europe.”

Concerning EU enlargement to the Western Balkans, the Croatia document points out that the upcoming summit will be held 20 years after the first EU Zagreb summit when dialogue was launched with Southeast European countries. (Croatia at the time was an aspiring member as several of its neighbours are today.)

“The presidency will focus on achieving progress in accession processes and in the implementation of stabilisation and association agreements. Albania and North Macedonia are candidates and the presidency will advocate launching talks with those two countries as well as Bosnia and Herzegovina's possible advancing to the status of candidate country,” says the programme as quoted by Hina.

It will also “encourage the fulfilment of the necessary criteria for the further progress of Montenegro and Serbia in their accession talks.” “Kosovo is a potential candidate and the presidency will see to it that relations with Kosovo are further developed,” it adds.

Another issue still to be finalised is Brexit, and the Croatian presidency will aim to ensure “an orderly exit of Great Britain from the EU and the opening of talks on future relations.” Among the other areas of interest for Zagreb are further deepening the European banking union, increasing the resilience and stability of the EU's banking system, and strengthening and integrating EU member states' capital markets.

With its declining population, demography is of concern in Croatia, along with other Central and Southeast European EU members, and the country will work on promoting activities and measures to alleviate the negative fiscal effects of demographic trends during its presidency.

Emphasis is placed on further deepening the single market and developing a long-term sustainable industrial policy strategy in line with the demands of the digital era, according to Hina.

Economic slowdown expected

Croatia’s economy expanded by 2.9% y/y in the third quarter of 2019, accelerating from 2.4% y/y recorded in the previous quarter. But this is seen as something of a last gasp before a slowing of growth anticipated international financial institutions (IFIs). 

The largest contributions to the GDP growth in 2019 came from increases in exports of goods and services, which were up by 4.7% y/y in 3Q19, and from household consumption spending, which increased by 3.3% y/y.

“The continuously high level of consumer optimism reflects the steady and continuous increase of households’ consumption which finds support in the good tourist season, further improvement on the labour market (including rising wages in public and private sector), low financing costs and subdued inflation,” Raiffeisen analysts said. 

The International Monetary Fund (IMF) and European Bank for Reconstruction and Development (EBRD) both anticipate 3% growth in 2019, and the European Commission 2.9%; all three IFIs expect growth to slow in 2020. 

The European Commission projects a growth slowdown to 2.6% and 2.4% respectively in 2020 and 2021. 

According to the EC, “uncertainties surrounding global trade and the weakening economic performance expected in some of Croatia’s main trading partners are expected to slow down growth in goods exports throughout the 2019-2021 period”. Exports of services, dominated by the tourism sector, are also expected to grow more moderately, according to the EC.

“As growth in Croatia’s main trading partners moderates, domestic demand will remain the main driver of economic activity. Household consumption remains strong, driven by growing employment and wages as well as low inflation,” the European Commission said.

The EBRD is somewhat more optimistic, having lifted its forecast for 2019 GDP growth by 0.5pp to 3% in November, while maintaining its forecast for 2020 at 2.5%.

It noted the broad-based domestic demand supported by both private consumption and investments, the latter supported by growing disbursements of EU funds.

Looking ahead to 2020, “Growth is likely to be mainly driven by private consumption, which is supported by positive labour market developments and low inflation. Risks to the projection come from possibly weaker demand from Croatia’s main economic partners, such as the eurozone,” the EBRD said. 

The development bank also notes that “supply-side constraints for the tourism sector [have] become more apparent. Discussions have been ongoing in Zagreb over how to ensure the tourism sector, which makes up a large part of Croatia’s economy, can continue to expand in the face of strong competition from rival Eastern Mediterranean destinations and growing labour shortages. 

Raiffeisen analysts describe a “seemingly very favourable macroeconomic picture and good prospects in the short term”, but like the EBRD warn of longer-term constraints. The positive short-term picture does “not mean that fundamentals for a stronger and more resilient growth and development have changed”. 

“The labour market remains characterised by low employment and activity rates and there is a relatively high household indebtedness and poor business environment burdened with numerous barriers stuck in the highly bureaucratized system. Therefore, competitiveness has remained stagnant over the years and exports are based on tourism as well as labour and resource intensive production,” warn Raiffisen analysts. 

Meanwhile, analysts note the low inflation in Croatia that is also helping to support private consumption; headline inflation declined compared to 2018 in the first half of 2019, which was mainly due to the reduction in the VAT rate on certain unprocessed foods. According to the IMF, consumer prices are expected to rise 1.2% in 2019, after moving up 0.9% in 2018. They will rise by 1.3% in 2020. The European Commission’s forecast is for inflation to pick up in 2020 to 1.3% and rise further to 1.5% in 2021. 

Domestically, one of the biggest issues that needs to be tackled is worker shortages, especially in the seasonal tourism and construction sectors. Zagreb had to raise quotas for this year following pressure from employers associations as employers in the tourism and construction sector in particular were unable to recruit enough staff to fill vacant positions. 

Croatia faces acute shortages of skilled labour that need to be addressed sustainably, the EBRD told Croatia in its latest Transition Report. The development bank warns that tightening of labour market conditions and an “increasingly difficult” demographic profile are making it steadily harder for employers to fill highly qualified positions in particular. 

Small budget surplus targeted for 2020

The Croatian parliament approved the 2020 budget in mid-November, targeting a 0.2% of GDP surplus, broadly in line with the budgets of 2017, 2018 and 2019, which have also been close to balanced. 

The 2020 budget is based on a forecast of 2.5% economic growth in 2020, down slightly from the 2.9% projected for this year. 

The European Commission forecasts the budget will remain balance in 2020-2021. It notes that while  tax revenue is expected to grow at a slower pace than nominal GDP, due to further tax cuts, EU funds will continue supporting revenues. “Expenditure growth should continue in 2020 and moderate somewhat in 2021, largely due to the strong base effect of the rising wage bill, investment and capital transfers in 2018-2019. Additional savings are expected in interest payments, most notably in 2020, as a sizable portion of maturing debt is refinanced at lower rates,” said the European Commission in its Autumn Forecast. 

Fitch also forecasts the general government budget will remain broadly balanced in 2019-2021. “Fiscal dynamics are underpinned by the authorities' track record and commitment to fiscal prudence as well as favourable macroeconomic and financial conditions,” the rating agency said in December. 

Compared to 2019, spending will increase by 6% to HRK147.3bn, while revenues will rise by 5.4% to HRK145.1bn. 

With elections in both December 2019/January 2020 and again towards the end of 2020, there has been strong pressure on the government to raise the salaries of public sector workers. 

At the beginning of December, the government reached a deal with teachers that enabled children to return to school after weeks of strike action. Pressure from other categories of public sector workers will most likely continue despite the government’s efforts to resist any increases that could jeopardise the budget. 

“Growing social pressure to increase expenditure or delay key reforms, as was the case with the plan to increase the retirement age to 67 years, represent a modest risk, particularly ahead of a busy electoral calendar. However, the risk of abrupt fiscal policy changes is mitigated by an improving policy framework and the commitment to join the ERM II,” commented Fitch. 

Finance ministry aims to cut public debt 

The finance ministry has said Croatia plans to cut public debt to below 70% of GDP in 2020. 

Croatia’s general government debt to GDP ratio is relatively high compared to its BBB peers, rating agency Fitch said in December.  The rating agency forecasts Croatia’s general government debt/GDP to fall to 71.3% of GDP at end-2019, down from a high of 84.7% at end-2014, and to 65.2% by 2021 on the back of strong primary surpluses. While this level would still be well above the current BBB median of 40.1% of GDP, low interest costs and longer maturities mean debt servicing should be less difficult for Croatia than for its peers. 

The World Bank forecast Croatia's public debt could continue its decline from 70.4% of GDP at the end of 2019 to an anticipated 67.5% at end-2020, and 64.6% of GDP by end-2021. 

In 2018 Croatia issued its latest Eurobond on the most favourable terms to date. Croatia successfully issued the 10-year Eurobond, raising €1.5bn. The bond, maturing in 2029, had an annual coupon interest rate of 1.125% and final yield of 1.324%. 

The bond was issued a week after Fitch raised the Croatian credit rating from BB + to BBB, following S&P which also raised Croatia to investment grade earlier in the year. “The record low interest rate reflects to a large extent the improvement of the macroeconomic picture and the reduction of macroeconomic imbalances in the Republic of Croatia, which has contributed to raising the country’s credit rating to investment grade,” the finance ministry commented at the time. 

For the remainder of the year, Croatia only tapped the local market. 

Banks healthy — but warnings over rise in consumer lending 

The latest data from the central bank shows that Croatian commercial banks (not including savings banks) posted total pre-tax profit of HRK5.31bn in January-September 2019, slightly up compared to the same period of 2018. This continues the increasingly healthy results achieved by the sector since the resolution of the debt crisis at conglomerate Agrokor that hit the economy as a whole in 2017, and dented demand for corporate lending. 

The highest pre-tax profits were reported by UniCredit’s Zagrebacka Banka and Intesa Sanpaolo’s Privredna Banka Zagreb, while only Croatia Banka reported a pre-tax loss for the period. 

“The banking sector remains profitable, highly capitalised (the capital adequacy ratio stood at close to 23% in June), very liquid and with diminishing reliance on cross-border lending. The ratio of non-performing loans (NPLs) continues to trend downwards (it stood at a revised 7.3% in June) in part due to ongoing sales of NPL portfolios,” rating agency Fitch said in December. 

Croatian banks are coming under scrutiny from the European Central Bank (EBC) which will carry out comprehensive asset quality reviews of the country’s major banks as Zagreb aims to join the Exchange Rate Mechanism (ERM2) and the European Banking Union by mid-2020, critical steps on its path towards euro adoption. The Croatian government says it will carry out reforms within the banking sector as part of the preparations to join ERM2. 

Commenting on the health of the banking sector, Raiffeisen analysts said in September: “From a risk perspective, monetary easing is allowed by banks’ strong external positions, steady FX outlook and reduced fiscal risk.”

Raiffeisen also pointed to competition between banks on lending, a result of the rising surplus of liquidity in the financial system. 

After new restrictions on mortgage loans, unsecured cash loans have accelerated by 12.5% on an annual basis, Raiffeisen said. Fitch also noted that household credit growth (up 6% in 3Q19) has been offsetting ongoing deleveraging in the corporate sector.

“Interest rates offered by banks on time deposits are close to zero … Consequently, the share of time deposits has fallen under half of total customer deposits. As interest rates offered on time deposits are not forecasted to change in 2019, the maturity gap in banking assets and liabilities will deepen further,” says Raiffeisen. 

“Portfolio quality is expected to make a positive contribution to the banking sector profitability in the coming period, but the base is shrinking. On the negative side, the credit registry has suspended consumer debt reports since May 2018 due to incompatibility with the GDPR. Rising consumer loans, disbursed without information of total client indebtedness could lead to higher NPL ratios and risk costs in the future. It is still unclear when the credit registry will be able to renew the full service.”

In common with the rest of Southeast Europe, Croatia has seen some consolidation in the banking sector, notably the merger of the Croatian branch of SocGen with OTP. Further consolidation among the smaller banks is likely.