Why Moody’s should have made Croatia investment grade a long time ago

It finally happened. On July 15, Moody’s awarded Croatia a sovereign borrower investment-grade rating.

The move came two days after Fitch raised its BBB rating to BBB+, which in turn was influenced by the EU green-lighting the country’s bid to become a euro member state with effect from January 1, 2023.

Croatia will become the 20th member of the eurozone and the first since Lithuania joined in 2015.

The announcement is notable, not only for Croatia but also for the region. Yet the question is whether it needed this official endorsement to become the catalyst for an investment grade from Moody’s or for Fitch to bugle-call its higher rating.

Euromoney’s country risk survey suggests otherwise.

Croatia has been moving up Euromoney’s global risk rankings for years on the back of reforms that have strengthened the economy.

Climbing 10 places since 2017 to 55th out of 174 countries, the country is firmly within tier three, the middle of five tiers according to the survey metrics, making it a moderate risk.

Lower currency risk will contribute to the reduction of the exchange-rate risk premium and generally will contribute to reducing the external cost of borrowing 

 - Aljosa Sestanovic

That means Croatia is less risky than several other investment grades in Europe, and elsewhere, that are lower down the scale. They include Bulgaria (67th), Italy (69th) and Hungary (73rd), and that has been the case for some time.

Consequently, analysts agree on the fact the credit-rating agencies have been slow to adjust Croatia’s rating, despite admitting it still faces many challenges.

They include the shipyards restructuring, relying less on tourism for economic growth, reforms to healthcare, pensions, and to make the judicial system more efficient. There is also the pressing issue of coping with high inflation and all the other effects of the war in Ukraine.

The introduction of the euro will reduce currency risk.

Most of the deposits in the banking sector are denominated in euros, says Aljosa Sestanovic, a professor at the University College for Law and Finance (Effectus), and a considerable number of tourists arrive from the eurozone.

“Lower currency risk will contribute to the reduction of the exchange-rate risk premium and generally will contribute to reducing the external cost of borrowing,” he says.

Yet Sestanovic agrees the credit-rating agencies have proved cautious in raising their ratings. Croatia has had strong growth in tourism and public debt is under control. These should have been the triggers, he says, not the expected formal approval into the eurozone.

[There is] no doubt that Croatia belonged to the investment category way earlier than it has been recognized 

 - Milos Vulanovic

Vanja Piljak, a lecturer in finance at the University of Vaasa, notes that Croatia has been developing its financial markets, banking sector, corporate governance and overall financial stability since joining the EU in 2013. In that respect, the upgraded ratings can be considered validatory.

“The news about joining the eurozone represents assurance for the credit-rating agencies that public finances, exchange-rate exposure and financial stability will be aligned with the eurozone criteria, enabling Croatia to improve its creditworthiness and reputation,” she says.

Milos Vulanovic, associate professor at the EDHEC Business School, notes that the rating agencies often “act with a lag when it comes to smaller countries in terms of bond investments”.

Bojan Ivanc, chief economist at the Chamber of Commerce & Industry in Slovenia, who has a keen eye on neighbouring Croatia, agrees. He says the rating agencies are usually a lagging indicator for economies that are smaller in size and have “some specifics which are not well understood by their credit team”.

With experts from the ECR panel continuously scoring the country better than the main rating agencies, Vulanovic says there is “no doubt that Croatia belonged to the investment category way earlier than it has been recognized”.

Endorsing this, he lists its favourable features as stable tourism revenue, an excellent infrastructure and well-educated labour force.

Piljak notes how fiscal consolidation has reduced government debt from 87% of GDP to 77% and the recovery of tourism – accounting for around a quarter of GDP – is propelling economic growth.

In that respect, as Ivanc goes on to say, it is interesting to note that while the European Commission recently downgraded its GDP forecasts for EU countries for 2023, it remained positive on Croatia, predicting 2.9% real-terms growth.