Moody's Investors Service said it has placed the government of Croatia's Ba1 foreign- and domestic-currency long-term issuer ratings and foreign-currency senior unsecured ratings on review for upgrade by two notches, to Baa2, due to the country's prospects to adopt euro as of the beginning of the next year.
“The decision to place the ratings on review for upgrade was caused by the recommendation of the EU Economic and Financial Affairs Council on June 17 proposing that Croatia adopt the euro as its domestic currency as of January 1, 2023,” Moody's said in a statement late on Friday.
The review period which is expected to last until mid-July will allow Moody's to determine whether progress towards formalizing Croatia's membership of the euro area through the adoption of the relevant EU legal acts will take place as expected.
The long-term country ceilings of Croatia for local and foreign currency bonds remain unchanged at A2.
On June 1, the European Commission and the European Central Bank gave positive assessments of Croatia's progress towards euro adoption as of January next year as its 20th member.
The heads of state and government of the EU gave their assent to the recommendation made by ECOFIN at the European Council on June 23-24.
“In light of this, Moody's expects Croatia's membership of the euro area to be formalized with the adoption of the relevant legal acts at the ECOFIN meeting on July 11-12,” the statement said.
Croatia, together with Bulgaria, joined the exchange rate mechanism (ERM II), seen as the training grounds for the euro adoption, and the EU's banking union, on July 10, 2020. Moody's believes that the eventual adoption of the euro would have significant positive implications for Croatia's credit profile.
“It would reduce Croatia's share of government debt denominated in foreign currency from over 70% at present to close to zero, as this debt is almost wholly denominated in euro. This, in turn, would have a significant positive impact on its assessment of the government's fiscal strength as it eliminates the risk of a debt-to-GDP increase in case of a devaluation,” it said adding that it also significantly reduces government funding risks.
Croatia's economy is already highly integrated with that of the euro area and the country has maintained a managed float of its domestic currency against the euro for a number of years.
“Nevertheless, we expect that euro adoption will have positive effects on Croatia's economic strength over the medium to long term by reducing transaction costs and eliminating any remaining foreign currency risks for transactions between Croatia and the euro area, which already accounts for more than half of all of Croatia's imports and exports. This is likely to spur further economic integration and foreign direct investment into Croatia, supporting its longer term growth potential,” it added.
Euro adoption will also reduce foreign currency risks for the banking sector, and will also have a positive impact on the Moody's assessment of government liquidity and external vulnerability risks of the Adriatic country. As a euro area member, Croatia would in a future crisis stand to benefit from potential ECB support programmes, while eventual membership of the European Stability Mechanism would also support the government's ability to fund itself in a crisis situation.
The ability of the Croatian institutions to steer the country into the euro only two years after joining ERM II supports Moody's assessment of the effectiveness and strength of the country's institutions and governance, the credit rating.