We expect the city of Zagreb will continue posting strong operating margins through 2019

  • We expect the city of Zagreb will continue posting strong operating margins through 2019, somewhat mitigating the pressure on capital account surpluses, since we expect investments will pick up in 2018-2019.
  • In our view, the institutional framework remains volatile, which, alongside relatively weak liquidity coverage, constrains Zagreb's creditworthiness in the medium term.
  • We are affirming our 'BB' long-term issuer credit rating on Zagreb.
  • The stable outlook reflects our expectation that the city will continue to perform in line with our base-case scenario over 2017-2019 and limit accumulation of debt, both directly and via municipal companies.

The stable outlook on Zagreb reflects our view that continued strong operating
balances will help counterbalance Zagreb's increased investment plans. Despite
our expectations of a slight rise in tax-supported debt in absolute terms, 
which includes the debt of municipal company Zagrebacki Holding, the city's 
debt burden will remain low over 2017-2019.

Downside Scenario 
We could downgrade Zagreb if we saw a significant worsening of financial 
performance and an increase in tax-supported debt to over 120% of consolidated
operating revenues. We would also consider revising our assessment of Zagreb's
creditworthiness downward if we saw continued pressure on its cash levels, 
resulting in further deterioration of its liquidity coverage ratio.

Upside Scenario 
Contingent on an upgrade of the sovereign, we could raise the rating if the 
city structurally improved its liquidity position, resulting in cash and funds
available under credit facilities covering yearly debt service sustainably by 
more than 80%. Additionally, stronger medium- and long-term planning, coupled 
with strict oversight of municipal companies, could enhance our view of the 
city's financial management and intrinsic creditworthiness.


The rating reflects our view that the city will continue its trend of high 
operating balances, exceeding 10% of operating revenues, allowing room for 
more rapid investments. This should enable the city to avoid excessive debt 
accumulation and retain its current liquidity position.

Nevertheless, these factors remain counterbalanced by an institutional 
framework that is subject to relatively frequent changes, revenue and 
expenditure mismatches, and financial management weaknesses. Zagreb's 
stand-alone credit profile (SACP) is at 'bb'.

The institutional framework and financial management limit Zagreb's creditworthiness 
In our view, Zagreb's creditworthiness remains constrained by the 
institutional setup under which Croatian municipalities operate. The framework
exhibits frequent changes and an unbalanced distribution of resources that are
not sufficiently aligned to tasks delegated to the municipal level. This is 
exemplified by the latest change to the tax system, which took effect at the 
beginning of 2017. The tax reform is aimed at easing the tax burden for 
individuals and companies by decreasing several tax rates and brackets (for 
example, the maximum rate for personal income tax to 36% from 40%). This 
effectively diminishes Zagreb's revenue-raising abilities. The reform 
stipulates that revenue shortfalls that result will be covered by the central 
government through transfers. However, these transfers have not yet been fully
codified by the government. Ultimately, the unpredictability of the central 
government's actions constrains policy effectiveness at the city, limiting 
Zagreb's ability to effectively plan for the long term.

Milan Bandic was re-elected to serve as the mayor of Zagreb for a sixth 
four-year term in June 2017, indicating some stability of the city's 
management. Nonetheless, we see management's effectiveness as constrained by 
unreliable long-term planning. The use of unconventional debt instruments such
as factoring deals, and a somewhat difficult relationship between the 
government and city assembly, as shown by the mayor almost being ousted in 
December 2016, further constrain our management assessment.

The city's management of municipal companies remains weak overall. The board 
of Zagrebacki Holding maintains very close ties with the city's management, 
although clear decision-making procedures appear to be lacking. The city 
provides subsidies to Zagrebacki Holding of about Croation kuna (HRK) 580 
million (about $90 million) annually. There have been ongoing discussions 
between both parties on removing the loss-making transportation company (ZET) 
from Zagrebacki Holding's portfolio, but a decision has not been taken yet. 
This is an important decision since it would substantially alter Zagrebacki 
Holding's financial performance.

Zagreb's economy is diversified. Companies in the city contribute roughly 50% 
of all corporate profits in the country, and unemployment has been steadily 
decreasing (7.6% in 2016). The pull the city exerts has resulted in a growing 
population, which in turn supports the city's economic and tax base. We 
estimate that the city housed around 798,500 inhabitants, or 19% of Croatia's 
total population in 2016. Furthermore, the city's management continues to 
focus on projects intended to promote Zagreb as a tourist and international 
conference destination. For example, it is building a new center for corporate
conferences and a network of cycling paths, among various other projects. In 
our view, however, these strengths are muted by the country's national GDP per
capita, which is the basis for our assessment of Zagreb's economic profile. We
forecast GDP per capita at around $15,000 in 2019, increasing broadly in line 
with sovereign growth trends, but this remains average compared with 
international peers'.

Operating surpluses will remain strong, helping keep debt low and limiting the risks from weak liquidity 
Looking ahead, we expect that Zagreb will exhibit operating balances averaging
11% of operating revenues between 2017 and 2019, broadly unchanged from our 
previous review. This is mainly owing to solid economic growth averaging 3%.

In our view, Zagreb's budgetary flexibility is weak. Personal income tax, 
which the city cannot modify, accounted for roughly 70% of operating revenues 
in 2016. However, the new 2017 tax reforms are effectively decreasing tax 
brackets, and personal income surtax is limited at 18%, implying the city's 
dependence on the central government regarding taxation matters.

Difficult-to-cut personnel and goods and services expenses represented 37% of 
Zagreb's operating expenditure in 2016, limiting its expenditure flexibility. 
Furthermore, Zagreb regularly reports payments of subsidies totaling about 
HRK700 million annually. Although, theoretically, the city has some discretion
to reduce subsidies, these costs are relatively inflexible, particularly given
the importance they hold for Zagrebacki Holding.

Zagreb's capital program targets transportation infrastructure, street 
renovations, and social service facilities. Capital expenditures represent 
approximately 11%-12% of expenditures in 2017-2019 and we forecast they will 
average about HRK760 million over that period (total of approximately HRK2.3 
billion). This, in turn, results in expected surpluses after capital accounts 
decreasing to approximately 1.4% in 2019 from 2.7% in 2017 as capital 
expenditures pick up in the later years of our forecast. This is also in line 
with previous EU-program fund utilization picking up toward the end of the 
cycle. The city is also contemplating the possible next programming period, 
and its better utilization, in conjunction with the central government.

The city's strong operating surpluses will help limit debt accumulation over 
the coming years. We forecast moderate debt intake, principally via Zagrebacki
Holding, while debt issued directly by the city is likely to reduce. In our 
base-case scenario, we assume that the city's tax-supported debt, which also 
includes debt of other municipal companies and Zagrebacki Holding, will 
decrease to 89% in 2018 from 94% in 2016. In our view, this level of debt is 
comparably high relative to that of peers in the region, but is generally 
neutral to Zagreb's intrinsic creditworthiness, supported by high operating 
margins. Direct debt, which includes the factoring deals the city services on 
behalf of Zagrebacki Holding, is forecast to decrease to about HRK2.2 billion 
in 2019 from around HRK2.4 billion in 2017 (around 35% of operating revenues).
However, we cannot rule out the possibility of an increase in debt, if 
operating balances were to be under pressure and Zagreb needed liquidity.

Zagreb's available liquidity remains limited, with the debt-service coverage 
ratio just below 60% over the coming 12 months. Zagreb's cash holdings average
HRK240 million per month; we factor into our assessment of maturing debt 
liabilities, loans, factoring deals, and guarantee payments. Additionally, we 
view access to external liquidity as limited, since Croatia's domestic banking
sector is relatively weak; this is reflected in our assessment of the banking 

In our view, Zagreb's contingent liabilities remain moderate. We factor in 
Zagrebacki Holding's payables of HRK600 million as well as the long-term and 
short-term debt of self-supporting entities in analyzing the city's total 
exposure. The city also has an ongoing legal case against the Ministry of 
Finance and previously won a verdict relating to its overdue payables. Given 
that the favorable decision effectively reduced the city's payables and the 
city made a partial payment to suppliers, its payables now stand at no more 
than 10% of operating revenues. We estimate that the maximum loss under a 
stress scenario would be 10%-15% of operating revenues.


Table 1

City of Zagreb Key Statistics
--Fiscal Year End Dec. 31--
(Mil. HRK)201520162017bc2018bc2019bc
Operating revenues6,1616,3766,7746,9697,182
Operating expenditures5,4715,6966,0776,1816,352
Operating balance690680697788830
Operating balance (% of operating revenues)11.210.710.311.311.6
Capital revenues465113810595
Capital expenditures409750650790820
Balance after capital accounts327(19)185103105
Balance after capital accounts (% of total revenues)5.3(0.3)
Debt repaid518525441450461
Gross borrowings193444320340350
Balance after borrowings2(100)6602
Modifiable revenues (% of operating revenues)23.838.336.135.635.1
Capital expenditures (% of total expenditures)
Direct debt (outstanding at year-end)2,6812,4362,3662,3062,246
Direct debt (% of operating revenues)43.538.234.933.131.3
Tax-supported debt (outstanding at year-end)9,0898,9828,9078,9428,977
Tax-supported debt (% of consolidated operating revenues)97.793.790.288.886.5
Interest (% of operating revenues)
Local GDP per capita (single units)142,887147,188153,129159,629166,734
National GDP per capita (single units)79,81082,75486,26190,01194,109