Croatia—Letter of Intent

March 11, 2002

Zagreb, Croatia
March 11, 2002

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

Dear Mr. Köhler:

2. The performance criteria for December 31, 2001 have been observed except for that on government arrears, which was exceeded by a very small margin, and those on government borrowing from domestic banks and on contracting and guaranteeing public debt, which were missed by larger margins. All three breaches were the result of a shortfall in privatization receipts. To make up for the breach of the performance criterion on arrears, we have programmed a more rapid reduction of arrears in the first quarter of 2002. As we have not changed the scope of our privatization program, we expect the higher recourse to domestic bank financing also to be temporary. And, as noted in paragraph 8, we intend to use any excess of privatization receipts in 2002 to lower government indebtedness.

3. Macroeconomic developments in 2001 were better than programmed: economic growth was higher, inflation lower, and the international reserves gain larger than originally programmed. Notwithstanding the unfavorable external environment, we expect real GDP growth to slow only moderately in 2002 to 3.5 percent, while inflation is expected to subside further on an average annual basis to no more than 4 percent despite excise tax and administered price increases. Our fiscal and monetary programs for 2002 have been based on these assumptions.

4. The budget approved by parliament envisages a further reduction of the deficit of the consolidated central government from 5.4 percent of GDP in 2001 to 4.25 percent of GDP in 2002. At the same time, the expenditure to GDP ratio is expected to decline further from 43.3 percent in 2001 to 41.0 percent in 2002. The government debt to GDP ratio would decline from 50.7 percent at end-2001 to 50.4 percent at end-2002, assuming no further increase in guaranteed debt (disbursed and outstanding). We are thus continuing to implement our medium-term fiscal consolidation program that aims at reducing and eventually stabilizing the public debt ratio, while streamlining fiscal operations and reducing the size of government.

5. The 2002 budget seeks to enhance transparency by incorporating all five extrabudgetary funds¹ in the central budget, bringing spending units' own resources (estimated at 0.5 percent of GDP) and expenditure financed therefrom on budget, and presenting the budget on a modified accrual basis with privatization receipts treated as a financing item. At the same time, as a sign of the government's commitment to reduce unemployment and raise the standard of living throughout the country, we have created two funds for development and employment and for regional development. The funds, which remain on the budget and are authorized to spend up to 2 percent of GDP, will channel privatization receipts and supplementary budgetary resources to selected priority capital investment and active labor market projects in an attempt to rally support for privatization and address a perceived lack of development and labor market orientation of the government's policies. The funds will be managed without additional staffing and their activities will be subject to parliamentary oversight. We intend to review their operation in mid-2002. In line with Fund technical assistance recommendations, we have postponed the implementation of the second and third phases of our decentralization plan. However, the first phase of decentralization was completed at the start of 2002 with the transfer to local bodies of responsibility for operational and maintenance costs for the homes for the elderly and disabled.

6. The revenue to GDP ratio is expected to decline further from 38.4 percent to 37.2 percent of GDP, despite higher excises on cars and beer, a new car insurance tax, measures to boost social security collections, and the inclusion of ministries' own revenue in the budget. While the reduction of import duties and the full-year effect of decentralization do not entail substantial drops in revenue, the introduction of the second pension pillar on January 1, 2002 is expected to result in a revenue loss of 1.2 percent of GDP.

7. The deficit reduction is thus again more than fully attributable to a cut in the expenditure ratio. Among the major expenditure categories, only interest payments will increase faster than nominal GDP. All other expenditure categories (wages, goods and other services, subsidies and transfers, and investment and net lending) are expected to decline in relation to GDP by a combined total of 2.6 percentage points. With the basic wage unchanged in 2002, we expect to realize sufficient savings from layoffs, especially in the defense sector, to address some pay inequities and still remain within the budgetary envelope. While social spending (including cash benefits and the provision of health services) is projected to be reduced by almost 1.4 percent of GDP as a result of the measures adopted in September-October 2001, the total amount of subsidies and current transfers declines by less than this amount because of new subsidies toward job creation and agricultural and industrial development. Spending for these purposes by the two new budgetary funds is to be financed mainly by privatization proceeds. We intend to limit the prefinancing of such spending to no more than 20 percent of budgeted privatization revenue (i.e., HrK 500 million or 0.25 percent of GDP). In the first quarter of 2002, such prefinancing will not exceed one half of this amount (Attachment I, footnote 3).

8. The deficit is expected to be more than financed by privatization receipts of 1.5 percent of GDP and net foreign borrowing of 2.9 percent of GDP, leaving a domestic financing surplus of 0.2 percent of GDP. As the private pension funds and other nonbanks are likely to absorb a substantial amount of government debt (2.3 percent of GDP), there would be a sufficiently large surplus to eliminate remaining government arrears (0.3 percent of GDP) and reduce indebtedness to domestic banks (by 2.2 percent of GDP). Although the government is still firming up its privatization plans, the budget counts on a much lower level of privatization receipts than in the past. Any excess in the realization of receipts during 2002 will be used to reduce government borrowing. About one quarter of the budgeted annual total is expected to be realized by end-March 2002, mainly from the privatization of Dubrovačka banka and the sale of the government's remaining stake in Splitska banka. Also, we have already obtained US$102 million under the recently approved World Bank SAL and borrowed €500 million in the international capital market.

9. The cumulative deficit of the consolidated central government for the first quarter of 2002 will be a performance criterion under the stand-by arrangement for March 31, 2002. It will be adjusted by the amount by which social contributions collected by the private pension funds deviate from the amount projected (Attachment I). Consistent with the first-quarter deficit's financing plan, performance criteria are also being proposed on net credit of the banking system and arrears of the consolidated central government for March 31, 2002. The programmed contraction of net bank financing will be reduced by up to HrK 500 million to reflect the amount of any prefinancing of expenditures by the two new budgetary funds (Attachment I). In addition, limits on short-term external public debt and the contracting and guaranteeing of nonconcessional external public debt with a maturity of more than one year (including a subceiling on such debt with a maturity of less than 5 years) are being proposed as performance criteria for end-March 2002 (Attachment I).

10. We will start immediately with work to broaden the coverage of the government sector. To this end, we will consolidate with the newly expanded budget in the course of 2002: the fiscal operations of the counties and larger cities; the recently established agencies for highway construction (HAC) and for road maintenance and construction (HC); the privatization fund (CFP); and the deposit insurance and bank rehabilitation agency (DAB).² Fund technical assistance will be provided in March 2002 to help with the setting up of the reporting system and overcome difficulties experienced with the new chart of accounts. Since January 1, 2002, the transactions of all former extrabudgetary funds are being channeled through the treasury single account and all separate ministerial accounts were closed as of that date. While some 2,400 accounts of individual spending units cannot be closed immediately due to legal constraints, budgetary revenue and expenditure will no longer be channeled through these accounts. The upgrading of software for the single treasury system allows the daily reporting of arrears since the start of 2002.

11. In accordance with the new CNB law, monetary policy continues to aim at price stability. The CNB intends to pursue this objective during 2002 primarily by aiming at a broadly stable exchange rate. The external current account outlook gives no indication that the present level of the exchange rate is inappropriate. If base money exceeds its projection, the CNB will consult with the Fund to determine whether the inflation outlook warrants an unsterilized buildup of international reserves (Attachment I).

12. The monetary program adopted for 2002 aims at keeping gross official reserves at about five months of imports on average. It is based on the assumption that a substantial share of the inflows related to the euro conversion will remain in the banking system. Nonetheless, some outflows can be expected and, on an annual basis, the pace of remonetization is expected to slow down considerably in 2002. The government's financing surplus would leave sufficient room for noninflationary credit expansion to the nongovernment sector. With government arrears reduction, financing from the new private pension funds, continued good profitability, and an expected slowdown of credit to the household sector, this should allow for a further recovery of investment. To protect the private sector's access to domestic bank credit in the first quarter of 2002, a performance criterion is being proposed for the extension of bank credit to 10 large public enterprises as of March 31, 2002 (Attachment I). Performance criteria are also being proposed for the CNB's net usable international reserves and net domestic assets at end-March 2002 (Attachment I).

13. The CNB will exercise prudence in implementing its monetary program. The extent of deposit withdrawals after the euro conversion is uncertain, and unexpectedly large withdrawals--which would lead to a lower demand for required reserves in kuna— may need to be countered with prompt liquidity tightening. At any rate, the CNB does not intend to reduce reserve requirements during the remainder of the arrangement period. The CNB will improve short-term liquidity forecasting as a basis for its effective liquidity management. For this purpose, the Ministry of Finance will from April 1, 2002 provide information on its cash flow projections to the CNB on a regular basis.

14. A new draft banking law to strengthen the legal framework, including with respect to consolidated supervision and capital adequacy (currently, market risks are excluded), has been discussed by parliament in its first reading and is expected to be adopted by end-March 2002. As the last part of the major payment system reforms, a new law on national payment systems and a new law on financial agencies were adopted by parliament on December 14, 2001. From April 1, 2002, payment transactions can be handled by banks rather than exclusively by the domestic payment agency (FINA, formerly ZAP). The new law on financial agencies gives the management of FINA up to end-2002 to determine services to be privatized, including the national clearing system (NKS).

15. We realize that insufficient progress has been made to boost the efficiency of the economy and attract foreign capital. We therefore will re-energize our privatization drive in an effort to put government owned assets to more productive use. We will definitely privatize in 2002 Croatia banka and the insurance company (CO) and parts of the petroleum company (INA) and sell our remaining shares in Riječka banka and Privredna banka. The laws authorizing the privatization of INA and the power company (HEP) will be adopted by parliament by March 20, 2002 (prior action; Attachment II), thus completing a measure that was a structural benchmark for December 31, 2001 under the arrangement. A privatization program for INA will be developed by end-March 2002 as a new structural benchmark. Under this program, at least 25 percent of INA will be privatized in the second half of 2002 in accordance with a recent government decision. Because of depressed telecom prices, we have decided to postpone the IPO of the telecommunications company (HT). However, if market conditions improve, we will proceed with the IPO in 2002.

16. We will also privatize the postal bank (HPB). Under new management, and with the sale of its nonperforming portfolio to the privatization fund and a reduced fee for its use of post office (HP) facilities, its performance has improved. There has been a small (as yet unaudited) profit in 2001, and another small profit is envisaged for 2002. HPB's capital adequacy ratio is now very high, and the bank will not require budgetary support in the foreseeable future. Nonetheless, the bank needs a strategic investor for its long-term viability. We have therefore appointed a privatization advisor (prior action; Attachment II) to prepare a plan by May 15, 2002 to sell a large enough share of the bank to remove the government's veto power on management decisions. A shareholders meeting of HPB will decide by June 30, 2002 on how to privatize the bank in accordance with the privatization advisor's recommendations. In the meantime, we already have approached the IFC as a possible investor in HPB.

17. To attract foreign investment, we have adopted a series of measures proposed by the World Bank's FIAS to cut red tape and opened a one-stop shop to facilitate dissemination of information to potential investors and their applications for visas, permits and licenses. We expect parliament to approve a law on industrial parks by end-March 2002. We also expect to send to parliament by end-March 2002 a draft bankruptcy trustee services law aimed at improving the qualifications of certified bankruptcy trustees.

18. Financial discipline in the public enterprises has been strengthened. Labor cost and employment have been reduced in the 10 large enterprises subject to close monitoring (for their list, see Annex VI to the Supplementary Memorandum of Economic and Financial Policies). In addition, we have reduced government sector employment to below the agreed limit on December 31, 2001. However, because of the delayed approval of the defense sector reform laws, we will not reach our end-March 2002 employment reduction target (a structural performance criterion) until the end of May 2002. We therefore request a modification of this performance criterion (Attachment II). Additional employment reductions in the government sector will be effected during the remainder of 2002 on the basis of the new legislation aiming at restructuring and modernizing the defense sector, which we expect to be approved by parliament by March 15, 2002. We expect the absorption of unemployed labor to improve following implementation of the recently approved employment law (prior action; Attachment II) and of a new labor law, which is expected to be approved by parliament by June 30, 2002. Retraining and other active labor market measures under the 2002 budget, financed in part by World Bank lending, will support this effort.

19. On the basis of our performance to date and the policies described in this letter, we request the completion of the second review under the stand-by arrangement and waivers for the nonobservance of the three performance criteria indicated in paragraph 2. We believe that the policies described in this letter are adequate to achieve the objectives of our economic program, but we stand ready to take any further measures to keep our program on track. We will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations. Discussions on an arrangement to succeed the present one will provide an opportunity to assess progress with program implementation and reach any understandings that may be needed to achieve the present program's objectives.

20. We would like to reaffirm our intention not to make the purchases that will become available under the arrangement with the completion of the second review and with observance of the performance criteria for March 31, 2002.

Sincerely yours,

²The financial operations of the development bank (HBOR) will continue to be monitored outside this consolidation, but using the same GFS methodology.

ANNEX I

ANNEX II

Croatia: Prior Actions, Structural Conditionality, and Performance Clauses For the Remainder of the Program Period, January 1–March 31, 2002
Prior Actions
	1. Parliamentary approval of the privatization laws for HEP and INA
	2. Appointment of a privatization advisor for HPB
	3. Parliamentary approval of the employment law
Performance criterion
	1. Reduction of government employment to no more than 168,804 people by March 31, 20021
Structural benchmark
	1. Government approval of a privatization program for INA by March 31, 2002
Performance clauses
	1. No new external payments arrears
	2. No new, or intensification of existing, payments restrictions, multiple currency practices, bilateral payments agreements inconsistent with Article VIII, and import restrictions for balance of payments purposes
1Modification of the limit of 167,514 employees approved by the Fund's Executive Board in completing the first program review on November 7, 2001. See SMEFP, paragraph 8.