Mission Concluding Statement 

Croatia- 2012 Article IV Consultation Concluding Statement of the Mission

October 2, 2012

The economy is still struggling to restart growth after the deep recession in 2009. Economic prospects are hampered by persistent domestic demand weakness, inauspicious external environment, and deep-rooted competitiveness problems. In addition, large external and foreign-currency debt imply high vulnerability to external shocks. The authorities’ fiscal consolidation measures in 2012 will likely achieve the targeted deficit. However, further efforts are needed in 2013 and beyond to return to fiscal sustainability. The structural reform program––critical for resuming growth and raising the economy’s potential––is being launched, but reforms in important areas remain to be fully developed and articulated to the public. Key policy priorities are to design, announce, and implement a credible and balanced fiscal consolidation package to ensure medium-term fiscal sustainability; initiate far-reaching structural reforms to improve competitiveness and growth prospects; and maintain financial stability by containing funding and credit risks.

Economic prospects are weak and risks large

1. Croatia is in recession and economic prospects are challenging. After a second year of contraction in 2010, output stagnated in 2011. With unfavorable external conditions and subdued domestic demand amid high unemployment, low confidence, and weak credit growth, GDP is set to contract further by 1½ percent in 2012, only modestly picking up by ¾ percent in 2013 on the back of the expected sizable public investments and modest improvement in external demand. Inflation would hover around 3 percent, affected by rising food and energy prices, while the current account deficit would remain about 1-1¼ percent of GDP. Structural impediments and weak competitiveness hamper medium-term prospects. Without significant progress in structural reforms, potential growth will remain modest.

2. Vulnerabilities remain high. Debt rollover risks are significant with external, mostly private debt of about 100 percent of GDP, and an external financing requirement of 30 percent of GDP in 2012. The budget deficit is high and public debt is rising fast. Although bond and CDS spreads have declined lately, influenced by external factors and Fitch’s raising the sovereign outlook to stable, market confidence remains fragile. Large liabilities in foreign currencies expose corporate and household balance sheets to exchange rate shocks.

3. Risks are large and clearly tilted to the downside. Significant setbacks in Croatia’s main external partners in the EU and the Balkans are a key risk to economic prospects and financial stability. Such setbacks would lead to a sharp decline in exports, employment, and domestic demand, while capital outflows would pressure the balance of payments and reduced bank and corporate financing from foreign banks would shrink available credit. Dwindling fiscal revenue and increasing expenditure needs would significantly widen the budget deficit. In the medium term, without fundamental policy changes, sluggish growth and elevated vulnerabilities will further weaken the economy’s ability to withstand shocks. On the upside, the forthcoming EU accession can spur official and private capital inflows, but the experience of new member states suggests that concerted efforts are needed to strengthen absorption capacity.

4. Policy challenges are complex and demanding. Slow adjustment to the post-crisis environment has exhausted the government’s fiscal space, calling for significant and sustained fiscal consolidation to keep public debt under control. However, this consolidation has to take place amid weak growth and high unemployment, both amplified by incomplete adoption of market-friendly policies to stimulate private investment and employment creation. Vested interests’ resistance to reforms is also complicating the process. Policy makers and social partners should recognize the major challenges Croatia is facing and swiftly agree on decisive actions to address them.

Significant and sustained fiscal consolidation has no alternative

5. Against this background, resolute implementation of fiscal consolidation policies for a number of years is crucial to restore debt sustainability and retain market access. In the short run, the imperatives of establishing credibility, satisfying the requirements of the Fiscal Responsibility Law (FRL) for expenditure reduction, and maintaining market access call for a structural adjustment of about 1¼ percent of GDP in 2012 and ¾ percent in 2013, corresponding to headline deficit targets of 4 and 3 percent of GDP, respectively. Further on, a gradual but steady adjustment path of about ½ percentage points of GDP a year in structural terms strikes the right balance between the lukewarm growth prospects and the shrinking fiscal space. The mission recommends that consolidation be continued until the structural deficit is brought to zero. This policy would lower debt, vulnerabilities, and borrowing costs to a more manageable level particularly in view of the sizable stock of contingent liabilities and create more fiscal space for countercyclical policies. It is also consistent with the EU Fiscal Compact, which calls for a structural deficit of at most ½ percent of GDP, reduced with the fiscal costs of ageing. Furthermore, it will reduce the total financing requirement in 2014-15 when the amortization needs rise sharply and financing constraints could become binding.

6. The expenditure-based consolidation required by the FRL is appropriate given Croatia’s high tax burden and unsustainable expenditure levels. Policies should continue to focus on rationalizing bloated public employment and remuneration, revamping the unaffordable pension and health systems, and reducing overly generous subsidies. Such cuts are likely to have less damaging effect on growth in both the short and the medium-term than capital expenditure cuts. The authorities should identify early on the measures that will support the FRL targets in 2013-15 in order to make them credible.

7. The 2012 budget execution marks the first step on this road. The mission expects that the 2012 budget deficit target amounting to about 4 percent of GDP (ESA 95) under staff’s macroeconomic projections will be reached, provided the collective labor agreements for public servants are amended as the government proposes. This success would, however, be achieved in a less than optimal way, with overruns in the wage bill and social security benefits partly offset by underexecution of the capital expenditure budget. On the other hand, the better than expected revenue performance, bolstered by strong efforts to fight tax evasion and collect arrears, is welcome.

8. Additional efforts are needed in 2013. On currently contemplated policies, the mission projects that the 2013 general government budget deficit will amount to 3.3 percent of GDP, with expenditure adjustment of ½ percentage points of GDP relative to 2012 and a revenue increase of ¼ percentage points, mainly due to one-off effects. To comply with the spirit of the FRL and minimize the risk of losing market access in the face of rapidly rising public debt (projected to exceed 55 percent of GDP in 2013), the mission advises cutting expenditure further by ½ percentage points of GDP and targeting a headline deficit of no more than 3 percent of GDP while continuing to rebalance the tax mix (¶9). The expenditure cuts can be achieved by preventing a rise in subsidies from their 2012 level and strengthening pension and health care entitlement reforms.

9. The authorities’ efforts to rebalance, in a revenue-neutral way, the tax structure away from labor are welcome and should be pursued further. The 2012 reduction of health contributions with its revenue impact offset by the increase in VAT (a.k.a. fiscal devaluation) should help improve competitiveness and underpin demand for labor. To create space for further reduction in labor taxation, the mission recommends increasing the zero VAT rate on certain domestic sales––an EU requirement––to 10 percent rather than the minimum admissible 5 percent, with part of the additional revenue used to augment targeted social assistance to the most vulnerable. Introducing a modern value-based property tax, accompanied by transferring additional spending responsibilities to local governments, would also help in this regard.

10. The planned large investment projects by state-owned enterprises could support growth, but should be accompanied by efficiency-raising enterprise restructuring and subjected to a careful cost-benefit analysis. The large projects in the energy sector and water supply, as well as PPPs in education and health care could underpin growth, reduce costs, and raise the economy’s capacity in the medium term. They should, however, be accompanied by restructuring of the involved state-owned enterprises to ensure efficient implementation. Moreover, given that these investments will raise the debt of the broader public sector, the mission recommends a careful assessment of their benefits for long-term growth versus financial cost. In this context, the authorities appropriately plan to rely as much as possible on the forthcoming EU structural and cohesion funds and private borrowing in a PPP context; care should be taken in the latter case, however, to ensure the proper division of the associated benefits, costs, and risks.

11. The Fiscal Council should be strengthened considerably. Created to monitor compliance with the FRL, the Council needs a clarification of its mandate, resources to implement it, and independence from the executive. In particular, it should be made clear that the Council is expected to assess compliance with the FRL both on an ex-post and ex-ante basis, with the technical parameters of these assessments unambiguously defined and written reports required. Moreover, the Council’s meeting schedule could be regularized, following the fiscal calendar.

Far-reaching structural reform agenda must be carefully designed and rapidly implemented

12. Croatia’s business environment and weak competitiveness hamper medium-term growth. In recent years progress has been made in some areas (notably reduction in health expenditure and a pension reform), but only limited reforms have been launched to foster labor market flexibility, improve the business climate, and reduce the size of the public sector. As a result, labor force participation remains very low, barriers to investment tall, and wages high relative to productivity. All these factors restrain Croatia’s export growth as evidenced by her falling share in world imports and limit penetration in EU markets. Far-reaching reforms are therefore needed to return to robust medium-term GDP growth and reverse the sharp increase in unemployment.

13. A strong reform agenda to address these problems is long overdue. The fiscal and structural agendas in Croatia go hand in hand, as many consolidation measures also strengthen medium growth prospects. The government’s structural reform program, adopted in August, is a good start, but many key reforms remain to be developed in terms of specific policies and desired effects. The mission recommends that priority be given to reforms aiming to: (i) boost work incentives via a faster increase in the retirement age for women to 65, a further increase to 67 for both men and women, higher penalty for early retirement, and tighter control over the apparently abused system of disability retirement; (ii) improve labor market flexibility by reducing hiring and dismissal costs, including for poor performance, and allowing firms to opt out from onerous sector-level collective agreements, while ensuring that the envisaged single open-ended contract does not impede flexibility; (iii) following the best examples in the region, foster competition and reduce barriers to market entry by relaxing the licensing and administrative requirements to open a business (notably at the local level) and speeding up privatization. In addition, continuing the fiscal consolidation efforts in the medium-term will reduce macroeconomic risks that deter investment and improve the cost and availability of capital. The mission estimates that these reforms could lift GDP growth by about 2 percentage points in the medium to long term by improving labor force participation, raising investment, and strengthening productivity.

14. It is crucial to take full advantage of Croatia’s forthcoming accession to the EU. Official and private capital inflows triggered by EU accession could significantly boost medium-term growth if oriented to productivity-enhancing projects. This, however, requires designing a coherent development strategy with clear project prioritization, strengthening the administrative capacity to develop those projects, reducing barriers to investment, and creating fiscal space for Croatia’s co-financing of EU-funded projects. In this context, Croatia’s inclusion in the EU’s economic governance mechanisms will spur further needed institutional and structural reforms.

Monetary policy: maintain macroeconomic stability and mitigate external vulnerabilities

15. Within its framework centered on a broadly stable exchange rate, the Croatian National Bank (CNB) should continue to allow increased exchange rate flexibility and gradually accumulate international reserves. Since 2009, the CNB has appropriately allowed increased two-way exchange rate flexibility, which has facilitated macroeconomic adjustment and limited speculation. Moreover, accumulating reserves at times of ample foreign exchange liquidity, as the CNB has been doing, would build further an important buffer against external shocks. This would contribute to the current accommodative monetary policy stance, which is appropriate as long as it remains consistent with the exchange rate-based nominal anchor given the low core inflation, the weak growth prospects, and the ongoing fiscal consolidation. Credit schemes aimed at boosting credit growth by offering lower interest rates and risk sharing between commercial banks and the state development bank HBOR could help underpin firms’ activity in an environment of weak credit demand and high bank risk aversion. However, caution is needed to avoid compromising HBOR’s balance sheet or banks’ credit standards.

Regulation and supervision: key to maintain financial stability

16. Despite the slow deterioration in asset quality, the banking sector remains stable, well-capitalized, and resilient to shocks. The ongoing recession is affecting the nonperforming loan (NPL) ratio, which reached 13 percent in June 2012, with corporate NPLs at 23 percent. Profitability has started to decline from relatively high levels, in part owing to a pick-up in NPL provisions, which still remain low relative to neighbors and history. High capital adequacy and liquidity ratios, however, indicate sufficient buffers to ensure the system’s stability. Notably, the CNB stress tests suggest that most banks could absorb the effects of an immediate increase in the NPL ratio to 20 percent (34 percent for corporates), and only a few banks would need additional capital totaling about 0.6 percent of GDP. Liability deleveraging has been proceeding in an orderly manner, with banks relying on rising domestic deposits to reduce external credit lines.

17. In view of the existing vulnerabilities, strong regulation, supervision, and cooperation with other supervisory authorities are essential to preserve financial stability. Growing NPLs, the large exposure of household and corporate borrowers to currency and interest risk, and sizeable dependence of subsidiaries on euro area parent banks for funding create vulnerabilities that need to be carefully monitored. The CNB should maintain high statutory capital buffers, call for raising banks’ capital early on if needed, ensure adequate provisioning for NPLs, and further strengthen cross-border supervision cooperation. In this context, the forthcoming Host Country Cross Border Forum under the auspices of the Vienna 2.0 initiative is timely. Obstacles to quick resolution of NPLs (notably the slow bankruptcy process, the difficulties to foreclose collateral, and tax impediments) should also be swiftly removed.

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The mission is grateful to the authorities for their excellent cooperation, open and candid discussions, and warm hospitality.