Mission Concluding Statement 

Croatia- 2013 Staff Visit Concluding Statement

February 25, 2013

Economic conditions have deteriorated lately, reflecting weak external demand, private sector debt reduction, and lack of business and consumer confidence. The implementation of the structural reform program––critical to restart growth, fully benefit from EU accession, and improve medium-term prospects––must accelerate. Reforms aimed at increasing labor force participation, enhancing the functioning of the labor market, and reducing barriers to investment should top the agenda. As difficult as it is, gradual fiscal consolidation should continue in order to restore debt sustainability and preserve market access. Recently announced public sector wage cuts and intended pension and health sector reforms are steps in the right direction; however, further enhancements as well as swift and front-loaded implementation are needed to rein in the unaffordable pension and health care spending. In the financial sector, it is important to keep striking the right balance between safeguarding financial stability and supporting credit growth recovery.

Difficult economic challenges call for ambitious and steady policy action

Economic conditions have deteriorated since mid-2012 and risks to the outlook are substantial. GDP likely contracted by 1.8-2 percent in 2012 amid weak external demand, continuing debt reduction by households and businesses, and rising unemployment that is sapping consumer confidence. Strengthening of economic activity in 2013 would depend mainly on the timely realization of the large public investment plans. However, possible delays in their implementation, negative growth surprises in Croatia’s main external partners, and further bank credit contraction pose important downside risks to the country’s economic prospects.

The challenges Croatia is facing demand comprehensive, ambitious, and steady policy response. The mission sees three immediate priorities:

• Rapidly move on the structural reform agenda to improve Croatia’s competitiveness and boost medium-term growth. Structural reforms take time to bear fruits and should be implemented expeditiously;
• Continue with the gradual but steady fiscal consolidation to restore debt sustainability and retain market access at reasonable cost. The respite given by the financial markets so far should not be a reason for complacency;
• Keep an appropriate balance between enhancing financial stability and supporting recovery in credit growth.

The structural reform agenda adopted in 2012 must be implemented swiftly to restart growth

The authorities should urgently enact long-overdue reforms in the pension system and the Labor Law, and ease barriers to investment. Rapid implementation of pension system reforms is needed to raise the very low labor force participation and support fiscal consolidation. The mission supports the government plans to raise the penalty for early retirement and the retirement age to 67 for both men and women at a pace of six month per year, stop indexation of privileged pensions, and tighten control over the apparently abused system of disability retirement. To speed up their beneficial effect, it is important that these reforms become effective already in the second half of 2013. The planned Labor Law amendments appropriately aim to enhance the functioning of the labor market, but could be more ambitious in the areas of reducing hiring and dismissal costs, including for poor performance, and allowing firms to opt out from onerous sector-level collective agreements. Moreover, the mission recommends that the authorities facilitate agreements between the social partners to bring labor remuneration in line with business conditions. The recently adopted Law on Strategic Investments will ease the implementation of large investment projects. However, more needs to be done to reduce investment barriers at the local level for all projects and speed up the privatization process. Progress in these areas is a necessary condition to promote sustainable growth and take full advantage of EU accession.

Gradual but steady fiscal consolidation must go on

Difficult as fiscal consolidation is, its alternative carries large risks. The current trajectory of public debt remains unsustainable and interest costs are rising rapidly, crowding out productive expenditure. The longer this process continues, the larger and more disruptive the eventual adjustment will be. Moreover, the recent loss of the sovereign’s investment-grade credit rating raises Croatia’s vulnerability to a rise in interest costs for public and private borrowers and further hits on growth and fiscal soundness should the current benign international financial environment worsen again. To minimize these risks, the government must dispel doubts about its commitment to fiscal consolidation by rapidly implementing further adjustment policies that will put the budget back on the consolidation track.

The adjustment achieved in 2012 is a welcome first step. The mission estimates that the targeted budget deficit of 4 percent of GDP has likely been reached, achieving a structural adjustment of some 1½ percentage points of GDP. Regrettably, overruns in the unaffordable wage bill and pension/health care spending have been offset by growth-suppressing underexecution of capital spending.

However, the 2013 budget partly reverses the gains from 2012 and needs aditional policy measures to establish its credibility. The budget targets a deficit of 4 percent of GDP (ESA 95), ¾ percentage points higher than earlier plans. While the recently announced 3 percent wage cut in the public sector should broadly ensure the budgeted wage bill reduction, the planned savings in pension/health spending are not sufficiently supported by explicit policies yet, although medium-term policy intentions in these areas are encouraging. The mission therefore projects that, under policies currently in place, the budget deficit would reach 4¼ percent of GDP in 2013 and would remain close to 4½ percent of GDP through the medium term, with public debt exceeding 60 percent of GDP by late 2014 (75 percent including publicly guaranteed debt).

The mission welcomes the authorities’s intention to revise the 2013 budget and advises further gradual consolidation based on reforms targeting the unaffordable pension and health care expenditure. To move toward debt sustainability and reduce the risk of a loss of market access, the mission recommends targeting a structural deficit of 2½ percent of GDP in 2013, which is estimated to translate into a headline deficit of 3½ percent (ESA 95). This can be achieved by: (i) swift implementation of the planned pension reforms, with the new parameters effective already in 2013; (ii) determined cost-cutting in loss-making hospitals, rationalization of the hospital network, and limiting exemptions to co-payments to support the budgeted reduction in health care spending by reducing inefficiencies and waste and improving targeting of benefits, and (iii) further cuts in other current expenditure, including subsidies, while protecting essential capital expenditure.

Strengthen financial stability while supporting resumption of credit growth

The mission supports the authorities’ objectives to enhance the financial system’s resilience to shocks while fostering credit growth recovery and corporate debt restructuring. A gradual increase in specific bank provisions against NPLs based on the current loan classification rules is desirable in view of the somewhat low provisioning in the system and uncertain collateral values. Care must be taken during policy implementation to preserve the banks’ incentives to extend new loans and restructure existing ones to give viable borrowers a chance to survive. On a related matter, initial experience with the Act on Financing and Pre-bankruptcy Settlement suggests a possible need to clarify the interpretation of the law and increase the coordinating capacity of the involved government bodies. This will help maximize the likelihood of successful out-of-court corporate debt restructuring. Moreover, further efforts should be taken to improve the functioning of the judiciary system to make bankruptcy procedures more efficient and shorter. Finally, while designing policies to ease lending conditions for households, it is important to allow sufficient latitude for competitive banking operations.

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