Public Information Notice No. 04/90

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Republic of Croatia

August 12, 2004

On August, 4, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Croatia.¹

Background

Croatia has established a record of solid growth and low inflation since the mid-1990s: real GDP growth has averaged about 4.5 percent with inflation in the low single digits. This performance compares well with the EU-15 and other Central and Eastern European countries (CEECs). Structural reform has also advanced and the private sector is vibrant, although Croatia lags behind CEECs in terms of overall progress in this area, partly due to the war and disruptions in the early 1990s. This record has provided the basis for the recent decision by the Council of the European Union to grant candidate status to Croatia and start accession negotiations in early 2005.

This performance, however, was accompanied by a gradual worsening of the external position. Domestic investment has outpaced savings since the mid-1990s, resulting in persistent current account deficits. These trends accelerated after the turn of the decade due to a credit-financed surge in private domestic demand in 2001-02, and the current account deficit reached about 8.5 percent of GDP in 2002. As a result and despite Croatia's ability to attract high foreign direct investment (FDI) compared with other CEECs, private and public external debt gradually increased, facilitated by an investment grade rating and low world interest rates and spreads.

Although domestic demand pressures began to ease in the second half of 2003, fiscal discipline waned in the runup to the November elections. Both capital and current spending—particularly on highway construction, went significantly over budget, and there were sizeable off-budget fiscal operations, notably hidden subsidies to the Croatian Railways in the form of government-guaranteed loans. As a result, the fiscal deficit reached 6.3 percent of GDP in 2003 compared with the target of 4.5 percent, derailing the last Stand-By Arrangement. Monetary policy could only play a limited role due to the Croatian National Bank's (CNB) choice of exchange rate stability, the open capital account, and high degree of euroization. The CNB resorted to direct credit controls in January 2003. Although this may have dampened spending by households that do not have easy access to foreign borrowing, corporations were able to switch their borrowing from domestic to foreign borrowing and leasing.

Despite the fiscal relaxation and the largely unsuccessful effort of the CNB to control aggregate demand, bumper tourist receipts and the slowing of private consumption eased balance of payment pressures last year and the current account deficit declined to 6 percent of GDP. Due to continuing high capital inflows, however, external debt continued to increase, reaching about 74.5 percent of GDP in euro terms at end-2003. These trends have continued thus far in 2004: bank credit and import data confirm the moderate pace of aggregate demand and preliminary first quarter national accounts show a pickup in net exports. However, reflecting seasonally high financing needs, external debt rose further to 77 percent of GDP at end-May.

The new government, which has been in office since January, has resumed the fiscal consolidation effort, aiming at a general government deficit of 4.5 percent of GDP in 2004 and 3.7 percent in 2005, with a view to containing the external imbalance and keeping the external debt-to-GDP ratio broadly stable during these two years. The government also took steps to improve transparency in the fiscal accounts, rein in quasi-fiscal operations, and strengthen public expenditure and debt management. The CNB intends to continue playing a supporting role, managing closely domestic bank liquidity, and working with the Finance Ministry to introduce open market operations to facilitate the planned shift of government financing to domestic sources. To support their policies for 2004-05, the authorities have requested a new 20-month Stand-By Arrangement, which they intend to treat as precautionary.

Executive Board Assessment

Croatia's economic growth and inflation performance since the mid-1990s compares well with the CEECs, the economy is open, and structural reform is advanced—although Croatia still lags other CEECs in this area. This overall performance had contributed to the recent decision by the Council of the European Union to grant candidate status to Croatia and start accession negotiations in early 2005. While recognizing these achievements, Directors expressed concern over the persistently wide current account deficits and rising external debt-to-GDP ratio, which have over time increased significantly Croatia's external vulnerability.

Directors supported the authorities' overall strategy to deal with external vulnerability mainly through renewed fiscal consolidation. Most Directors agreed that the choice of a broadly stable exchange rate regime remained suitable for Croatia, provided that supporting policies are in place and the level of the exchange rate continues to promote competitiveness. Some suggested, however, that the appropriateness of the exchange rate regime should be reassessed as circumstances change.

Directors considered the envisaged fiscal adjustment for 2004-05 to be significant, but questioned its composition. A total fiscal and quasi-fiscal adjustment of 2¾ percentage points of GDP, while ambitious, was the minimum required to stabilize the external debt-to-GDP ratio around its current level by the end of 2005, in the context of the projected moderation of private domestic demand pressures. Directors commended the government's decision to postpone the reduction of VAT rates planned for 2005. However, they pointed to the need to further curtail current spending, which is high relative to other similar countries. They also regretted the reliance on one-off revenue measures in 2004, although they recognized that this was a response to the inherited burden from 2003 and the size of the planned adjustment. Directors cautioned that the authorities should be ready to take additional measures if the envisaged adjustment proves insufficient to reduce external vulnerability.

Directors welcomed the measures to enhance fiscal transparency and improve public expenditure and debt management. Weaknesses in these areas were major factors behind the sharp deterioration in the fiscal stance which derailed the previous Stand-By Arrangement. Directors underscored, in particular, the importance of controlling the issuance of government guarantees, introducing a single treasury account, and monitoring closely the financial performance of public enterprises.

Directors urged the authorities to articulate a medium-term expenditure plan. A detailed and comprehensive plan, underpinning far-reaching reforms of government spending, is a prerequisite for the successful implementation of the government's objectives of reducing Croatia's high tax burden, meeting the Maastricht deficit ceiling, and reallocating spending priorities in order to meet the EU-related needs. Directors recommended that these reforms should cover wages and the public administration, the welfare system, and subsidies.

Although monetary policy, in the context of the current exchange rate regime, was not an effective tool for managing aggregate demand, Directors felt it had an important supporting role to play by reining in the growth in bank liquidity and providing an enabling environment for fiscal consolidation. Directors welcomed the abolition of direct bank credit ceilings, which had done little to curb aggregate demand during 2003, as well as the CNB's plans to introduce, in cooperation with the Ministry of Finance, open market operations with government paper.

Directors noted the reassuring financial sector indicators, but recommended that the authorities remain vigilant to ensure that the system can withstand the risks associated with currency mismatches of borrowers and existing gaps in supervision. Directors encouraged the authorities to close gaps in nonbank financial supervision and improve cooperation between bank and nonbank, and domestic and foreign supervisors.

Directors encouraged the authorities to reinvigorate structural reform efforts. In particular, they urged them to accelerate privatization and give high priority to the restructuring of public enterprises, most urgently the railway company. They also stressed the need to improve the business environment with a view to preparing for competition within the EU.

Directors urged the authorities to improve the quality of economic statistics. Deficiencies in national account and balance of payments statistics, in particular, hampered surveillance and program monitoring.