Press Release No. 14/513

Press Release: Statement at the Conclusion of an IMF Staff Visit to the Republic of Croatia

November 12, 2014

A staff team from the International Monetary Fund (IMF) visited Zagreb during November 4–10, 2014 to review economic developments, focusing primarily on fiscal policy. The mission met with Deputy Prime Minister Branko Grčić, Minister of Finance Boris Lalovac, Croatian National Bank Governor Boris Vujčić, other senior public officials, parliamentarians, academics, and representatives of the international community. At the conclusion of the visit, Mr. Johannes Wiegand, the mission chief, made the following statement:

“Moving the Croatian economy out of its difficult spot will require significant additional reforms. While several measures have been adopted in recent years to strengthen the economy and the public finances, it is key that efforts continue. Steadfast fiscal consolidation is needed to stabilize public debt, supported by steps to shore up demand—such as accelerating the restructuring of private sector debts and enhancing the absorption of EU structural and cohesion funds—enhance the transparency of fiscal management, and strengthen the economy’s capacity to adjust.

“Real GDP is projected to shrink by ½-1 percent in 2014, driven by a continued contraction in domestic demand that reflects a mix of private sector efforts to reduce debts, the impact of fiscal adjustment, and policy uncertainty. Disinflationary spillovers from the euro area and commodity markets, coupled with weak domestic demand, have given rise to deflation pressures. For 2015, IMF staff expects real GDP to stagnate. There is considerable uncertainty around this forecast, as next year’s fiscal stance is still not fully known.

“Economic weakness has complicated fiscal consolidation. The mission projects the 2014 general government cash deficit at 5 percent of GDP, revised from 4 percent of GDP at the time of the 2014 Article IV consultation (the deficit is likely higher in ESA-terms relevant for the European Commission’s assessment in the context of the Excessive Deficit Procedure). More than two-thirds of the revision reflects revenue shortfalls, notably on value-added tax, that are due in part to weak activity and deflation. However, there have also been spending overruns, notably on public wages in two ministries (education and interior).

“The draft 2015 budget is still under discussion, preventing the mission at this time from conducting a full assessment of next year’s fiscal policy.

• Further fiscal consolidation needed. Based on already announced measures, IMF staff projects a deficit of around 5¼ percent of GDP. The mission welcomes, however, the government’s plan to make additional savings that would contain the deficit at around 4 percent of GDP. Provided the corresponding measures are structural, deficit reduction of this scale would imply structural adjustment of at least one percent of GDP—which, in IMF staff’s view, would balance the need for credible consolidation with avoiding excessive burdens on the economy.

• Tax measures. Among the already announced tax measures, the introduction of a tax on interest income and tighter eligibility for the tax exemption on reinvested profits appear appropriate, as these steps are likely to have a relatively muted impact on private demand. The mission is skeptical, however, about the planned adjustment of income tax brackets that result in effective tax cuts. While this may contribute to strengthening competitiveness in the longer term, it comes with sizeable short-term budgetary cost (about 0.6 percent of GDP) that will need to be compensated by tightening measures elsewhere. Further, the cuts benefit mostly middle and high incomes, hence their immediate impact on private demand will likely be limited.

• EDP/European Commission. With a view to reducing policy uncertainty, the mission encourages the government to discuss the 2015 budget early with the European Commission. A concerted effort should be made to increase the absorption of EU structural and cohesion funds to limit the contractionary impulse of fiscal adjustment.

“Health sector reforms remain an urgent priority to render the sector sustainable and more efficient. Also this year, arrears are projected to accumulate, despite intensified cost control efforts. This suggests that revenue measures—such as raising co-payments—or further efficiency increases in the provision of health services are needed. The mission is skeptical about the planned exit of the health insurance fund from the treasury. By separating the authority for contracting health services from the responsibility of covering the cost of public hospitals, the step will likely exacerbate coordination and cost control problems.

“Reform fatigue is a risk, especially in view of approaching presidential and parliamentary elections. The government has advanced several commendable reforms in recent years, including measures to attract foreign direct investment, reforms to labor legislation, measures to increase tax collection from the informal economy (“fiscalization”), and progress with installing a central salary accounting system. Another helpful reform has been the pre-bankruptcy settlement procedure (PBSP). The mission is concerned that the revised PBSP—that folds the procedure back into formal bankruptcy proceedings and assigns a key role to court-appointed trustees—may again complicate and delay corporate debt workouts. Staff welcomes the intention to introduce write-off measures for debts of distressed households.

“However, other, urgent reform needs have not yet been fully addressed. These include further reducing incentives for early retirement, reforming the local government system and decreasing overlapping responsibilities between different levels of government, further restructuring state-owned enterprises and reducing their role in the economy, and strengthening the judicial system. In this context, the planned streamlining of public wage bonuses and reforms to the indexation of privileged pensions should be implemented swiftly.”