Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

Dear Mr. de Rato:

We have prepared an economic policy program for 2004 and 2005 to limit external vulnerability arising from the high current account deficit and the heavy external debt burden, and prepare Croatia for EU accession. To achieve these objectives, our program relies on fiscal adjustment to stabilize the external debt-to-GDP ratio at approximately its present level, and structural reforms to reduce the role of the state in the economy and promote private sector activity. In support of our program and to signal our commitment to strong macroeconomic policies, we herewith request a Stand-By Arrangement in an amount of SDR 97 million (26.7 percent of quota) for a 20-month period starting from Board approval.

The implementation of our program, which is described in the attached Memorandum on Economic and Financial Policies (MEFP) and Technical Memorandum of Understanding (TMU), will be monitored through quantitative performance criteria, indicative targets, and structural benchmarks. Our fiscal program will be monitored by performance criteria on the general government and HBOR deficits, the change in the stock of general government arrears, the contracting of new nonconcessional external debt of the general government and HBOR, and the cumulative issuance of debt guarantees by the general government. To ensure that the operations of public enterprises will not jeopardize fiscal consolidation and to increase transparency, the deficits of selected public enterprises, net of budget transfers, will also be monitored on the basis of indicative targets. The implementation of the CNB's monetary program will be monitored through performance criteria on the net international reserves and net domestic assets of the CNB.

The MEFP proposes performance criteria and indicative targets for end-September and end December 2004. There will be two reviews during the period of the requested arrangement, before the third and sixth purchases, respectively, to assess progress in implementing the program and reach understandings on any additional measures that may be needed to achieve its objectives. The first review will focus in particular on the 2005 budget. Program implementation will also be monitored through a structural performance criterion on the preparation of 3-year rolling budgets starting in 2005 and structural benchmarks.

We believe that the policies and measures set forth in the MEFP and the TMU are sufficient to attain the objectives of our economic program. However, we stand ready to take any further measures that may be needed toward this end. We will consult periodically with the Fund, in accordance with the Fund's policies on such consultations, about the progress being made in implementing our economic program, and in advance of any revisions to the policies covered by the MEFP. We will provide the Fund with such information as it requests on policy implementation and achievement of program objectives.

In view of Croatia's comfortable international reserves position and easy access to international capital markets, we intend to treat the arrangement as precautionary. Therefore, we do not intend to make the purchases under the requested arrangement that will become available upon its approval and after observance of its performance criteria and completion of its reviews.

Sincerely yours,

Memorandum on Economic and Financial Policies

1. Croatia is a functioning market economy with a well-established track record of satisfactory growth and low inflation. Real GDP growth has averaged 4½ percent with inflation in the low single digits since the mid-1990s, the economy is open to the rest of the world, foreign investment is strong, and structural reform has advanced over a wide front. This performance compares favorably to that in other countries in the region and has provided the basis for the recent positive avis by the European Commission, which recommended opening negotiations for EU membership with our country.

2. But certain structural problems have long been left unaddressed and our government is starting with a heavy burden from the past. This burden is reflected in two features of our economy. First, the public sector is large and inefficient: the share of public spending to GDP is higher than in other countries at a similar level of development; public agencies and enterprises are not subject to strict financial discipline; state aid in various forms is higher than in the rest of Central and Eastern Europe—indeed above the average in the EU; and the fiscal deficit last year was very high. And second, public and private external debt has reached high levels, exposing Croatia to significant risks.

3. Addressing the underlying causes and alleviating this burden is critical for the health of our economy and for an early and successful entry into the EU, which is our primary strategic objective. The government and the Croatian National Bank (CNB), with the support of the International Monetary Fund (IMF), have thus cooperated in the design of an economic policy program with two main goals:

• in the short term, restoring order in Croatia's public finances and limiting the vulnerability arising from the high current account and external debt burden; and
  
  
• in the medium term, modernizing and reducing the role of the state, promoting private sector activity, and preparing Croatia to compete within the EU.

These goals are complementary: the long-term competitiveness and growth of our economy and, in particular, the accession to the EU require a stable macroeconomic environment and a low fiscal deficit. This Memorandum presents the policies that we believe will achieve these goals and is an integral part of our government's broader economic and social program. Although it focuses on the period immediately ahead, it also incorporates policies that have a longer time horizon and will require consistent implementation in the coming years.

4. Our program will be monitored by quarterly performance criteria, indicative targets, and structural benchmarks specified and defined in the attached Technical Memorandum of Understanding.

I. Macroeconomic Policies for 2004–05

5. The immediate objective of macroeconomic policies for 2004–05 is to reduce external vulnerability. Croatia is a small open economy operating in an uncertain international environment. Heavy foreign borrowing by both the public and the private sectors in the last decade has resulted in a very high foreign debt to GDP ratio (77 percent of GDP at end-May 2004 in euro terms). Although foreign borrowing is likely to continue as our economy invests in the future, the size of the current account deficit and foreign debt makes Croatia vulnerable to external shocks and shifts in market sentiment: for example, tourism receipts may fluctuate substantially in reaction to international events, while foreign borrowing by domestic banks and enterprises can be very volatile. Our immediate objective therefore is to contain the external current account imbalance and reduce sharply the reliance on foreign borrowing.

6. Fiscal policy is the main instrument to achieve this objective. The external imbalance can only be addressed by a lasting reduction in the domestic saving-investment gap. Given its focus on exchange rate stability, monetary policy can only play a supporting role; the burden for narrowing the saving-investment gap falls on fiscal policy. The fiscal effort will encompass not only the central government but also extra-budgetary funds and agencies, the broader public sector, and the Croatian Development Bank (HBOR).

7. Our fiscal targets for 2004 and 2005 are also guided by the need to restore credibility and set fiscal policy on a course that meets EU requirements in the medium term. A sizable fiscal adjustment is needed in order to reverse the excesses of last year, when spending slippages by the previous government in the last quarter of the year resulted in a widening of the general government deficit to 6.3 percent of GDP (including hidden subsidies to Croatian Railways—see ¶9), missing the 2003 budget target by a wide margin and taking the previous Stand-By Arrangement with the IMF off track. At the same time, we intend to continue critical infrastructure projects and provide budgetary room for the costs associated with the process of harmonization with the EU.

8. Achieving the main short-term objective of our program will be facilitated by the return of the pace of economic growth to a more sustainable level. The unwinding of the credit boom and the restoration of fiscal discipline are expected to maintain real GDP growth to 3½-3¾ percent and keep the current account deficit around 5-5½ percent of GDP in 2004-05. Inflation will remain at the range of 2-3 percent per year. Given this economic outlook, we expect the policies for 2004-05 outlined in this Memorandum will result in stabilizing the external debt-to-GDP ratio at around its end-May 2004 level. If developments during the program period indicate a significant deviation from our macroeconomic objectives, in particular a sizeable increase in the external debt-to-GDP ratio net of official and commercial bank reserves, we will adjust macroeconomic policies, in particular fiscal policy, to achieve our targets.

A. Fiscal Policy

9. The first task of our government this year was to deal with the lack of transparent accounting and accumulated fiscal obligations inherited from 2003. First, the deficits reported in 2002 and 2003 had been artificially suppressed because the previous government had forced the loss-making Croatian Railways (HŽ) to finance part of its spending by government-guaranteed short-term loans, which were planned to be taken over and serviced by the budget this year. We have discontinued this practice and our budget now includes all transfers required by HŽ to finance both capital and current spending. And second, expenditures in 2004 are burdened by a number of one-off obligations inherited from last year, including hospital arrears, wage arrears, and contracts for housing reconstruction that amount to about HRK 800 million (0.4 percent of GDP), as well as the impact of substantial wage increases awarded to civil servants by the previous government one month before the last November elections.

10. Against this background, the main objective of fiscal policy in 2004 is to restore transparency and order in our public finances and begin the process of medium-term consolidation. We aim at a general government deficit of HRK 9.3 billion (4½ percent of GDP) on a GFS 2001 basis including net lending, an adjustment of 1.8 percent of GDP from 2003. This target was set in the 2004 budget, prepared by our government and approved in March, and is supported by a set of additional measures in a supplementary budget that we have submitted to parliament for approval by July 15.

11. To achieve this major adjustment, we rely on a combination of expenditure and revenue measures, as well as some one-off revenues. An adjustment of this magnitude could not be achieved by permanent measures alone, especially given the inherited obligations from 2003 and the fact that a quarter of the year had elapsed before the budget could be approved. Our budget and supplementary budget include a number of permanent measures:

• No increase in real terms in the wage bill, to be achieved despite the higher wage payments through the ongoing rationalization of the defense sector;
  
  
• Savings of about HRK 700 million as spending on highway and road construction return to more reasonable levels;
  
  
• A reduction in the statutory limit to local government borrowing from 3 percent to 2 percent of last year's annual revenue.
  
  
• Measures to improve spending control in the health sector and prevent the re-emergence of significant payments arrears by hospitals, notably introducing expenditure planning and reporting by hospitals on a monthly basis, limiting the number of prescriptions per doctor refunded by the Health Institute, introducing a tender system for the procurement of the most expensive drugs, and benchmarking domestic drug prices to the average of the 5 lowest-cost EU members;
  
  
• Additional revenue of HRK 200 million from higher excises on cars and tobacco that will take effect on July 15;
  
  
• The re-introduction of the Financial Police, which will improve tax compliance and lead to better collections (although most of this impact will be felt starting in 2005).

Moreover, we expect HRK 2.1 billion from additional dividend payments from a number of public enterprises and higher-than-planned receipts from the concession of the third GSM license. Finally, we will reduce the annual lending plan of HBOR, which is essentially an arm of government policy, by HRK 200 million by a decision of its Supervisory Board by July 23.

12. We are firmly committed to achieving this deficit target in 2004 and stand ready to take additional measures if necessary. To safeguard our target, we plan to use any receipts from privatization or succession agreements beyond what is currently budgeted to reduce foreign debt rather than finance spending. If our measures in the health area do not achieve the intended objectives, we will increase co-payments for medical services and drugs, reduce the number of exemptions from co-payments, and introduce changes to the supplementary health insurance scheme to reduce outlays by November 1.

13. The 2005 budget will aim at a general government deficit of 3.7 percent of GDP, with continued effort to limit HBOR's net lending. To achieve this objective, we intend to contain the general government wage bill growth to no more than the rate of inflation; lower further investment on roads and highways in the context of the new four-year plans of the Highway and Road Agencies (HAC and HC); contain health system spending further on the basis of the measures taken in 2004; and reduce administrative costs of the Health, Pension, and Employment Funds. At the same time, we will have to start meeting the costs associated with harmonization with the acquis communautaire in the context of EU membership negotiations, which we expect to begin soon, as well as provide additional resources to the priority sectors of education and the judiciary. All told, we intend to lower general government current spending-to-GDP ratio by about 1 percentage point and total spending and net lending by 1¾ percentage point. These measures, together with the full-year effect of the higher excises on cars and tobacco and the impact of the Financial Police on collection, will offset at least half of the loss of this year's one-off revenues. We also plan to reduce HBOR's lending plans by an additional HRK 200 million compared to 2004.

14. Next year, we also intend to start the medium-term process of tax reform. Our government believes that the relatively high tax burden, particularly on capital and labor, acts as a break on Croatia's growth. Given the urgent need to restore order in our public finances, we have postponed the VAT rate reduction initially planned for 2005. But we are considering a number of changes with a view to reducing distortions, improving incentives, broadening the base, and supporting low-income earners, such as eliminating a number of personal income tax exemptions, reducing some tax rates, simplifying the taxation of reinvested profits, and reducing the number of goods subject to zero VAT rate. These or any other tax reforms in 2005 will be revenue-neutral so as not to jeopardize our overall deficit target.

15. Budget financing will gradually shift to domestic sources. This would reduce the government's exposure to exchange rate risk, boost the development of the domestic capital market, and may help absorb excess liquidity in the private sector. We aim at raising at least HRK 2 billion of domestic financing this year (about one-third of the general government's borrowing requirement), and raise this proportion in the coming years. Specifically, we will cancel the issuance of a new Samurai Bond planned for 2004 and postpone the syndicated foreign loan planned by HBOR in the fourth quarter. As regards 2005, we intend to shift the bulk of both central government and HAC and HC borrowing to domestic sources.

16. We will limit the issuance of new government debt guarantees. The outstanding stock of debt guarantees to entities outside the general government (including guarantees issued for HBOR loans) has grown to some HRK 19 billion (almost 10 percent of GDP). We will limit the issuance of new debt guarantees to a level of HRK 2.2 billion in 2004, with a view to keeping the stock of outstanding guarantees broadly constant at its present level during this year and gradually reducing it over the medium term.

17. Finally, we intend to strengthen financial discipline and improve the performance of public enterprises. The recent transactions by HŽ highlight the soft budget constraint under which public enterprises operate. We intend to cover all of HŽ's financing needs for operating and investment expenditures from the budget and finalize by end-December 2004 a medium-term business plan that will return the company on a sound financial footing. We are seeking the assistance of the World Bank in this area. We also intend to continue restructuring the state-owned shipyards, with a view to reducing their reliance on the budget and preparing them for privatization. Finally, we will continue the restructuring efforts in key public enterprises, notably Croatian Forests and the shipping company Jadrolinija, with a view to improving asset management, reducing personnel, and preparing these enterprises for privatization. To ensure that the public enterprise sector as a whole continues to improve its aggregate financial position, we will impose limits on the total borrowing of 8 large public enterprises for 2004 and 2005.

B. Monetary and Exchange Rate Policy

18. The CNB has a secondary but nonetheless important role in reducing external vulnerability. Given the openness of the economy, strong trade links with the euro area, large capital flows, and limited hedging opportunities for kuna holders, the CNB intends to pursue its price stability mandate by continuing to maintain the exchange rate of the kuna broadly stable against the euro. Coupled with the high degree of integration of Croatian banks and corporates with the international capital market, this limits the ability of the CNB to affect the level of economic activity, the current account deficit, and foreign debt.

19. For the remainder of this year, the CNB will pursue its announced monetary policy targets. CNB's monetary program for 2004 targets reserve and broad money growth at about 8-9 percent. Gross official reserves at end-2004 are projected at HRK 47 million (equivalent to 4½ months of following year's imports of goods & nonfactor services or close to 200 percent of following year's maturing external debt), a level that we judge to be adequate for maintaining confidence in our policies. To achieve these targets and signal its commitment to the external objectives of the program, the CNB introduced as of July 1 a new marginal reserve requirement on borrowing from non-residents, to be kept with the CNB, and intends to maintain its Net Domestic Assets (NDA) below the level of HRK -3 billion for the remainder of the year. In the event of higher-than-expected capital inflows (aside from the usual seasonal fluctuations), the CNB will intervene in order to maintain broad exchange rate stability. Should liquidity in the system increase excessively or the balance of payments weaken significantly, the CNB will resume issuing CNB bills during the course of the year in order to meet the reserve targets under the program. In the event that massive private capital inflows threaten to undermine macroeconomic stability, the CNB will consider, in consultation with the IMF, introducing price-based controls on capital movements.

20. By the end of this year, the CNB, in cooperation with the Ministry of Finance, will establish technical prerequisites for the introduction of open market operations.To facilitate the shift towards domestic financing of the government and develop the domestic financial market, we will work on establishing the necessary technical preconditions for the introduction of open market operations with government paper. In particular, the Ministry of Finance will complete the transfer of the Treasury bill registry to the Central Depository Agency by end-July 2004 and ensure that the registry is fully operational; and the CNB intends to begin open market operations by end-2004 and will implement delivery versus payment in real time by end-March 2005 at the latest. Both the CNB and the Ministry of Finance recognize the need for a close coordination on these issues.

C. Structural Reforms

21. Structural reforms are a key part of our program in order both to supplement our macroeconomic policies and to prepare our economy for EU accession. Most of these measures require consistent implementation over time and will only bear fruit in the medium and long term. But they are an important part of our vision for the Croatian economy because they will raise the long-term potential growth rate and prepare the country for competing within the EU. Moreover, some of these measures will facilitate the achievement of our short-term macroeconomic objectives. These reforms are thus a critical part of our program also for 2004-05, and most of them are incorporated in a three-year Programmatic Adjustment Loan (PAL) from the World Bank, expected to be agreed in early 2005.

Public finance reforms

22. There is an urgent need to enhance transparency and efficiency in public expenditure and debt management. The recent fiscal ROSC mission with the IMF and the World Bank-IMF technical assistance mission on public debt management have helped identify the major weaknesses in these areas. During the next 18 months, we intend to:

• make the single treasury account fully operational by eliminating bank accounts of the Deposit Insurance and Bank Rehabilitation Agency (DAB) by end-June 2005, the Privatization Fund (HFP) by end-September 2005 and the Highway and Road funds (HAC and HC) by end-December 2005, as well as introducing commitments-based reporting;
  
  
• prepare an action plan by end-October 2004 to implement the recommendations of the fiscal ROSC report currently under preparation;
  
  
• strengthen public debt management by appointing by end-June this year the Steering Committee that will oversee the implementation of improvement measures; restructuring the Debt Management department by end-September and strengthening staff and training by year-end; enhancing software support by end-August; and, following the recommendations of the IT expert and with support by the EU CARDS program, decide on a permanent software solution for debt management by end-2004;
  
  
• complete by end-2004 the register of government debt guarantees, including guarantees by local governments, and reconcile data with the CNB;

23. We plan to set the annual budgets in the context of a medium-term fiscal policy framework. A detailed, multi-year policy framework, with annual targets for the major expenditure programs and the policies to achieve these, would be the linchpin of our fiscal policy. It would inform public debate, illustrate policy tradeoffs, and allow making strategic choices rationally. It will also allow us to plan our medium-term tax and spending reforms with a view to achieving a substantial reduction in the share of government spending to GDP. Such a framework will also be necessary once negotiations with the EU start. As a first step, the government will prepare rolling three-year budgets starting with the preparation of the 2005 budget.

24. The government is committed to ensuring the long-term sustainability of the pension system. The recent change in the pension indexation formula, on which we will seek a formal interpretation by parliament by July 15, 2004, links pension increases to the change in average real wages in the economy. This will ensure that the share of pension spending to GDP continues to decline in the medium-term. We intend to honor the 1998 Constitutional Court decision on "pensioners' debt" to the extent it has not been covered by subsequent laws. To ensure a solution that is consistent with the country's ability to afford such payments, we have decided to use only state shares in enterprises or other types of equity. We plan to consult with the staff of the IMF and the World Bank before determining the details of this solution and moving to the implementation stage. More generally, we are strongly committed to reviewing all aspects of the pension system and continuing the reform process, in order to maintain its financial sustainability, stimulate private savings, and encourage financial market developments.

Privatization

25. We will restore momentum in the privatization process. Privatization will enhance the economic efficiency and growth potential over the medium term and help reduce foreign debt. The HFP aims at privatizing all companies in which the government holds a share of up to 25 percent by year-end and all remaining holdings in its portfolio by end-June 2005. Outside HFP's portfolio, we will resume efforts to restructure and privatize large state enterprises. In particular, the government will sell at least 15 percent of the oil company (INA) by end-2005 and will formulate the plan on privatization of the insurance company (CO) by end-June 2005 and complete the third phase of privatization of the telecommunication company (HT) by end-December 2005. Finally, the government will disengage from Croatia Banka by end-June 2005 and consider the options for privatization or a strategic partnership for HPB.

Other structural reforms

26. Finally, the government will take steps to improve the business environment, financial sector supervision, and statistics.

• In the context of the World Bank PAL, we will implement reforms in the judiciary (including improving and computerizing the operation of courts, training court personnel, improving the operation of the cadastre and eliminating backlogs in land registration) and in public administration (including reforming the salary scale and introducing performance-related pay).
  
  
• The government intends to unify the supervision of nonbank financial intermediaries. In this context, it will appoint a Working Group by September 2004 to prepare this ambitious reform, and draft new laws on insurance and on investment funds to be adopted by end-2005.
  
  
• The CNB will step up its efforts to supervise banks' credit risk resulting from their borrowers' exposure in foreign exchange.
  
  
• We will make additional efforts to improve balance of payments statistics, where serious deficiencies hamper the analysis of external developments. We intend to request technical assistance from the IMF to help address this urgent problem.

27. Under our program, we will not impose or intensify restrictions on the making of payments and transfers for current international transactions, introduce or modify multiple currency practices, conclude bilateral payments agreements that are inconsistent with Article VIII of the IMF's Articles of Agreement, or impose or intensify import restrictions for balance of payments purposes, nor will we accumulate external payments arrears.

Technical Memorandum of Understanding

I. Limits on the Cumulative Deficits of the Consolidated General Government

1. The above ceilings on the cumulative deficit of the consolidated general government are on a GFS2001 basis (including net lending) and cover: (i) central government operations, that is, the central government budget (the Office of the President, the parliament, the government, the constitutional court, all ministries, other independent state administration and judicial bodies); (ii) existing central budgetary funds (health, pension, employment, and water management) and agencies (the agencies for state aid, for investment and export promotion, and for small and medium-sized enterprises); (iii) the highway (HAC) and road (HC) construction and maintenance agencies, the privatization fund (HFP), the bank rehabilitation and deposit insurance agency (DAB), and the Environment Protection Fund; and (iv) the 53 largest local governments (20 counties, Zagreb, and 32 other cities). The government does not intend to establish new budgetary or extrabudgetary funds or agencies during the program period, but any new funds or agencies would be covered by the ceilings.

2. The September 30, 2004 ceiling above will be adjusted upward by HRK 2,283 million in case the dividend payment by the telephone company (HT) expected in 2004 is not received by September 30, 2004.

3. For purposes of the program, the deficits of the consolidated central and general governments will be defined on a modified accrual basis with cash data corrected for changes in outstanding stock of central and local government arrears and commitment based spending reported for HAC and HC.

4. Fiscal performance will be monitored monthly at the consolidated central government level covering (i)-(iii) defined above and tested quarterly at the consolidated general government level covering (i)-(iv) defined above with the test dates for 2004 being September 30 and December 31. The Ministry of Finance will provide data for consolidated central government on a monthly basis within 30 days from the end of the month and data for local governments every 3 months within 30 days from the end of the month.

II. Limits on the Cumulative Changes of the Stock of general Government Arrears

5. Arrears include (i) all payments overdue according to their original or modified terms; and (ii) any promissory notes issued by the Ministry of Finance and the central budgetary funds. Arrears comprise both domestic and external payments arrears and are not netted out by government cash holdings in banks. The stock of arrears will be provided monthly to the Fund by the Ministry of Finance within 30 days. Arrears monitored under the SBA are limited to arrears extended by the general government to all entities outside the general government. In case the general government assumes responsibility for arrears extended by entities outside the general government (e.g., hospitals), such arrears will be treated as expenditures of the general government at the time they are taken over by the government.

III. Limits on the Cumulative Deficits of HBOR

6. The above ceilings on the cumulative deficit of HBOR are on a GFS1986 basis with revenues comprising interest receipts, fees, and other lending-related revenues, and expenses comprising wages, use of goods and services, interest payments, net lending, and capital spending. The ceilings are adjusted downward for central government transfers.

7. Fiscal performance by HBOR will be monitored on a monthly basis and tested on a quarterly basis with September 30 and December 31 being the test dates for 2004. HBOR will provide data on a monthly basis within 30 days of the end of the month.

IV. Ceilings on the Contracting of Nonconcessional External Debt by the General Government and HBOR

8. For program purposes, the term "debt" is understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services at some future points in time; these payments will discharge the principal and/or interest liabilities under the contract. (For details of definition of debt, refer to "Guidelines on Performance Criteria with respect to External Debt in Fund Arrangements" (IMF Executive Board Decision No. 12278—[00/86], August 25, 2000).

9. The limits on short-term debt do not apply to normal import-related credits and nonresident deposits in state-owned banks (HPB, HBOR).

10. Concessional loans are defined as those with a grant element of at least 35 percent, using currency-specific discount rates based on the six-month average commercial interest rates reported by the OECD (CIRRs) for loans with maturities of less than 15 years, and on the 10-year average CIRRs for loans with maturities of 15 years and more.

11. The ceilings will be raised by the amount by which the government retires existing debt before its scheduled maturity.

12. Debt falling within the limits shall be valued in euro at the following exchange rates (in euro per unit of foreign currency) at the end of the quarter in question:

13. Information on the contracting of new debt falling both inside and outside the limits will be reported monthly to the Fund within 30 days by the CNB.

V. Limits on the Cumulative issuance of debt guarantees extended by the General Government

14. Cumulative issuance of debt guarantees listed above will be measured at the exchange rates listed in Section IV. The above limits cover debt guarantees issued by the general government to entities outside the general government as well as guarantees extended for HBOR's lending to entities outside the general government. The limits do not cover guarantees extended to HBOR's borrowing from entities outside the general government. In case some of these loans are dropped from guarantee register because the government takes over the liability, the ceilings will be adjusted downward by the amount of amortization due to these loans from the time of debt assumption to the end of the year.

15. Guarantee issuance will be monitored on a monthly basis and the Ministry of Finance will provide data within 30 days from the end of the month. Performance will be tested on a quarterly basis and in 2004 with September 30 and December 31 as test dates.

VI. Indicative Limits on the Net Borrowing of Selected Public Enterprises

The above listed indicative aggregate limits cover the following 8 enterprises:

1. Hrvatska Elektropriveda, Zagreb (Croatian Electricity Company)

2. Hrvatske Željeznice, Zagreb (Croatian Railroads)

3. Hrvatske Šume, Zagreb (Croatian Forests)

4. HP, Zagreb (Croatian Post)

5. HRT, Zagreb (Radio and Television Company)

6. Jadrolinija, Rijeka (Shipping Line)

7. Croatia Osiguranje, Zagreb (Insurance Company)

8. Croatia Airlines, Zagreb

16. These cumulative flows do not include transfers or net lending by the general government or amortization of debt of these enterprises taken over by the general government and included in the budget; they include borrowing by HBOR.

17. Enterprises on the above list in which the government's share falls below 50 percent in the course of the arrangement will be removed from the limits and the limits will be adjusted downward by the amount of the net borrowing of these enterprises by the end of the month preceding privatization. The limits will be adjusted by the amount of any government assumption of their debts.

18. The above indicative limits will be cumulative and will be monitored on the basis of the average quarterly exchange rates (as listed in Section IV) from data collected monthly by the Ministry of Finance (ORESE) and supplied to the Fund within 30 days.

VII. Floors under the Cumulative Changes in the Net International Reserves of the Croatian National Bank

	Floors (In millions of euro)
Stock as of December 31, 2003	6,188
Cumulative changes from December 31, 2003: September 30, 2004 December 31, 2004	12 -138

19. For purposes of the program, net international reserves of the Croatian National Bank (CNB) are defined as the euro value of gross foreign assets minus gross foreign liabilities minus off-balance sheet foreign currency obligations.

20. For purposes of the program, gross foreign assets shall be defined as monetary gold, holdings of SDRs, any reserve position in the IMF, and holdings of foreign exchange in convertible currencies by the CNB. Any return to the CNB of blocked foreign assets that are not part of CNB foreign assets as of December 31, 2003 will be added to the reserve floor. Reserves that are pledged, frozen or used as collateral shall be excluded from the gross foreign assets. In particular, any reserve assets pledged to secure government debt will be excluded from the reserves definition.

21. For purposes of the program, reserve liabilities shall be defined as all liabilities of the CNB to non-residents—excluding deposits into the special accounts for external debt servicing—with an original maturity of up to and including one year, as well as liabilities arising from IMF purchases and bridge loans from the BIS, irrespective of their maturity. For purposes of the program, reserve liabilities shall also include guarantees provided by the CNB backed by reserves as collateral.

22. The net forward position of the CNB is defined as the difference between the face value of foreign currency-denominated CNB off-balance sheet claims on nonresidents (forwards, swaps, options, and futures market contracts) and foreign currency obligations to both residents and nonresidents. This position was zero on December 31, 2003. For program purposes, only the off-balance sheet obligations will be deducted from the CNB's net international reserves position. These liabilities amounted to zero on December 31, 2003.

23. For the purpose of program monitoring, the stock of reserve assets and liabilities for each quarter in question will be valued in euro at the exchange rates specified in Section IV.

24. For purposes of the program, the end-of-quarter net international reserves of the CNB are calculated as the arithmetic average of 11 observations centered on the last business day of each quarter.

25. The limits will be monitored from data on the accounts of the CNB supplied monthly to the Fund by the CNB within 15 days of the last business day included in the observations.

VIII. Limits on the Cumulative Changes in the Net Domestic Assets of the Croatian National Bank

26. The net domestic assets of the Croatian National Bank (CNB) are defined as the difference between the base money and the net international reserves of the CNB (as defined for program purposes in Section VII), both expressed in local currency at program exchange rates (see Section IV). Base money is defined as currency outside banks, vault cash of banks, giro and required reserve deposit of banks in domestic currency, deposit money, required reserve deposit of banks in foreign currency, restricted deposits, and escrow deposits held at the CNB.

27. The September 30, 2004 ceiling above will be adjusted upward by HRK 2,283 million in case the dividend payment by the telephone company (HT) expected in 2004 is not received by September 30, 2004.

28. If reserve requirement ratio and/or the definition of liabilities subject to reserve requirements is changed during the program period, the CNB will consult with the Fund to modify the above limits appropriately.

29. For purposes of the program, the net domestic assets of the CNB and the base money at the end of each quarter will be calculated as the arithmetic average of 11 observations centered on the last business day of the quarter.