Press Release No. 03/13

Press Release: IMF Approves 14-month, US$146 Million Stand-By Credit for Croatia

February 3, 2003

The Executive Board of the International Monetary Fund (IMF) today approved the Republic of Croatia's request for a 14-month stand-by credit for SDR 105.9 million (about US$146 million) to support the country's economic and financial program through April 2004. The authorities intend to treat the arrangement as precautionary and are not planning to draw funds under the credit.

Following the Executive Board discussion, Anne Krueger, First Deputy Managing Director and Acting Chair, said:

"The Croatian authorities are to be commended for adopting an economic program for 2003 that aims at further fiscal consolidation and structural reform, with emphasis on stabilizing the public debt ratio, increasing labor market flexibility, and stepping up progress in privatization. The program begins to lay the foundation for fiscal sustainability and sustained high economic growth rates, but will need to be followed up in future years with continued fiscal adjustment and structural reform.

"To stabilize the public debt ratio after many years of uninterrupted increases, it is important for the authorities to reduce the fiscal deficit and prevent an increase in government debt guarantees. Privatization receipts, which are conservatively projected, are also expected to contribute to stabilizing the debt ratio. The planned fiscal deficit reduction depends crucially on the implementation of the adopted wage policy and on plans to reduce employment in the defense sector. Firm implementation of these policies would help avoid cutbacks in the investment program. The new criteria for extending government debt guarantees should be applied strictly in 2003 to prevent an increase in such obligations. The authorities' privatization plans will help ensure that net borrowing does not exceed the budgeted level.

"Fiscal consolidation and the budget's increased reliance on domestic borrowing should help stem exchange rate appreciation pressure and coincides well with the investment needs of the new private pension funds and the development needs of the domestic capital market. While exchange rate stability has served the economy well, the central bank should allow greater exchange rate flexibility to reduce incentives for unhedged foreign exchange exposure and one-way bets.

"Notwithstanding the expected slowdown in monetary expansion in the wake of last year's euro conversion, credit to the private sector continues to grow rapidly. The central bank needs to continue to supervise closely the banking system to ensure that banks' lending decisions remain sound.

"The structural measures to be adopted under the program are intended to increase competitiveness, employment, and growth in the medium term. Most important in this context are the measures to improve the functioning of factor and product markets by aligning them with best practices in the European Union," Ms. Krueger said.

ANNEX

Recent Economic Developments

Following two years of steady economic growth, buoyant domestic demand continues to bolster economic activity. After 3.8 percent in 2001, real GDP accelerated to 5.0 percent in the first nine months of 2002, underpinned by strong household consumption and business and government investment. Despite an expected deceleration in consumption and investment in the last quarter, staff projects growth to have exceeded 4 percent in 2002.

Strong exports of services and private transfers have helped restrain the current account deficit, despite a disappointing merchandise trade performance due to a weak external environment and lack of structural change. The tourist season was good enough to offset a strong increase in imports. As a result, the current account deficit is likely to narrow to 3.6 percent of GDP in 2002 from 3.8 percent in 2001.

Inflationary pressures remain subdued with headline inflation on average likely having fallen to 2.2 percent in 2002 from 4.9 percent in 2001. While monetary expansion is slowing, credit to the private sector continues to expand rapidly. The currency has been broadly stable and the Croatian National Bank (CNB) has intervened mostly to stop its appreciation. Liquidity in the banking system remains high, and money market interest rates currently hover around 1.5 percent.

Further progress has been made on fiscal consolidation and, notwithstanding stepped-up highway and housing construction, the general government deficit is expected to have declined to 6.2 percent of GDP in 2002 from 6.8 percent in 2001. Despite the reduction of the deficit, however, general government debt is projected to have risen to 57.5 percent of GDP at end-2002 from 55 percent at end-2001, mainly due to the extension of government guarantees.

Program Summary

The aim of the new program is to make progress toward long-term fiscal sustainability and strengthen the prospects for sustained high rates of growth. The authorities view their program as a continuation of their medium-term efforts at fiscal consolidation and structural reform in a difficult pre-electoral period. In view of the strong external position, the authorities do not need the support of the IMF's financial resources, but are convinced that the discipline of an IMF-supported program and the increased financial market confidence that would accompany it would help them achieve their objectives.

Notwithstanding some fiscal withdrawal, the program seeks economic growth of some 4.5 percent resulting from an improvement in external conditions, confidence effects, and the cumulative impact of structural reforms. The principal contribution would come from net exports and private domestic demand. Most of the impulse provided by the major highway construction program will occur in the first half of 2003.

Inflation is targeted to remain below 3.5 percent. In line with its primary policy objective of price stability, the CNB stands ready to tighten monetary policy if the inflation objective is threatened. It intends to keep the reserve cover at over 5 months of imports. The conduct of monetary policy under the program will be greatly facilitated by fiscal adjustment, reduced government reliance on foreign borrowing, and the new foreign exchange law.

The principal aim of the 2003 fiscal program is to stabilize the general government debt ratio. To this end, the 2003 budget envisages a further reduction of the general government deficit to 5 percent of GDP in 2003 from an expected 6.2 percent of GDP in 2002. With a conservatively estimated amount of privatization receipts and no further increase in government guarantees, a deficit of this size would stabilize the debt ratio at its estimated end-2002 level of 57.5 percent of GDP. Given the impact on the 2003 budget of exceptional factors—notably the highway construction program, which accounts for a net deficit of 1.9 percent of GDP—and the revenue loss from introducing the second pension pillar, which is expected to reach 1.3 percent of GDP, a fiscal deficit of 5 percent of GDP is an ambitious target. As the revenue ratio is budgeted to decline, the deficit reduction would be achieved by an even larger reduction of the expenditure ratio.

To achieve its fiscal adjustment objectives, the program relies heavily on a tight wage policy in the government sector. This is to be achieved through a general wage freeze and the implementation of the recently adopted defense sector reform legislation, which envisages a reduction of employment by 12,000 in the first nine months of 2003. Nominal reductions of some other bonuses and allowances for central government workers would also help contain the total wage bill. Under the program, deficit financing relies less on privatization and foreign borrowing and more on domestic financing than in the past. In contrast to the past and the government's original borrowing plans for 2003, net borrowing, equivalent to 3.8 percent of GDP, will rely mainly on the domestic capital market. This borrowing is to be carefully coordinated with the CNB, whose monetary program envisages bank financing for the government of 1.3 percent of GDP.

Structural reforms will be a crucial element of the program because of their importance for sustainable high growth. In the fiscal area, the authorities fully recognize the need to improve fiscal transparency and strengthen debt management. In the financial sector, they are further strengthening the legislative framework with a new foreign exchange law, bylaws to implement a new banking law, and a new regulation to calculate the net open foreign exchange position of banks for prudential purposes. Further, the government is determined to accelerate privatization and restructuring of the oil (INA) and power (HEP) companies and of the companies owned by the privatization fund, the deposit insurance agency, and the pension fund. It submitted to parliament a labor law aimed at making the labor market more flexible. Finally, it is preparing new company, competition, and bankruptcy laws, and will begin implementing judicial reform.

The Republic of Croatia joined the IMF on December 14, 1992, and its quota¹ is SDR 365.1 million (about US$503 million). Croatia has no outstanding use of IMF financing.