Press Release No. 16/309

IMF Executive Board Concludes the 2016 Article IV Consultation with the Republic of Croatia

June 28, 2016

On June 22, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with the Republic of Croatia.

Croatia has been gradually recovering from a six year recession, mostly on the back of strong exports, tourism activity, and private consumption. These factors, as well as better absorption of EU structural and investment funds are expected to give a further moderate boost to economic growth in 2016. However, GDP remains well below its pre-crisis level and unemployment is very high. Inflation was negative over the past two years, mainly due to lower energy and food prices. The current account surplus increased significantly in 2015, but almost half of this increase was due to a one-off decline in profits of foreign-owned banks related to the conversion of Swiss franc loans. Vulnerabilities remain high due to elevated public and external debt levels.

The 2015 general government deficit was substantially smaller than anticipated. This was due to a cyclical upturn in revenue, under-execution of public enterprise investment in the fourth quarter during the care-taker government, and some consolidation efforts. A further reduction in the deficit is targeted in 2016, reflecting a combination of a cyclical revenue upturn and across-the-board freeze of expenditure, excluding items that are funded by the EU.

Monetary policy has remained relatively accommodative within the limitations of the quasi-peg, which does not have a viable alternative at this juncture given the high degree of euroization. The Central Bank has continued to reduce its key policy rates and ensure ample liquidity in the banking system. Bank lending, nevertheless, has contracted further, as enterprises and particular households continued to deleverage.

The banking sector has remained stable and, on average, liquid and well-capitalized. The system remained profitable during the recession, with the exception of 2015 due to losses from the Swiss franc loan conversion. The non-performing loan ratio seems to have stabilized, albeit at a still high level. In 2015, one small, but regionally important, bank began the resolution process in accordance with the EU Bank Recovery and Resolution Directive.

Although some modest structural reforms have been implemented in recent years, Croatia is still lagging most EU countries, when comparing standard business environment indicators.

Executive Board Assessment²

Executive Directors welcomed Croatia’s ongoing economic recovery and the reduction of the fiscal deficit in 2015. Nonetheless, important challenges remain, including high public and external debts and elevated unemployment. Directors emphasized that decisive and timely implementation of the new National Reform Program will be crucial to further reduce vulnerabilities and boost growth and job creation.

Directors encouraged the authorities to continue fiscal consolidation in a more growth-friendly manner. They suggested avoiding reliance on across-the-board expenditure cuts and focusing on durable and targeted measures. They welcomed the plan to simplify the tax system, but stressed that any tax reduction should be implemented after making progress on fiscal consolidation. Directors supported plans to introduce a modern real estate tax, implement pension reforms, streamline social benefits, improve the efficiency of the healthcare system, and make part of civil servants’ compensation performance-based. Directors encouraged the authorities to increase the absorption of EU structural and investment funds to mitigate any adverse effect of fiscal consolidation on growth.

Directors agreed that monetary policy is appropriately accommodative within the limitations of the quasi-peg exchange regime, which remains an adequate monetary anchor at this juncture in the context of euroization. They called for continued efforts to achieve gradual de-euroization and to safeguard financial stability until the euro can be adopted. Directors encouraged the Croatian National Bank (CNB) to smooth any sharp fluctuations in the foreign exchange market and look for opportunities to boost reserves. Directors underlined the importance of preserving the central bank’s independence.

Directors commended the CNB for maintaining banking system stability and stressed the need for continued supervisory vigilance. They recommended additional efforts to clear impaired bank assets to improve credit creation. Directors noted that across-the-board bailouts similar to the conversion of the Swiss franc loans in 2015 should be avoided in the future, as they increase the risk of moral hazard and could adversely affect investor confidence.

Directors urged the authorities to accelerate structural reforms to boost growth and employment creation and facilitate income convergence with the EU. They highlighted the need to advance privatization and enhance the efficiency of the public sector, while removing bureaucratic impediments to doing business. In this regard, they underscored the need to reduce red tape and streamline overlapping layers of government and public agencies. Other priorities include further enhancing labor market flexibility to increase labor participation. Directors noted the importance of building political consensus to ensure broad support for the reforms.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

² At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of the Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summing ups can be found here: https://www.imf.org/external/np/sec/misc/qualifiers.htm