Mission Concluding Statement 

Republic of Croatia: Staff Concluding Statement of the 2019 Article IV Mission

December 16, 2019

Croatia has come a long way over the last five years. Growth is strong, inflation is subdued, and unemployment has been significantly reduced. Public debt is steadily declining and external reserves are healthy. As long as the authorities maintain prudent policies and global conditions remain supportive, this picture is likely to continue next year. Looking further ahead, Croatia must rise to the significant challenge of successfully deepening integration with Europe—including through future Euro adoption—during a period of rapid technological change. Prudent investment is needed to catch up with other countries that have made greater progress. Yet, this requires reforms for which strong support across the population is essential.

The skies have brightened

Following a protracted and painful recession, the last five years have seen the Croatian economy become stronger and healthier. Some of this can be attributed to “good fortune”, that is to say favorable global conditions, helping a tourism boom. However, a significant share is due to good policies—strong budget management and skillful policies by the Central Bank. Therefore, public debt has fallen along with interest rates, creating room for a robust consumption-led private sector expansion. Yet, clouds are appearing on the global horizon once again. Whether they will intensify is still unknown. It is important to prepare for the future, mindful of what weather could come.

What is missing?

The economic expansion needs to be felt more broadly across the population. The share of the workforce between the ages of 20 and 64 that is employed is only slightly above 60 percent. And the share of the population at risk of poverty and social exclusion is estimated at 25 percent. The country’s most vital resource—its youth—remain concerned about their long-term prospects. This has spurred emigration and a hollowing out of the internal regions of the country. In the short-term, the obvious symptom has been labor shortages in areas like construction and tourism. However, the more insidious problems are those of “brain drain”, and challenges to the sustainability of pension and healthcare systems. So, there is clearly scope for even better performance.

According to current official figures, the income per person of Croatia stands at 63 percent of the EU average. This gap cannot be bridged by policies that keep pushing public consumption at the expense of public investment needed for higher productivity. Higher wages must be supported by higher productivity that grows the economy. Otherwise, just to keep today’s standard of living will require ever increasing amounts of debt, erasing the gains that have just been won. There are three steps to durably raising living standards:

• Maintaining macroeconomic and financial stability.

• Making the state a source of greater dynamism through reforms.

• Investing resources wisely to raise productivity.

Considerable success has been attained with the first step and needs to be carefully preserved. However, without more significant progress on the second step, the right climate and needed resources for the third step will prove difficult to realize.

Maintaining macroeconomic and financial stability—fiscal and monetary policies

In the near-term, if the global clouds do indeed intensify, the authorities are advised to first allow the existing tax and transfer system to play their roles as “automatic stabilizers”. It is only if the global weather proves itself to be unusually inclement for a long period, should further tax cuts or higher spending be considered.

Over the medium-term taxation, spending, and government incomes policies need to be set such that budgets are in structural balance—in short, feed the horse well, and avoid spurring it too hard. With growth at or near its current potential, excessive short-term stimulus would risk destabilizing the economy. The focus today should be on generating growth through reforms and medium-term investments.

For this reason, the IMF supports the government’s decision to withhold the reduction in the overall VAT rate from 25 to 24 percent, given recent demands for higher wages. Indeed, we would recommend holding back on any other tax reductions at this stage, as they could return the fiscal balances to deficits, and undermine the reduction in public debt which is still elevated. For the same reason, we also strongly urge restraint with regard to any further wage demands, until a thoroughly analytically researched new public sector wage grid and coefficients are developed. This new system should reward talent and productivity in the public sector along with a simultaneous optimization of staffing levels.

Monetary policy remains appropriately accommodative, given the exchange rate anchor that has served Croatia well for the last 25 years. Bank lending to the private sector—primarily to households—is strong. House prices are picking up in the capital and coastal areas. Although there is little immediate cause for concern, it is important to ensure that these developments do not germinate future problems. The housing markets need continuous close monitoring to guard against too much household borrowing which could be particularly damaging for lower-and middle-income households.

The banking system, taken as a whole, remains profitable, liquid, and well-capitalized. However, the current low interest rate environment and lingering uncertainties related to legacy Swiss Franc housing loans could pose new challenges:

• Reforms to the framework of debt restructuring, insolvency, and efforts to improve predictability and efficiency in court procedures are very important. Intensified efforts in these areas will enhance needed trust in contracts, so that borrowers and lenders can interact smoothly to raise private investment.
• The credit register has stopped fully operating, and this is not advisable in a time of strong consumer lending growth. The underlying causes that impede its complete restoration should be quickly addressed to prevent a build-up of systemic risk.
• Recent recommendations by the CNB for banks to be more careful with longer-term uncollateralized consumer lending seem to be having the desired effects. If there is a migration to other forms of household lending, similar supervisory responses warrant close consideration.

Implementing reforms to make the state a source of greater dynamism

For the coming decade, Croatia needs to strive for sufficiently challenging economic targets, to be a vital partner of the EU. Otherwise, the existing economic gap between Croatia and the rest of Europe is more likely to widen, rather than narrow. If, for example, Croatia were to aspire to bridge 15 percentage points of the current average per person income gap with the EU by 2030, the economy would need to grow at 1.5 percentage points more rapidly than the EU average, over this period. To maintain such higher relative growth rates, in addition to higher private investment, Croatia needs to raise its public sector investment as well—both in quantity and quality.

Increases in public investments are consistent with continued debt reduction, and do not call for any austerity measures. Yet, they do require strong public sector reforms and a shift of some share of current spending to capital spending. Over the last decade, whether compared to the EU, or to other emerging economies, the balance of public spending in Croatia has tilted considerably toward spending on items like non-investment goods and services, subsidies, compensation of employees, and other social benefits, and away from public investment. This has reduced the flexibility of the budget and its capacity to spark economic growth.

It is now time to implement the following key reforms to generate the needed resources for additional public investment:

• In conjunction with a meritocratic system for public sector wages, public employment levels need to match the economy’s needs. Active employment policies to facilitate smooth transfers of public sector workers with suitable skills to the private sector will be effective now, when the economy as a whole is doing relatively well.
• State-owned enterprise management and performance needs to continue on the path of more modernization, so that enterprises in core areas support the productivity of the economy. It is noteworthy that this year they will meet or exceed the initial target of 0.4 percent of GDP contribution to the budget. Further increases should be targeted and persistently achieved.
• The social benefits system should be optimized through better targeting of benefits to those who are most vulnerable and in need. Continuing improvements in Information Technology (IT) systems, and better coordination across levels of government are the keys to achieving this. The government should also continue social dialogue to come up with measures that mitigate the effects of the recent roll-back of pension reforms. Young people are leaving the country and those who remain are going to continue to live longer and more productive lives. Unless migration flows reverse, retirement incentives must eventually align with this reality.
• Improving the territorial organization of local governments would significantly improve their capacity to invest and deliver uniform high-quality public services.

It is for these reforms that broad public understanding and support is highly essential. They will enable savings in current spending that can be redeployed to capital spending, without the need to raise taxes, or cut the overall level of government spending. These adjustments, if properly executed and implemented, will repay the Croatian people handsome returns in the future. We estimate that if around 4 percent of overall government revenues were gradually and efficiently reallocated to smart investments, the Croatian economic growth rate can be raised sufficiently as to bridge a significant portion of the gap with the EU over the next decade.

Investing wisely in the future

In which areas does Croatia need to invest to deliver higher future living standards? In terms of transportation infrastructure, the country already has a good network of roads. Investment in ports on the coast are also underway. However, to make these ports fully productive, investment in railways—particularly for freight purposes—also needs to occur. Investments in both solid waste and waste-water treatment are also high priority areas. Such investments are by no means straightforward and need to be delivered carefully with high-quality, and cost-effectively. In turn, the public investment assessment and management capacities need to improve at all levels of government. If requested, the IMF stands ready to provide Croatia technical assistance in these areas.

Aside of “physical” infrastructure, Croatia also needs to upgrade its technological infrastructure. The overall strategy and responsibility for digitalization of the country would benefit from having a single independent entity with a long-term perspective. Although connectivity with regard to existing fixed broadband and mobile technologies is good, Croatia significantly lags behind advanced European peers and many other New Member States when it comes to leading edge fast and ultra-fast digital technology. At a time of historic technological change, any country that gets left behind will find it far more difficult to catch up later. Furthermore, even though connectivity with regard to currently “mainstream” technologies is good, the degree to which households are taking them up remains relatively slow, as is the integration of these technologies by businesses. Croatia has made some progress in the availability of digital public services for individual citizens. More progress is needed when it comes to the availability and use of digital services for businesses. The recently launched “START” initiative which allows for simple electronic procedures to start a business is a welcome development in this regard.

Upgrading and enhancing the availability of the latest technologies will not deliver results, unless the skills of the people adapt to make good use of them. Here, Croatian progress is uneven in two respects:

• First, although the country does relatively well with respect to European peers in terms of the share of university graduates with engineering and technology skills, the ability of these graduates to find competitive employment within the country is still limited. There are some promising signs emerging in the area of Information and Communication Technologies (ICT) and business services exports. “Near-shoring” in manufacturing that is enabled by better technology and more capital-intensive factories represents a good opportunity for Croatia to integrate itself in the next generation of European value chains. Croatia needs to produce an even greater talent pool of university graduates in these fields than larger countries, to successfully position itself as a hub for these areas.
• Second, on a broader level, despite having one of the lowest pupil-to-teacher ratios in Europe, Croatia is stagnating in terms of natural science, mathematics, and problem-solving skills by most established measures at the primary and secondary education levels. So, the problem does not necessarily lie with the level of expenditure on education, or the number of teachers, but with whether these levels of expenditures are delivering the much-needed results. Vocational and technical training of pre-high school graduates through apprenticeship programs are a good step towards enhancing the efficiency of secondary education.

Conclusion

Croatia is deepening its integration with Europe at a time when technology is also evolving rapidly. It is important to consider the valuable opportunities and great challenges that lie ahead, with a long-term vision. The ERM-II process currently underway sets the stage, at the appropriate time, for euro adoption. These changes will ease some of the current economic and financial frictions that EU membership alone cannot remove. Yet, the long-term future of the country still very much lies at home. It is in the hands of the Croatian people to help make the country more dynamic today, for a better tomorrow.

The mission would like to thank the authorities and all interlocutors for the constructive dialogue and kind hospitality.