IMF Executive Board Concludes 2019 Article IV Consultation with the Republic of Croatia
February 19, 2020
On February 14, 2020, The Executive Board of the International Monetary Fund (IMF) concluded the 2019 Article IV consultation [1] with the Republic of Croatia, and considered and endorsed the staff appraisal without a meeting. [2]In 2019, Croatia experienced its fifth consecutive year of solid economic growth, once again driven largely by private consumption and tourism. Employment gains have been robust, wages have continued to rise, while import prices have helped to keep inflation muted. Increased absorption of EU funds is likely to raise public investment in the coming years. In conjunction with continued strong consumption, the current account surplus is expected to decline, and turn into a moderate deficit, while economic growth moderates. Both public and external indebtedness are expected to continue their declining trajectories.
The pace of fiscal consolidation in 2019 continued to slow, with the budget estimated to be close to balance. Recently agreed wage increases in the public sector are expected to increase current spending in 2020. Even though revenues will remain buoyed by economic activity, the budget balance is expected to turn into a small deficit in 2020, in part due to additional tax cuts. Contingent liabilities could also pressure budget balances in the coming years.
Monetary policy remains appropriately accommodative within the limits of the exchange rate anchor. Excess liquidity in the banking system continues to rise, and interest rates remain low. Bank lending to households has continued to grow. The Croatian National Bank (CNB) has issued recommendations to banks to be more cautious with long-term uncollateralized consumer lending. The banking system, on the whole, remains well capitalized and liquid, and the NPL ratio continues to decline. The CNB continues to utilize the current conditions to build reserves.
Croatia is currently targeting ERM II entry in mid-2020, and eventually the Euro Area.
Executive Board Assessment
The Croatian economy has performed well, but convergence with the EU needs to accelerate. The Croatian economy has become stronger over the last five years. This is significantly because of strong budget management and skillful policies by the Central Bank. As a result, public debt has fallen along with interest rates, creating room for a robust consumption-led private sector expansion. Strong tourism has helped the external accounts. Unemployment is down, wages are growing, and inflation remains subdued. Yet, Croatia has barely reduced its distance with the EU average in terms of income per capita in the last decade, and emigration of the young continues to pose challenges. The external position of Croatia is broadly consistent with fundamentals and desirable policy settings.
Hard-won fiscal gains are fragile and should be carefully preserved . While public debt ratios continue to decline due to buoyant activity, fiscal performance has recently become encumbered by numerous spending demands. For this reason, staff supports the government’s decision to withhold the planned reduction in the overall VAT rate. Indeed, staff would recommend holding back on any other tax reductions at this stage, as they could reignite deficits and undermine recent gains.
A more dynamic state is vital for future economic prospects. The budget is currently too rigid and losing its capacity to spark economic growth. Staff recommends shifting spending priorities towards more and better public investment. Better absorption of EU funds could ease this shift in priorities but cannot substitute for deeper reforms to the cost structure of public administration, pensions and healthcare systems, and the fiscal and territorial relationships between different levels of government. State-owned enterprise management and performance needs more modernization, so that enterprises in core areas do more to support the productivity of the economy. Accelerating the digitalization of public administration and using technological improvements to better target social-benefits would also help make the state more dynamic.
Renovating the capital stock and enhancing the business climate will help raise potential growth. Recent improvements in streamlining the administrative and fiscal burdens on the business sector are welcome. Staff encourages further progress in the areas of enhancing digital public services and adapting legislation to facilitate Croatia’s integration in the EU’s Digital Single Market. Barriers to regulated professions and remaining parafiscal fees should be eliminated. Yet, business activity will not thrive unless the capital stock is renovated. Croatia needs to focus on areas where its “hard” physical infrastructure needs improvement (e.g., railways for freight purposes, solid, and waste water treatment), while also upgrading its “soft” technological infrastructure to position itself attractively in the next generation of European value chains and broaden its economic base in the areas of ICT and business services. Education policies in the primary, secondary, tertiary, and continuing areas need to work hand-in-glove with these changes.
Macroprudential action warrants constant consideration to prevent excessive lending. 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 prevent potential future problems. 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 real estate prices accelerate, or there is a migration to other forms of household lending, stronger supervisory responses merit close consideration. The credit register needs to become fully operational again to prevent a build-up of systemic risk. Consideration should be given to include all debt in an extended debt-service-to-income ratio. Enhancements to the efficiency of bankruptcy procedures (e.g., by facilitating out-of-court settlements) would help further private sector deleveraging.
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Croatia: Selected Economic Indicators |
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[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] The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.
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