Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

Dear Mr. Köhler:

1. We have reviewed with the Fund staff the implementation of our economic program for 2003 that is supported by a 14-month stand-by arrangement in an amount of SDR 105.88 million (29 percent of quota). This review has shown that our program remains largely on track and that its main objective—the stabilization of the general government debt ratio—is likely to be met with the continued implementation of prudent economic and financial policies. Nevertheless, we have found it necessary to make certain policy adjustments to begin to reverse an unexpected deterioration in the external current account in late 2002 and early 2003.

2. The attached Supplementary Memorandum of Economic and Financial Policies (SMEFP) for 2003 (i) reports on program implementation to date and on the measures we intend to implement in the remainder of this year in pursuit of our program objectives and (ii) proposes the quantitative performance criteria and structural benchmarks for September 30, 2003 and December 31, 2003. The SMEFP supplements the Memorandum of Economic and Financial Policies (MEFP) that is attached to our letter to you of December 27, 2002 and that continues to represent our policy undertakings in all respects not specifically addressed in the SMEFP.

3. On the basis of our performance under the program so far and the policies described in the SMEFP, we request (i) completion of the first review under the stand-by arrangement, (ii) a waiver of the nonobservance of the March 31, 2003 structural performance criterion on the adoption of criteria for issuing government guarantees, and (iii) waivers of applicability in respect of the June 30, 2003 quantitative performance criteria for which data will not be available by the time of the Executive Board meeting scheduled for August 1, 2003. We are confident that all end-June quantitative performance criteria will be met.

4. We believe that the policies described in the attached SMEFP are adequate to achieve the objectives of our economic program, but we stand ready to take any further measures to keep our program on track. We will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations. The second program review, scheduled for mid-November 2003, will provide one such opportunity to assess progress with program implementation and reach understandings on any measures that may be needed to achieve the program's objectives. In addition, there will be a third review of program implementation, scheduled to take place in mid-February 2004.

5. We would like to reaffirm our intention not to make the purchases that will become available under the arrangement with the completion of the present review and after completion of the second and third reviews and observance of the performance criteria for September 30 and December 31, 2003.

Sincerely yours,

/s/ Slavko Linić Deputy Prime Minister

/s/ Mato Crkvenac Minister of Finance

/s/ Željko Rohatinski Governor Croatian National Bank

Supplementary Memorandum of Economic and Financial Policies

1. The main objectives of our economic program for 2003, as described in the Memorandum of Economic and Financial Policies attached to our letter of December 27, 2002 to the Managing Director of the International Monetary Fund, remain unchanged. There is mounting evidence that our strategy of seeking higher employment and standards of living through fiscal consolidation, price stability, and structural reforms is bearing fruit: per capita income is expected to exceed US$ 6,000 in 2003 compared with US$ 4,371 in 1999, while employment is likely to show growth of some 5 percent over the same period.

I. Recent Economic Developments and Near-Term Outlook

2. The prospects for achieving our economic growth objective of 4.2 percent for 2003 remain good (Table 1). A surge of domestic demand in the second half of 2002 boosted real GDP growth to 5.2 percent in 2002. Investment (both public and private) and private consumption experienced high growth while public consumption was reduced again in accordance with our medium-term fiscal consolidation program. Reflecting the burgeoning domestic demand, the foreign contribution to GDP growth became strongly negative as imports surged while export growth remained subdued (despite a good tourist season) in the face of near stagnation in our principal export markets. The growth of industrial output by 5.6 percent during January-April 2003, an acceleration of exports in the early months, and an increased share of capital goods imports all give us confidence that real GDP growth will reach 4.2 percent this year. While private consumption is expected to slow down and public consumption will once more contract, both private and public fixed capital formation are likely to maintain their momentum. Higher exports and an expected deceleration of import growth will sharply reduce the drag from net foreign demand.

3. Retail price inflation is likely to remain well below the 3 percent program objective in 2003. After declining to 2.2 percent in 2002, its twelve-month rate of increase fell to 0.9 percent in April 2003. At the same time, the core rate of retail price inflation reached 0.1 percent. We do, however, expect a slight increase in inflation during the remainder of 2003. Producer price inflation has been rising for almost one year and stood at 2.8 percent in April 2003, suggesting that retail price inflation has reached bottom and is about to edge up, reflecting comparatively lower productivity growth in the nontradable sector in the context of broad exchange rate stability. As a result, we expect retail prices to increase by some 2 1/4 percent in 2003.

4. We hope to reduce the external current account deficit to 5.5 percent of GDP in 2003. The sudden widening of the external imbalance to 6.9 percent of GDP in 2002 must be addressed forcefully. It has contributed to a sharp increase in the external debt ratio and raises issues of external sustainability. While we cannot return to our original program target (a deficit of 3.6 percent of GDP) during the remainder of the year, we have taken measures, described in section III below, aimed at reducing it to 5.5 percent of GDP in 2003. Privatization receipts and direct foreign investment are expected to finance most of this deficit in 2003 while allowing to maintain the reserve cover ratios of imports and external debt service at slightly above 5 months and more than 200 percent, respectively, without increasing the external debt ratio. In the medium term, however, we believe that the external current account deficit needs to be reduced further to 3 1/2-4 percent of GDP.

II. Program Implementation and Performance

5. Except for delays of some structural reforms, we are broadly satisfied with the implementation of our economic program. Our fiscal program is being implemented without major difficulties. The higher than anticipated level of economic activity is boosting tax receipts. At the same time, the budget is executed as planned except that highway construction was delayed in early 2003 because of severe winter weather. A € 500 million seven-year bond was placed at a record low 4.6 percent yield and its current spread is hovering at around 100 basis points, which reflects the improved standing of Croatia in international markets.

6. Contrary to earlier expectations, the Croatian National Bank (CNB) had to tighten monetary policy in early 2003 in an attempt to slow an excessive expansion of credit. As banks increasingly borrowed abroad to sustain annual rates of credit expansion of some 30 percent, the CNB announced in mid-January that banks whose lending grows by more that 4 percent per quarter would be obliged to buy CNB bills at penalty interest rates in an amount twice as high as the excess credit. At the same time, the CNB increased the minimum foreign exchange cover requirement of banks' foreign exchange liabilities to raise banks' liquidity in foreign exchange and discourage foreign borrowing. As a result, credit growth slowed to 5.8 percent during the first quarter, with almost half of the expansion reflecting the valuation effect from the weakening of the kuna. Despite the depreciation (since then largely reversed) and foreign exchange sales of €315 million, the CNB's international reserves increased to new record levels as the government deposited the proceeds of its euro bond issue with the CNB.

7. Structural reforms proved more difficult to implement than initially thought. The delays experienced included the privatization of the oil company (INA), which required further discussions with the successful bidders; the preparation of a privatization plan for the postal bank (HPB); and the adoption of new labor, competition, company, bankruptcy, budget, and foreign exchange laws. However, in accordance with our program, parliament did approve the state aid law in March; the government did issue a decree on limiting new state guarantees to the expiration or amortization of old ones in January; and the CNB adopted a regulation to include options in the calculation of banks' net foreign exchange position from April 1, 2003, thus meeting structural benchmarks for end-June 2003 and end-September 2003 ahead of time.

8. Most of Fund conditionality for the end-March 2003 test date was met. All quantitative performance criteria for that date were observed except for that on arrears reduction by the central government (Table 2). As noted in section III below, we intend to make up for the slippage by end-September 2003. Moreover, two of the three indicative limits for the end-March test date were met. The one on the central government wage bill was missed by a small margin. By contrast, most structural conditions have not been met. The structural performance criterion on preparing criteria for issuing government guarantees was not met, and all three structural benchmarks (on privatization of INA, a privatization plan for HPB, and the adoption of a new budget law) were missed. As noted in section III below, we intend to implement these measures during the remainder of 2003.

III. Policies for the Remainder of 2003

9. The recent deterioration of the current account and the attendant rise in the external debt ratio pose new policy challenges. While progress with fiscal consolidation has been faster than anticipated, the surge of private domestic demand, supported by the strong expansion of credit, must be slowed down to help reduce the external imbalance. Also, such an expansion, if not bridled, may over time have a negative impact on the stability of the banking system. While an eventual recovery in our principal export markets and continued structural reforms are bound to strengthen our export performance in the medium term, the CNB will further tighten its monetary policy to bring about an early slowdown of imports.

A. Fiscal Policy

10. The stabilization of the general government debt ratio remains our principal fiscal policy objective in 2003. The elimination of double counting of some direct and guaranteed debt from our data base has led to a downward revision of the ratio by several percentage points. We will monitor the stock of outstanding guarantees during the remainder of the program period (structural benchmark) and restrain the extension of new guarantees appropriately to ensure that the debt ratio does not increase in 2003.

11. A very significant contribution to the stabilization of the debt ratio will come from a more rapid than originally programmed reduction of the general government deficit. The higher than expected growth in 2002 and buoyant tax collections in early 2003 have led us to raise our revenue projection for 2003 by 0.9 percent. At the same time, total expenditure is projected to remain virtually unchanged from its budgeted level. As a result, we now expect the general government deficit to be reduced to 4.6 percent of GDP instead of 5 percent of GDP under the original program (Table 3). As bids received indicate higher receipts from the privatization of INA, the net borrowing requirement has been reduced even more.

12. The government is determined to resist any pressures for tax relief or expenditure increases. There will be no supplementary budget this year, although we expect some revision in the composition of actual spending. As the table below shows, the largest projected increase is in expenditure for goods and nonwage services, which were budgeted at unrealistically low levels. The upward revision of subsidies and other transfers is more than explained by likely transfers to clear arrears of public hospitals outside the general government consolidation. Lower interest payments result from lower interest rates, favorable exchange rate movements, and a lower debt stock. Capital expenditure has been reduced on the assumption that the delays in highway construction experienced due to adverse weather conditions in early 2003 is not likely to be fully compensated for in the remainder of the year as some capacity constraints impede the attainment of the original expenditure target.

13. Our revised deficit financing plan for 2003 relies on more domestic borrowing than in 2002 in an effort to support the CNB's monetary tightening. Privatization receipts have been raised to a still conservative 1.7 percent of GDP. We reaffirm our intention to (i) use higher receipts to reduce our net debt; and (ii) reduce the fiscal deficit by the amount of any shortfalls. A large amount of foreign borrowing has already been obtained through the euro bond issue, and we expect to receive the second tranche of the World Bank's SAL in the third quarter. Despite sharply lower gross foreign borrowing than in 2002, net foreign borrowing will still amount to 1.3 percent of GDP because of the absence of bullet bond repayments in 2003. As a precautionary measure, we have decided to issue a Yen 25 billion Samurai bond in June 2003, but its proceeds will remain abroad so that this operation will have no effect on net foreign borrowing¹. Net domestic borrowing, mostly from the pension funds, will amount to 1.5 percent of GDP, compared with 0.2 percent of GDP in 2002. Despite a slow start, arrears reduction will amount to 0.3 percent of GDP in 2003 and the slippage recorded in the first quarter will be made up by the end of the third quarter.

B. Monetary and Exchange Rate Policy

14. The measure introduced in early 2003 to slow down credit expansion is temporary. The CNB intends to replace it by prudential and more priced-based measures at the end of 2003. In the meantime, the CNB will not hesitate to enhance the effects of the current measure by tightening banking sector liquidity through an increase in minimum reserve requirements if warranted by developments in domestic inflation, credit growth and the external current account balance. To this end, the second review under the program will focus on any monetary and other measures that may be needed to keep external developments in line with program targets.

15. The recent sharp deterioration of the external current account balance was not caused by a sudden drop of competitiveness, which remains adequate according to the standard indicators. The CNB realizes the usefulness of short-term exchange rate variability to discourage the buildup of unhedged foreign exchange positions and intends to continue with this policy. It will also increase its efforts to use its supervisory powers to warn banks, and through them their clients, about the risks of unhedged foreign exchange exposure and to ask them to inquire and report on their largest customers' foreign exchange exposure. In this connection, the new requirement to include foreign exchange options in banks' net open positions has raised some banks' long position above the regulatory limit of 20 percent of capital. The trend toward greater use of the kuna in deposit and credit operations that is evident since the start of the year is likely to be reinforced as banks convert their loans with asymmetric foreign exchange indexation clauses to comply with the new regulation.Banks exceeding the 20 percent limit have been given deadlines to comply with the new regulation. At any rate, the CNB has agreed on phased compliance schedules with the banks with excessive net foreign positions.

16. The CNB's monetary program for 2003 has only been slightly modified. With unchanged growth prospects and a slightly more favorable inflation outlook, broad money growth is expected to remain at some 14 percent. Assuming a phased compliance of banks with the new foreign exchange liquidity requirements against their foreign exchange liabilities, the CNB's net purchases of foreign exchange are estimated at US$ 412 million². The associated buildup of net international reserves and the general government's net bank borrowing of 0.2 percent of GDP would leave 9 percent of GDP of credit to the nongovernment sector. This would represent a slowdown of credit expansion to the nongovernment sector from 31.3 percent in 2002 to 18.2 percent in 2003, contributing to the adjustment of the external current account while leaving the CNB's gross international reserves at 5 months of imports of goods and nonfactor services.

C. Structural Reforms

Fiscal sector reforms

17. A new budget law satisfying the criteria spelled out in paragraph 16 of the MEFP has been adopted by parliament and the 2004 budget will be prepared in accordance with its provisions. The government will by July 15, 2003 adopt new criteria for issuing guarantees, in line with the requirements in paragraph 16 of the MEFP (prior action), thus ensuring that the recent extension of a guarantee to the private Viktor Lenac shipyard remains an exception. Moreover, the Ministry of Finance, which has the exclusive right to issue guarantees on behalf of the Republic of Croatia, will compile a complete register of active guarantees by July 15, 2003, including a record of all new and expired or amortized guarantees in the first half of the year (prior action). This register will be kept up to date so as to facilitate monitoring the evolution of government debt under the program.

18. We welcome the Fund's acceptance of our request to place a resident fiscal advisor in the Ministry of Finance to strengthen the operations of the debt management, macroeconomic analysis, and treasury departments and offer the advisor our full cooperation, including through any necessary organizational and staffing changes. We look particularly forward to a rapid improvement of the flow of high-quality, timely general government data (including debt stock statistics) at an appropriate frequency under both the GFS 1986 and GFS 2001 methodologies. On the basis of the output generated, we will resume publication of the Ministry's monthly bulletin. We also look forward to the conduct of a fiscal ROSC in October 2003 and remain committed to the other reform undertakings of paragraph 18 of the MEFP.

Financial sector reforms

19. We have issued a set of bylaws to implement the new banking law (as per paragraph 20 of the MEFP). We are currently preparing detailed guidelines to be issued by end-2003 in support of the application of the by-laws. We are confident that the by-laws and the guidelines will help to strengthen the banking sector regulatory framework. In particular, starting on January 1, 2004, (i) banks will be required to include charges for market risk in the reported capital adequacy ratios; and (ii) banks with rapidly expanding loan portfolios will have to create additional provisions for general risks. The CNB is working also on establishing cooperation and information-sharing arrangements with relevant foreign supervisory agencies, and on strengthening cooperation arrangements with domestic supervisory agencies. The CNB is also working towards strengthening its capacity to assess risks to financial soundness of individual banks as well as the banking sector as a whole. Finally, a new deposit insurance law is being drafted by a task force comprising the Ministry of Finance, the CNB, the bank rehabilitation and deposit insurance agency (DAB), and the bankers' association.

20. The Ministry of Finance eliminated the only remaining exchange restriction subject to Article VIII of the Fund's Articles of Agreement in June 2003. In response to the Fund's safeguards assessment, the CNB has added staff to its internal audit department and intensified training of the department's staff. An audit plan with expanded coverage of higher risk areas of the CNB's operations has been approved by the Governor. Finally, the CNB's financial report for 2002, with the auditor's opinion, was sent to parliament in May 2003 and posted on the CNB's web site in June 2003.

Public enterprise reforms and privatization

21. The government remains committed to public enterprise restructuring and privatization to boost competitiveness and the growth potential of the economy. Employment in the nine largest public enterprises was reduced by 3 percent during 2002 and their aggregate financial result improved from a net loss of 0.3 percent of GDP in 2001 to a net profit of 0.7 percent of GDP in 2002. Efforts to improve efficiency are continuing. As to privatization, we expect to reach a final decision on the sale of 25 percent plus one share of INA to a foreign strategic investor by July 15, 2003 (prior action). The sale of 7 percent of the already majority privatized telecommunication company (HT) to its employees has been postponed until after the elections. A 25 percent share in the insurance company (CO) will be offered to the Catholic church and other investors to settle restitution claims. The unbundling and restructuring of the electricity company (HEP) is continuing and we expect to begin privatizing power generation and distribution in 2004. The company's transmission network (as well as the JANAF pipeline) will remain publicly owned. We have sent the IFC a mandate letter on June 10, 2003 inviting it to do the due diligence for taking a 19 percent equity participation with strong veto powers in the postal bank (HPB) (prior action). We expect to sign the subscription agreement with IFC by end-September 2003 (structural benchmark). Together, we will prepare a plan to privatize more than 50 percent of the bank within 24 months of signing the subscription agreement. We will prepare a plan to privatize Croatia Banka, currently administered by DAB, by December 31, 2003 (structural benchmark). Finally, we will approach the IFC shortly to examine the possibility of auctioning off DAB's bad loan portfolio. The recent change in the supervisory board of the privatization fund (HFP) has not significantly slowed the fund's privatization program, as outlined in paragraph 21 of the MEFP. Priority is currently being given to privatizing tourism and agricultural enterprises from among the majority holdings in the HFP's portfolio. In a change from past practice, the HFP attempts to improve the balance sheet of these enterprises by writing off, capitalizing or extending the maturity of state creditor claims prior to privatization. In the meantime, the sale of HFP's minority participations continues apace on the Zagreb and Varaždin stock exchanges.

Product and labor market developments

22. Legislation to align Croatian law with that of the EU and to satisfy the conditions of the second tranche disbursement of the World Bank's SAL are high on the parliament's agenda. We therefore expect new bankruptcy, company, competition, and labor laws to be approved by end-July 2003.

23. With the entry into force of the free trade agreement with Albania on June 1, 2003, there remain only a few unresolved trade agenda items. We have ratified new free trade agreements with Serbia-Montenegro and Turkey, but the former one has not entered into effect pending resolution of the Montenegrin side's objections to some of its agricultural provisions, and we are still waiting for Turkey's ratification. Negotiations on a free trade agreement with Moldova have yet to resume. Lastly, we have so far been unsuccessful in persuading the EU to apply the Pan-European Diagonal Cumulation of Rules of Origin to Croatian exports. We are working to resolve these issues soon.

Table 4. Croatia: Amendments to Annexes III, IV, VI, and VII of the MEFP

Annex III

1. The projections for the cumulative privatization receipts are changed as follows. For the general government, HrK 2,905 million during January-September 2003 and HrK 3,251 million during January-December 2003. For the central government, HrK 2,623 million during January-September 2003 and HrK 2,859 million during January-December 2003.

2. The revised deficit projection of HBOR in 2003 is HrK 1,869 million.

3. It is clarified that all fiscal reporting should be on a modified accrual (commitment) — rather than cash — basis.

4. It is further clarified that all fiscal data should be reported by the Ministry of Finance.

5. The indicative cumulative limits on the wage bill of the central government are HrK 13,599 million for January-September 2003 and HrK 18,005 million for January-December 2003.

Annex IV

1. The debt contracting ceilings exclude municipal support agreements between local governments and the EBRD.

Annex VI

1. In accordance with the stipulation of paragraph 2 of Annex VI to the MEFP, the reserve floors will be raised by the amount of Funds disbursed by the U.S. Treasury after lifting the freeze on the assets of the National Bank of the former Socialist Federal Republic of Yugoslavia (approximately US$ 55 million).

2. The reserve floors will be raised/lowered by the amount by which the privatization receipts from the partial sale of INA exceed/fall short of US$ 362 million.

Annex VII

1. The net domestic asset ceiling will be lowered/raised by the kuna amount by which the privatization receipts from the partial sale of INA exceed/fall short of the kuna equivalent of US$ 362 million.

2. The stock of base money is projected to be HrK 25,191 million on September 30, 2003 and HrK 26,324 million on December 31, 2003.