Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with the Republic of Croatia

May 16, 2008

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2008 Article IV Consultation with the Republic of Croatia is also available.

Public Information Notice (PIN) No. 08/53
May 16, 2008

On May 9, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Croatia.1


Growth accelerated in 2007, but external imbalances continued to increase. Real GDP growth reached 5.6 percent, on the back of strong domestic demand. The latter was also reflected in a widening current account deficit (8.6 percent of GDP), with higher world energy prices contributing as well. External debt reached nearly 88 percent of GDP at end-2007.

Inflation picked up. Because of financial euroization and balance-sheet exposures, the Croatian National Bank (CNB) has maintained the exchange rate in a tight range. Until very recently, this has helped keep inflation between 2 and 4 percent, aided by moderate wage growth. Nevertheless, surging food and utility prices pushed year-on-year headline inflation above 6 percent in early 2008, the highest rate since the early 1990s.

The general government deficit was brought down significantly in recent years, from 6.1 percent of GDP in 2003 to 3 percent in 2006, and to an estimated 2.3 percent in 2007. But with economic growth particularly rapid in 2007, and taking into account off-budget and quasi-fiscal activities not included in the general government accounts, cyclical adjustment implies that the overall fiscal stance was expansionary in 2007.

External competitiveness appears adequate. Despite some gradual real exchange rate appreciation, indicators of price and cost competitiveness vis-à-vis central European peer countries remain benign. Market share of goods exports has been steady and tourism receipts strong. Staff estimates indicate that the real exchange rate is broadly consistent with fundamentals.

The financial sector is healthy, but risks associated with rapid credit growth have been a concern. Banks' capital adequacy and asset quality are at sufficiently comfortable levels to withstand a range of shocks. Though declining, profitability is still high. Nevertheless, significant external imbalances and rising asset prices—and volatility in the case of equities—accompanying credit growth could expose banks to sudden shifts in market sentiment. Banks also face significant interest and exchange rate induced credit risks. The CNB has taken a range of measures aimed at limiting vulnerabilities, including to curb banks' borrowing from abroad and domestic credit expansion.

Although Croatia was not particularly hurt by the global financial turbulence through 2007, stock prices slumped in the early months of 2008. Widening credit default swap spreads suggest concerns with external vulnerabilities, though not to the same extent as for some other countries.

Some progress was made on structural reforms, but Croatia still lags most central and eastern European countries on business environment indicators. In the heavily indebted shipyard sector, reforms were delayed through 2007; recently, the authorities announced plans to start the sale of two shipyards at end-2008. Progress on privatization was mixed: initial public offerings for the oil and telecom companies were successful but the broader privatization process slowed.

The discussions focused on measures aimed at reducing vulnerabilities, ensuring that higher inflation does not become entrenched in expectations, and raising potential growth.

Executive Board Assessment

Executive Directors welcomed Croatia's strong economic growth in recent years, which has generated an appreciable increase in employment. This strong performance has been accompanied by commendable improvements in policies, notably a reduction in the general government deficit since 2003 and a continued strengthening of financial supervision. At the same time, Directors noted that the current account deficit has continued to widen, external debt has remained high, and inflation has increased sharply. They emphasized the need for continued policy efforts to mitigate these imbalances and create an environment conducive to sustained high growth.

Directors stressed the importance of near-term wage moderation, both in the government sector as intended and the state-owned enterprises. Wage moderation will be key to avoiding second-round effects from food and utility price increases and preventing higher inflation from becoming entrenched in expectations, as well as underpinning external competitiveness.

Directors noted that the real exchange rate is broadly in line with fundamentals, and recognized the advantages of maintaining a stable exchange rate in circumstances of high financial euroization, sensitivities to balance-sheet mismatches, and the past success of this policy. At the same time, Directors emphasized the need for support from other policies, including continued fiscal adjustment to manage domestic demand and help address macroeconomic imbalances; accelerated structural reforms to lessen vulnerabilities while raising sustainable growth; and strong prudential policies and financial sector supervision.

Against this background, Directors welcomed the authorities' intention to continue to reduce the general government deficit. They noted that achieving the authorities' target of a deficit of ½ percent of GDP by 2010 would represent a significant adjustment, and encouraged them to maintain this momentum going forward by announcing a target of fiscal balance by 2011. Directors generally considered that frontloading fiscal adjustment—including by saving any revenue overperformance—would provide welcome immediate support in reducing macroeconomic imbalances and raising the likelihood of meeting the recommended targets. A fiscal deficit target of 1 percent of GDP or less in 2009 would have considerable merit.

Directors underlined the benefits of expenditure-led fiscal adjustment and saw room to reduce current expenditure without unduly compromising the delivery of public services. They also pointed to the importance of ensuring the sustainability of the pension system, including by avoiding further backtracking on earlier reforms. More broadly, Directors encouraged the authorities to identify contingency measures that could be readily put in place in case macroeconomic imbalances turned out worse than expected.

Directors noted that Croatia's financial sector remains healthy, while stressing that continued strains in global financial markets and balance-sheet vulnerabilities underscore the importance of vigilance in maintaining high prudential standards and closely monitoring banks' risk management and lending practices. Directors commended the authorities' measures to strengthen banking supervision, including through increases in required capital cushions, improved communications with market participants, and efforts to strengthen home-host supervisory coordination. They also welcomed the continued strengthening in supervision of the nonbank sector, and the authorities' plan to produce a forward-looking financial stability report.

While understanding the central bank's rationale for implementing credit and other administrative measures, Directors considered that, taking into account their side effects, a phasing out of the measures would be desirable, acknowledging that this would need to be done in a careful way. This would require support from tighter fiscal policy to reduce excess demand pressures and close supervision of banks.

Directors stressed the considerable benefits of faster structural reforms for reducing vulnerabilities, raising living standards, and successfully concluding EU accession negotiations. They encouraged the authorities to continue to improve the business environment by reducing administrative burdens, legal uncertainties, and corruption. Such actions would make Croatia a more attractive destination for the investments needed to sustainably increase productivity, exports, and potential growth. Directors also looked forward to swift action on reforming the heavily indebted shipyards and on completing the broader privatization process, with involvement of strategic investors.

Republic of Croatia: Selected Economic Indicators
  2004 2005 2006 2007 2008
        Est. Proj.

Output, unemployment, and prices

(Percentage change)

Real GDP

4.3 4.3 4.8 5.6 4.3

Unemployment (labor force survey, in percent)

13.8 12.7 11.1 9.5 9.0

CPI inflation (average)

2.0 3.3 3.2 2.9 5.5

Saving and investment

(In percent of GDP)

Domestic investment

30.6 31.0 32.8 32.7 32.1

Of which: fixed capital formation

28.1 28.1 29.8 30.0 29.4

Domestic saving

25.6 24.7 24.9 24.2 23.1


2.5 2.7 3.3 4.6 3.8


23.1 22.0 21.6 19.5 19.2

Government sector 1/


General government revenue

44.9 44.5 44.8 46.3 45.2

General government expenditure

49.7 48.5 47.7 48.6 47.6

General government balance

-4.8 -4.0 -3.0 -2.3 -2.3

General government financing requirement 2/

-4.8 -4.0 -3.9 -3.5 -2.6

HBOR balance (net of budget transfers)

-0.4 -0.1 -0.2 -0.7 -0.8

Cyclically adjusted primary balance, broader coverage 3/

-3.2 -1.9 -1.9 -2.5 -1.7

General government debt

43.3 43.8 41.0 37.9 37.0

Money and credit

(End of period; change in percent)

Bank credit to the nongovernment sector

14.0 17.4 23.1 15.0 ...

Broad money

8.6 10.5 18.0 18.3 ...

Interest rates 4/

(Period average; in percent)

Average kuna deposit rate (unindexed)

1.9 1.7 1.7 2.3 ...

Average kuna credit rate (unindexed)

11.7 11.2 9.9 9.3 ...

Average credit rate, foreign currency-indexed loans

7.4 6.7 6.3 6.3 ...

Balance of payments

(In millions of euros)

Current account balance

-1,434 -1,976 -2,692 -3,206 -3,672

(In percent of GDP)

-5.0 -6.3 -7.9 -8.6 -9.0

Capital and financial account

2,527 3,840 4,996 4,865 5,197

Overall balance

43 822 1,412 721 709

Debt and reserves

(End of period; in millions of euros)

Gross official reserves

6,436 7,438 8,725 9,307 10,016

In months of following year's imports of goods and NFS

4.4 4.5 4.8 4.7 4.8

External debt service to exports ratio (in percent)

24.4 27.2 37.5 37.7 31.2

Total external debt (in percent of GDP)

80.0 82.4 85.5 87.8 87.9

Net external debt 5/

37.7 43.1 44.3 46.1 46.1

Sources: Croatian authorities; and Fund staff estimates.
1/ Modified-accrual GFS methodology.
2/ Includes "pensioners' debt" repayments, equivalent to 1.0 percent of GDP in 2006, 1.2 percent in 2007, and 0.3 percent in 2008.
3/ Includes off-budget and quasi-fiscal activities (outside the general government accounts), in particular repayments of "pensioners' debt" and the balance of HBOR (net of budget transfers).
4/ Weighted average, all maturities. Foreign currency-indexed loans are indexed mainly to euros.
5/ Net of official reserves and commercial bank foreign assets.

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. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the May 9, 2008 Executive Board discussion based on the staff report.


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