Republic of Croatia and the IMF

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Croatia—Supplement Letter of Intent

Zagreb, Croatia, October 31, 2001

The following item is a Letter of Intent of the government of Croatia, which describes the policies that Croatia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Croatia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street NW
Washington, D.C. 20431

Dear Mr. Köhler:

1. With reference to our letter to you of August 29, 2001, we are pleased to inform you that we have identified—and are in the process of implementing—budgetary measures which will ensure that the deficit target for 2001 of 5.3 percent of GDP for the consolidated central government will be achieved. Furthermore, the most recent economic developments in Croatia clearly demonstrate that we are on track to meet our 2001 objectives for real GDP growth of 4 percent and end-year retail price inflation of 4.5 percent, assuming no further increases in administered prices beyond those envisaged at the beginning of August 2001. We also expect to exceed the targeted gain in net international reserves of the Croatian National Bank (CNB) in 2001. The present letter describes the measures we have taken to ensure observance of our 2001 fiscal deficit limit, requests the modification of certain performance criteria and an extension of the program period, and proposes a postponement of the second program review.

2. In the Supplementary Memorandum of Economic and Financial Policies (SMEFP) that was attached to our August letter, we mentioned the adoption of a package of 11 laws to rationalize social transfers as a precondition for meeting the 5.3 percent of GDP deficit target (Annex IX). We are happy to report that the last three of these laws were passed by parliament on October 19, 2001, along with a revised budget for 2001. However, owing mainly to the prolonged debate in parliament, the implementation of many of these measures has been delayed. The total reduction in social expenditures in 2001 would therefore be HrK 660 million smaller than expected when the SMEFP was prepared. A major reason for this smaller reduction is the delay in approving the tightening of the means-testing criteria used to determine child allowances and some other social benefits, which will now be applied only as of 2002.

3. Furthermore, the reduction of the consolidated central government wage bill in 2001 is now projected to be HrK 766 million less than expected in August, mainly as a result of delays in staff layoffs and the full implementation of the new wage policy adopted in June 2001. In particular, higher wage coefficients have since August been agreed in the education and health sectors. Nevertheless, the overall trend for the wage bill of the consolidated central government is positive in the sense that the nominal wage bill in 2001 will be reduced by HrK 873 million (or 4.8 percent) compared to the wage bill in 2000. In addition, we intend to reduce the government wage bill to the originally targeted level for 2001 as part of the 2002 budget-a task that will be facilitated by the full-year effect of the new wage policy, its pending extension to the defense sector, and early layoffs of surplus labor in the government.

4. To offset the expenditure overruns that result from lower than initially programmed reductions in wages and social transfers and from a small (HrK 110 million) downward revision in expected revenue collections, we have increased the discretionary cuts in other expenditure items for 2001 by HrK 1,576 million with respect to the intentions expressed in the SMEFP. As shown in the table, the revised budget's cuts of subsidies and transfers are lower, while those for spending on goods and nonwage services and on capital investment are substantially higher than originally planned. As a result of these cuts, the projected 2001 deficit of the consolidated central government is now HrK 8,914 million, compared with HrK 8,955 million in the SMEFP.

Planned Fiscal Savings
SMEFP   Revised
  SMEFP   Revised

  (In millions of HrK)
Permanent measures 9171   257   2,706   2,850
In percent of GDP 0.53   0.15   1.46   1.54
Benefit rationalization 210   --   933   842
Reduction in general benefits 707   257   1,773   2,008
Discretionary measures 655   2,231   n.a.   n.a.
In percent of GDP 0.38   1.29   n.a.   n.a.
Subsidies and transfers 367   28   n.a.   n.a.
Goods and nonwage services 212   573   n.a.   n.a.
Capital spending 76   1.631   n.a.   n.a.
Total 1,572   2,488   2,706   2,850
In pecent of GDP 0.91   1.39   1.44   1.54

1The revenue from permanent measures was estimated at HrK 1,001 million in the SMEFP, but the fiscal program was based on a more conservative estimate of HrK 917 million.

5. The state-owned postal bank (HPB) needs an early and final resolution. Accordingly, we have called a shareholders meeting on December 22, 2001 to which the government as the majority shareholder will recommend the least-cost solution to HPB's operational problems. On current indications, immediate privatization would seem to be the least-cost solution. A firm decision on HPB's future will be taken before completion of the second program review. Any budgetary costs associated with the resolution of HPB will be accommodated within the deficit target of the consolidated central government of 4¼ percent of GDP in 2002.

6. The SMEFP reports on our performance under the arrangement through end-June. While final data on the majority of the quantitative performance targets for end-September will be available only after the end of October, it is clear already that the targets for the net domestic assets and the net usable international reserves of the CNB have been met. We have also made considerable progress regarding most of the structural reform measures and we have made a full report to the World Bank concerning implementation of the prior actions for the new SAL.

7. While we remain strongly committed to the full implementation of all the policy measures described in the original MEFP as amended by the SMEFP, it has become necessary to modify two of the end-2001 targets. We would, therefore, like to propose the following adjustments.

8. First, as a result of the above-mentioned delays in layoffs of central government workers, we request that the structural performance criterion on reducing staff by a total of 10,000 during 2001 (SMEFP, ¶14) be modified as follows. By end-December 2001, the net reduction of central government employment since the end of 2000 would be 6,385, including 5,000 people laid off but still receiving severance pay. The original target of reducing employment by 10,000 would be reached at end-March 2002. Accordingly, the projected development in central government staff would be as follows:

Number of Central Government Staff
(1) Number of staff at end-December 2000 177,514
(2) Actual layoffs during 2001 (i.e., staff no longer on payroll) 1,385
(3) Staff laid off but still receiving severance pay at end-December 2001 5,000
(4) Number of staff by end-December 2001 (1-2-3) 171,129
(5) Additional staff laid off with severance pay 3,615
(6) Number of staff by end-March 2002 167,514

9. Second, as a result of changes implemented by the CNB in September and October 2001 concerning the reserve requirements of commercial banks, it is now obvious that we will not be able to observe the original end-December target on the increase in net domestic assets of the CNB (SMEFP, Annex VIII). In September, banks were required to hold 10 percent of their required reserves on foreign exchange deposits in local currency, and in October this proportion was raised to 20 percent. In December, the CNB will consider increasing the portion of required reserves on foreign exchange deposits to be held in local currency further to 25 percent. The effects of these changes have increased or will increase the monetary base by HrK 1,614 million in September, HrK 1,711 million in October, approximately HrK 150 million in November, and by an additional amount in December which is yet unknown. As these changes do not entail any monetary expansion, we request that, commencing with the test date for end-December 2001, an automatic adjustor be applied to the performance criterion on net domestic assets of the CNB and that Annex VIII of the SMEFP be amended as suggested in the Attachment to this letter. We understand that the adjustor would also be applied to reduce the net domestic asset ceiling if we proceed with tentative plans to reduce the reserve requirement ratio from 22 percent to 19 percent in December.

10. Because of the delays experienced in completing the first program review, we propose to extend the program period by one quarter to the end of March 2002 and delay completion of the second review further to the end of February 2002. Quantitative performance criteria for end-March 2002 will be set as part of the second review.

11. While we have experienced unfortunate delays in policy implementation in a number of areas, much has been achieved in a relatively short time. Furthermore, and despite the delays, with the reforms of the health and social transfer system and of the public wage structure firmly in place, we expect to see the full and positive impact on next year's budget, which will be discussed by parliament in November with expected approval by the end of December 2001.

12. Against that background, we are confident that we can achieve a deficit target of 4¼ percent of GDP for the consolidated central government in 2002, with a further significant deficit reduction in 2003. In this context, we would like to confirm our interest in a successor program to the present stand-by arrangement covering the period 2002-03.

Sincerely yours

Slavko Linić
Deputy Prime Minister

Mato Crkvenac
Minister of Finance

Željko Rohatinski
Croatian National Bank

Adjustor for CNB's NDA Ceiling

The following adjustor is proposed to be added to Annex VIII of the SMEFP.

"The ceilings shall be adjusted for changes in the required reserves in domestic currency, as follows.


where NDA = adjustment to the ceiling on net domestic assets of the CNB;
  BD, BF = domestic and foreign currency liabilities subject to reserve requirements;
  Equation, Equation = the originally programmed test-date levels of BD and BF;
  r = reserve requirement ratio;
  theta = the portion of liabilities in foreign currency subject to reserve requirements in domestic currency;
  r0 , theta0 = the originally programmed test-date levels of r and theta;
  ∆BD, ∆BF = unprogrammed administrative changes to BD, BF affecting the definition and/or coverage of BD, BF compared with their originally programmed test-date levels;
  ∆r, theta = unprogrammed changes to r and , so thathetat
  r1 = r0 + ∆r; and
  theta1 = theta 0 + ∆theta.

The adjustor applies only to the changes on account of administrative decisions that were not foreseen in the monetary program agreed in the SMEFP."