| Press Release: IMF Completes Second Review and Grants Waivers Under Stand-By Arrangement with the Republic of Croatia
November 12, 2003
Republic of Croatia and the IMF
Country's Policy Intentions Documents
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Republic of Croatia—Letter
October 27, 2003
Mr. Horst Köhler
Dear Mr. Köhler:
1. In accordance with paragraph 4 of our July 4, 2003 letter to you, we have conducted the second review 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). The review confirms that we remain on track to achieve our program's principal objective, the stabilization of the general government debt ratio after many years of uninterrupted increases. To shore up that objective, we have obtained parliamentary approval for an amendment of our budget in a way that safeguards the deficit target for 2003, which was tightened during the first review under the stand-by arrangement ("the first review"). The present review also indicates that the external adjustment is in line with the target set during the first review. Although the external current account deficit is now projected at 5.9 percent of GDP in 2003, the increase results entirely from higher profit remittances that were reinvested in Croatia. Nonetheless, we have tightened monetary policy further and taken measures to strengthen banking supervision to support the external adjustment. These and some other measures and the economic outlook for 2003-04 are described below.
The Economic Situation and Outlook
2. Despite the unexpectedly weak economic environment in Western Europe, domestic economic activity has remained strong amid easing inflation, and the near-term prospects for growth and inflation are favorable. Strong real GDP growth in the first quarter, continued strength of industrial production and retail sales in the second quarter, and indications of an exceptionally good tourism season in the third quarter have prompted us to raise our growth forecast for 2003 from 4.2 percent to 4.7 percent. We expect this higher growth rate to be broadly maintained in 2004 as moderating private consumption growth is likely to be balanced by higher growth of public investment with the initiation of a four-year railroad infrastructure project. Private investment is expected to remain strong due to strengthened confidence after the November election and the projected economic recovery in the EU. The contribution of net foreign demand is expected to be neutral—after three years of being a drag on growth—due to higher export demand in the EU and slower import growth.
3. The external current account deficit has not yet improved, but we are confident that the measures described below are adequate to reduce it sufficiently in the second half of 2003 to reach 5.9 percent of GDP for the year as a whole, as compared to 5.5 percent of GDP at the time of the first review. The larger current account deficit will, however, require no additional foreign borrowing, as the deterioration is more than explained by higher profit remittances, most of which have been reinvested in Croatia. As a result, the external debt ratio is expected to remain unchanged on a year-end basis at a little more than 68 percent of GDP in 2003. Under current policy intentions, the current account deficit is projected to decline to 5.2 percent of GDP in 2004 and the external debt ratio would remain at around 68 percent of GDP.
4. We are on course to reduce the general government deficit to 4.6 percent of GDP in 2003. After a disappointing second quarter, revenue collections have picked up and we are confident to reach our revenue target for 2003. Higher profit, excise, and non-tax revenues are expected to be offset by shortfalls in social security contributions and customs duties. Contrary to earlier intentions, we decided to seek parliamentary approval for a deficit-neutral budget amendment. As a result of this amendment, the wage bill has been increased by 0.6 percent of GDP relative to the first review, mainly to reflect court-mandated payments to unlawfully laid-off military staff in the early 1990s and overruns related to the current defense sector reform. As regards the latter, we already reduced military employment by more than 5,500 by end-August through voluntary separation, including early retirement and layoffs. By year-end we expect to reduce defense sector employment by another 3,000 to 30,260, including 3,000 reservists at 60 percent of previous pay. The size of the armed forces will be reduced further over the medium term. A reform of the military pay system (after a seven-year wage freeze), higher severance pay, and small increases in the education sector have added to the wage cost overrun, which was fully offset by lower spending on investment, interest, subsidies and transfers, and goods and services. The government is prepared to implement additional expenditure cuts if needed to achieve our deficit target.
5. The financing of the deficit has changed substantially. The partial privatization of the oil company (INA), although delayed to the beginning of the fourth quarter, has yielded higher receipts than anticipated (prior action), thus reducing the net borrowing requirement and boosting the prospects of stabilizing the public debt ratio. Net foreign borrowing is expected to be a little more than 1 percent of GDP higher than envisaged at the first review, reflecting higher disbursements and exchange rate related savings on amortization payments. In particular, contrary to earlier intentions, we have drawn down the proceeds of the Samurai bond to bridge the delay of the INA privatization receipts. In partial compensation, we have placed the proceeds of the second-tranche SAL disbursement from the World Bank in a foreign currency account with the CNB until they are needed for external debt service payments in early 2004 (prior action).1 Reflecting these developments, the domestic net borrowing requirement has been reduced sharply. As nonbank financing (including arrears reduction) remains unchanged, the government is expected to be a net provider of funds to the banking system to the tune of 1.2 percent of GDP for 2003 as whole.
6. In accordance with the new budget law, the government has prepared a provisional budget for 2004 and medium-term fiscal projections that envisage lowering the government deficit to 2 percent of GDP by 2007. However, this budget will not be submitted to parliament before the election. 2 The budget aims at reducing the general government deficit to 3.8 percent of GDP in 2004. Revenue is projected to decline modestly to 44.6 percent of GDP, largely reflecting new personal income tax deductions and the continued erosion of import duty collections due to the implementation of WTO and bilateral and regional trade liberalization agreements. There would be no other changes in the revenue system. To reduce the deficit as intended, the expenditure ratio would need to be compressed by 1.1 percent of GDP. The nominal wage bill would remain at its 2003 level, for a budgetary saving of 0.8 percent of GDP. Employment reduction (including that achieved during 2003) and the new income tax deductions would nonetheless allow net real wage increases of about 4 percent. An additional saving of 0.3 percent of GDP would result from keeping highway construction expenditure constant in nominal terms and from cuts in capital spending financed by the state budget. We realize that the 2004 budget will need to be tightened further if the external current account does not adjust as envisaged.
7. If the new government decided to proceed with the implementation of a four-year railroad infrastructure investment program, the 2004 fiscal deficit objective would require additional resources of 1.2 percent of GDP on an annual basis. Our projections assume that 0.3 percent of GDP would be generated by a small increase in the gasoline excise tax. Cuts of spending on transfers (0.5 percent of GDP), goods and services (0.2 percent of GDP), subsidies, and central government investment (0.1 percent of GDP each) would generate the remaining resources.
8. As privatization receipts are likely to be much lower than in 2003 (see paragraph 16 below), the net borrowing requirement would be higher than in 2003 but it would still allow a small reduction of the public debt ratio in the absence of a net increase in government guarantees. Notwithstanding large domestic amortization, the government will rely on domestic borrowing to the extent possible.
9. The postponement of the fiscal ROSC mission to early 2004 in an attempt to combine it with the World Bank's Country Financial Accountability Assessment allows the Ministry of Finance additional time to prepare for it. The new SAP software system has proved helpful in executing the 2003 budget and preparing the 2004 budget, but it has yet to be applied to debt management and arrears monitoring. The Fund-provided fiscal advisor is expected to assist in this endeavor as well as in the compilation of timely and reliable fiscal data (including on guarantees), which will allow the Ministry to resume regular publication of its monthly bulletin.
Monetary and Exchange Rate Policy
10. In response to weak current account data, the CNB has recently reinforced the measures it took in January 2003 to restrain credit expansion and external borrowing by raising the domestic component of the 19 percent reserve requirement on banks' foreign liabilities from 25 percent to 35 percent. This measure has reduced bank liquidity and put upward pressure on interest rates, with money market rates rising to some 10 percent. The CNB believes that no further measures are needed for the remainder of the year but stands ready to take further measures if developments indicate that credit growth, imports, and the current account deficit do not decline as expected.
11. In 2004 the CNB intends to adopt a major change of its monetary policy regime. The temporary credit limits introduced in early 2003 will be eliminated at the start of 2004. As new supplementary provisioning requirements for rapidly expanding banks that enter into effect at the same time will not provide an equally restraining effect on credit expansion, the CNB will use its existing instruments to ensure that monetary conditions remain appropriately tight. At the same time, the CNB will consider changing its monetary policy framework by introducing a deposit facility for bank liquidity, thus creating an interest rate corridor with the existing Lombard lending facility, and to begin open market operations to guide interest rates within this corridor. To help prepare for this regime change, the CNB has asked for early Fund technical assistance.
12. The CNB would like to reaffirm its exchange rate policy. It considers the level of the exchange rate broadly appropriate. Accordingly, it intends to continue to maintain the exchange rate of the kuna broadly stable against the euro, allowing short-term fluctuations as in the past. It will mainly rely on its regulatory and supervisory powers to discourage the buildup of unhedged foreign exchange positions. In line with this policy, the CNB has not intervened in the foreign exchange market since March 2003.
13. The twelve-month rate of credit expansion has fallen from 31.3 percent at end-2002 to 20.8 percent in August 2003 and is expected to decline to 16.2 percent by year-end. While the annual rate of credit growth to the corporate sector was more than halved to 9.2 percent by August, household credit growth remained high at 31.3 percent. Apart from this slowdown and the reduced financing need of the central government, the CNB's monetary program for 2003 is broadly unchanged, thus resulting in a stronger net foreign asset position of the banking system. The tentative program for 2004 envisages a further slowdown of broad money and private credit growth to 10 ¾ percent and 12 ½ percent, respectively.
14. The CNB continues to strengthen its regulatory and supervisory functions.3 The by-laws and guidelines for the recently approved foreign exchange law and all guidelines for the application of the by-laws adopted under the new banking law have been issued. By-laws on foreign bank branches and bank liquidity requirements have not been issued, the former because there is no present and foreseeable need for them and the latter because the CNB prefers instead to draw banks' attention to international best practice, as posted on the BIS and CNB websites. To improve cooperation among supervisors, parliament has asked the Ministry of Finance to establish a council of domestic supervisors, in which the CNB will participate. In the meantime, the CNB has obtained data from the insurance supervisor indicating that credit risk amounting to one sixth of retail credit (or 4 ¼ percent of GDP) had been transferred in mid-2003 from banks to insurance companies. The first memoranda of understandings on cross-border cooperation with foreign bank supervisors are expected to be signed in the next few months. In the meantime, the CNB is already cooperating informally with foreign bank supervisors. The CNB is compiling aggregate corporate balance sheets from data provided by the financial agency (FINA) and has asked banks (as a prior action) to report on their ten largest customers' foreign exchange exposure. It is also further developing its early warning system and stress tests of banks' balance sheets on the basis of recent Fund technical assistance. The banking supervision department will be restructured by end-2003 and strengthened by adding staff and continued professional training.
EU Accession and Structural Policies
15. EU membership remains our top political priority. The government has therefore sent its responses to the European Commission questionnaire and parliament has adopted the remaining 20 laws required to harmonize Croatian legislation with EU standards before adjourning. In the economic domain, it is now important to fully implement the new legislation. Thus, the new labor law, which will fully enter into effect on January 1, 2004, has lowered Croatia's employment protection legislation index, compiled in accordance with the OECD methodology, by 23 percent.
16. With the successful sale of 25 percent plus one share of INA, the government has all but completed its privatization program. To accelerate the privatization of the postal bank (HPB), the government has sent a revised mandate letter to the IFC (prior action), with a view to obtaining IFC Board approval to subscribe to 19 percent of the bank's capital by end-2003 (modified structural benchmark). The IFC has already sent a mission to initiate the due diligence process, which is expected to be completed in October-November 2003. In view of union resistance the government has postponed the sale of 7 percent of the telecommunication company's (HT) capital to 2004. This is likely to be the only major privatization receipt for the budget in 2004. The government still hopes to reach agreement with the Catholic church on the transfer of 25 percent of the insurance company's (CO) capital in restitution for post-Second World War expropriations. Another 20 percent of CO's capital could then be sold on the stock exchange in 2004. Finally, the government intends to privatize only the distribution part of the electricity company (HEP). Such privatization is not likely to happen before 2005. All privatizations through the privatization fund (HFP), except for a few tenders currently in the pipeline, have been stopped pending the adoption of a new privatization law by the next parliament.
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17. The assessments, projections and policies described in this letter supersede those set forth in the Memorandum of Economic and Financial Policies that is attached to our letter to you of December 27, 2002 and in the Supplementary Memorandum of Economic and Financial Policies that is attached to our letter to you of July 4, 2003, both of which continue to represent our policy intentions in all respects not specifically addressed in the present letter.
18. On the basis of the performance under our program to date and the policies in this letter, we request (i) completion of the second review under the stand-by arrangement and (ii) a waiver of the nonobservance of the September 30, 2003 performance criteria on the cumulative deficit of the consolidated central government, on the net usable international reserves of the CNB, and the net domestic assets of the CNB. The former performance criterion was missed because of the delay in the privatization receipts from the partial sale of INA. This payment has now been received and we believe that the performance criterion has otherwise been met. The latter performance criterion was missed by a relatively small amount as exchange market conditions were not conducive to intervention. We are confident that all other end-September performance criteria have been observed and that a waiver of applicability of performance criteria will not be needed at the time of the Board discussion.
19. We believe that the policies described in this letter 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 consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in this letter, in accordance with the Fund's policies on such consultations. The third program review, scheduled for completion in mid-February, 2004, will provide one such opportunity.
20. It remains 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 third review and observance of the performance criteria for December 31, 2003.
Deputy Prime Minister
Minister of Finance
Croatian National Bank
Attachment: Prior Actions and Revised Structural Benchmark
Table 1. Prior Actions and Revised Structural Benchmark
A. Prior Actions
1. Government to receive the proceeds of the partial privatization of INA.
2. CNB to ask banks to report on their ten largest customers' foreign exchange exposure.
3. Government to place the proceeds from the second-tranche SAL disbursement in a foreign currency account with the CNB until early 2004.
4. Government to send a revised mandate letter to the IFC requesting the latter to do due diligence of HPB with a view to subscribing to 19 percent of HPB's capital.
B. Revised structural benchmark
1. Obtain IFC Board approval to subscribe to 19 percent of HPB's capital by December 31, 2003.