Republic of Croatia - 2008 Article IV Consultation, Preliminary Conclusions
March 6, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The mission's key policy recommendations aim at narrowing the current account deficit and lessening associated vulnerabilities; ensuring that higher inflation does not become entrenched in expectations; reducing financial sector risks; and boosting the growth rate the economy can achieve on a sustainable basis. Jointly attaining these goals requires a significant reduction in the size of government, including by an expenditure-led contraction of the general government deficit. Frontloading this adjustment would be of considerable benefit. Maintaining high prudential standards in the financial sector, while ensuring they are rigorously applied is of critical importance too. So is significantly accelerating structural reform—also to ensure the successful completion of EU accession negotiations.
Background and Policy Challenges
1. Growth accelerated in 2007, but worrying external imbalances continued to increase. Real GDP growth reached nearly 6 percent, on the back of surging domestic demand. The latter was also reflected in a widening current account deficit, estimated at 8.8 percent of GDP, with higher world energy prices and a slump in export growth toward year end contributing as well. External debt reached 87½ percent of GDP at end-2007: the fall in banks' borrowing was more than offset by non-financial enterprise borrowing.
2. Inflation picked up. Surging food and utility prices pushed year-on-year headline inflation to 6.2 percent in January 2008, the highest rate since the early 1990s. Year-on-year core inflation reached 5.3 percent in the same month. Moderate wage growth has been a key factor in keeping inflation low in Croatia. Because the government is a very large employer, limiting government wage increases to the announced 6 percent sends a helpful signal to keep other wage increases moderate.
3. The financial sector is healthy, but faces risks associated with rapid credit growth. 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 expose banks to sudden shifts in market sentiment. Banks also face significant interest and exchange rate induced credit risks: the majority of their loans is at variable interest rates and linked to foreign currency; and adverse shocks would erode borrowers' debt-servicing capacity in circumstances of high corporate and household debt.
4. The outlook for 2008 suggests policy challenges will remain.
• In the mission's baseline, growth slows this year, but remains at the upper end of the mission's estimate of potential growth (4-4½ percent). Inflation, while projected to ease from its current rate, remains higher than in recent years. The current account deficit and external debt stay near their levels in 2007.
• Downside risks to the baseline predominate. Inflation could be worse than expected if there are second-round effects from higher food and fuel prices—for example, if wage moderation were not maintained. In addition to moderation in government wages, state-owned enterprises therefore need to follow suit, an intention the authorities could usefully reiterate. A deeper slowdown in trading partners' growth, larger-than-expected global energy prices, regional shocks, and/or greater-than-anticipated domestic demand pressures could widen the current account deficit and result in less favorable external debt dynamics. While Croatia has so far felt little impact from the turmoil in global financial markets, the ongoing global repricing of credit risks could eventually push up external costs for Croatian borrowers, both banks and non-financial enterprises.
• Thus, Croatia is confronted with important challenges: reducing external and financial vulnerabilities; ensuring that higher inflation does not become entrenched in expectations; and increasing the productivity of the economy to boost its growth potential. The specific policy recommendations to address these challenges are discussed below.
Monetary, Exchange Rate, and Financial Sector Policies
5. The mission continues to support the CNB's policy of tightly managing the exchange rate. A stable exchange rate has been a key element of Croatia's successes, including by acting as a powerful anchor for inflationary expectations after Croatia's experience with hyperinflation. And given persistently high levels of financial euroization, maintaining broad exchange rate stability mitigates significant balance sheet risks.
6. With monetary policy constrained by the tightly managed exchange rate, strong support from financial, fiscal, and structural policies is essential for maintaining stability. Because a stable exchange rate tends to reduce perceptions of exchange rate risk and is therefore conducive to unhedged foreign-currency borrowing, strong prudential policies and bank supervision are needed to ensure adequate risk management. In addition, the tightly managed exchange rate also limits the ability of monetary policy to respond to domestic demand pressures, implying that support from fiscal policy is essential to help contain higher inflation and external imbalances. Finally, a gradual narrowing of external imbalances and orderly real convergence with the EU can only be achieved through improvement in the competitiveness of Croatia's economy brought about by structural reforms.
7. In view of persistent external imbalances and rising demand, the mission understands the CNB's rationale for introducing credit measures. With the exchange rate tightly managed, and only intermittent support from fiscal policy (e.g., the fiscal stance was expansionary in 2007, taking into account off-budget activities), there were limited options to address the effects of rapidly growing credit. In these circumstances, the Croatian National Bank (CNB) introduced credit controls in 2007 and extended them to 2008, while recognizing their potentially negative side effects—including on credit to smaller enterprises and bank competition. The controls have contributed to a significant slowdown in bank credit, as intended by the CNB; available data suggests that total credit growth to the private sector (from domestic and external sources) slowed modestly. Arguably, the effects of the controls were more significant from a counterfactual point of view, to the extent that credit growth would have been higher without the controls. Looking ahead, carefully planning the transition away from administrative measures, with the objective of eliminating negative side effects while maintaining financial stability, would be well advised.
8. Cognizant of the risks associated with rapidly growing credit, the CNB has also taken a number of prudential and supervisory measures to limit macro-financial vulnerabilities. A new capital adequacy decision was introduced to support the credit limits and ensure an adequate capital cushion, by requiring banks to hold capital based on their credit growth and sources of financing. The risk weights for unhedged foreign currency loans have been further tightened. The prudential measures since 2006 have contributed to a fall in the share of foreign currency-linked loans. In addition, banks seem to be more aware of risks related to such lending, have reduced their foreign borrowing, and intensified efforts to attract deposits and capital. There are also recent signs of a tightening of lending standards, including through increased lending rates and tighter conditions in granting loans. That said, higher buffers may be needed in certain worse case, but plausible, scenarios, and further prudential measures may need to be considered to contain any emerging risks.
9. The mission welcomes the CNB's efforts to both improve communications with banks in Croatia and cooperation with the supervisory authorities of their parent banks abroad. The recent update of the IMF-World Bank Financial Sector Assessment Program (FSAP) viewed these actions as crucial. Interactions with banks (e.g., through workshops and consultations) have certainly contributed to a better understanding of CNB measures, improved their acceptability, and raised risk awareness, with a view to aligning the incentives of the financial institutions with that of the CNB. With foreign banks owning more than 90 percent of the banking system, strengthening home-host supervisory coordination is also key in ensuring the effectiveness of CNB measures.
10. Basel II preparations appear on track, to become effective in January 2009. While the framework for risk-focused supervision is still evolving, the current supervisory techniques and risk management processes do not appear to pose risks for successful implementation of Basel II, though greater dialog with the industry in the remaining areas, including consultative papers on Pillars 2 and 3, would be helpful.
11. Supervision and regulation of the nonbank financial sector has continued to improve. The inclusion of previously unregulated leasing companies under HANFA's oversight has helped in closing a channel for circumvention of the credit measures on banks. The mission is also encouraged by the coordination efforts between the CNB and HANFA on information sharing, the intention to jointly inspect banking groups under the CNB's lead supervision, and the plans to map cross-sector risk exposures and ownership linkages between banks and nonbanks-all in line with the recommendations of the FSAP update.
12. Croatia has been largely unscathed by the turbulence in global financial markets, given the absence of direct or known indirect exposures to the subprime crisis. Nonetheless, continued turbulence in the global markets highlights the need to be vigilant and, in this regard, the mission welcomes plans to produce a forward-looking financial stability report and the initiation of formal communications with foreign supervisory authorities concerning contingency planning for possible external shocks. Timely responses from foreign authorities would be very helpful. The mission also welcomes the authorities' efforts to clarify the roles of different agencies in bank resolution and deposit insurance. Progress made in all the above areas is all the more impressive in light of the intensive ongoing work toward harmonizing with EU legislation.
13. Bringing the general government deficit to balance by the end of the government's term would be a major step forward. The government has already gone a good way toward this goal by targeting a general government deficit of ½ percent of GDP (on a modified GFS basis, the basis used during the last stand-by arrangement) by 2010. The path to this target represents a significant tightening compared with the plans during the previous Article IV consultation (as then expressed in the Economic and Fiscal Policy Guidelines of July 2006), and is therefore in line with the recommendations the mission made before. To maintain momentum, it would make sense to aim for balance by 2011. The greater the frontloading of the adjustment, the more immediate would be the help to the effort to bring down inflation (and inflation expectations) and reduce external imbalances. The greater the frontloading, the higher would be the likelihood of meeting the recommended target for 2011, as politics will increasingly make reforms difficult, especially in the latter part of the government's term. Reducing the government's size is also critical for raising the private sector's share of economic activity and thus overall productivity and the rate of potential growth.
14. Reducing the fiscal deficit must rely on expenditure reduction. The international evidence is clear: large fiscal adjustments are more successful, durable, and friendly to growth when they rely primarily on reducing current expenditure. Given the significant room for improvement in the efficiency of public spending, a substantial expenditure reduction can be achieved without unduly compromising the delivery of public services. But bold measures are clearly needed, with a view to limiting, modernizing, and/or better targeting the delivery of public services. Some progress on reform is in train, including discussions on containing health care spending and designing an approach to compiling a database on various social assistance benefits paid. However, much more needs to be done to develop specific measures. And significant budgetary savings are also possible with reforms in other areas, including the civil service, education, and state aid (subsidies). Care must also be taken to ensure sustainability of the pension system, including by avoiding backtracking on earlier reforms.
15. There are favorable aspects to the proposed budget for 2008. The budget targets a general government deficit of 2.3 percent of GDP, lower than the 2.8 percent of GDP originally budgeted in 2007. In this sense, it is encouraging to see fiscal policy moving in the right direction. The budget also aims at keeping the general government deficit unchanged from the estimated outturn in 2007. Taking into account the formation of a coalition government and the associated spending pressures, the mission recognizes the accomplishment this would represent. Finally, taking into account off-budget spending, notably the reduction in pensioners' debt payments, the overall fiscal stance will considerably tighten in 2008—a welcome development indeed.
16. Nevertheless, reflecting the benefits of frontloading, every opportunity should still be taken to further reduce the 2008 fiscal deficit. Thus, the mission strongly urges the authorities to save any revenue overperformance, while keeping to or below budgeted expenditures, taking advantage of any buffers.
17. Looking to the rest of the government's term, 2009 is the time to undertake the lion's share of fiscal adjustment. Thus, serious consideration should be given to achieving a fiscal deficit no larger than 1 percent of GDP, preferably smaller (compared with the authorities' target of 1.4 percent of GDP in the Economic and Fiscal Policy Guidelines updated in July 2007). Any expansion in the deficits of off-budget entities, including HBOR, should be offset by general government adjustment. Because of the need to take underlying measures in several areas, preparatory work should start soon. The authorities should also consider introducing medium-term sub-ceilings on key expenditure items specifically related to reforms. Initially this could be done on an informal, but transparent, basis, and later more formally. Signaling commitment to spending reform, in addition to avoiding a ratcheting up of spending when revenues overperform, would increase confidence in economic stability and the prospects for acceding to the EU.
18. There would also be considerable benefits to enhancing fiscal flexibility. To improve the readiness of fiscal policy to respond to unanticipated shocks, consideration should be given to a gradual increase in the general contingency reserve to, say, about 1 percent of central government spending. It is also important to have contingent fiscal spending measures at the ready.
19. Faster structural reforms will be needed for Croatia to realize its goals of sustainably raising living standards and successfully concluding EU accession negotiations. The mission's discussions, with representatives of the public and private sector alike, continued to underscore the urgency of improving the business environment and addressing corruption, including by improving the efficiency and transparency of all levels of public administration. This is critical to enhance Croatia's attractiveness as a destination for "greenfield" foreign direct investment, rightly recognized in the authorities' Strategic Plan for the Economic Development of Croatia as key to sustainably increasing total factor productivity and thereby Croatia's growth potential. In this context, judicial reform becomes doubly essential, both to underpin the rule of law needed for a better business environment, and as part of the EU accession process. Absent reforms, it is doubtful that Croatia can substantially boost export growth, thereby lessen external vulnerabilities, and raise economic growth on a sustainable basis.
20. Reform of the heavily indebted shipyard sector is urgent, both for fiscal reasons and to comply with the EU's single-market rules. This sector represents a substantial drain on the public resources. Moreover, recapitalizations of shipyards, especially if not tied to their imminent privatization, could have potentially large fiscal implications. Difficult decisions to rationalize capacity and employment are inevitable.
21. Relaunching the privatization process, especially if targeted towards strategic investors, would send a positive signal on reform intentions. The government successfully launched IPOs for the oil and telecom companies. However, the broader privatization process has recently slowed. The recent appointment of new management for the privatization fund is a step forward. The authorities are also considering setting up "closed-end" investment funds, consisting of shares in the remaining state-owned enterprises. These fund shares would be sold by public offering and could accelerate privatization. However, whether the funds would substitute for strategic investors and ensure restructuring and strong corporate governance of the underlying enterprises is unclear.
As always, we very much appreciate the open and high-quality discussions we have had with the Croatian authorities and other public and private sector representatives. We would like to thank them for all the time and effort they put into this Article IV consultation.