Croatia—2009 Article IV Consultation, Concluding Statement
April 9, 2009
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.
1. The global economic crisis has begun to affect Croatia’s economy, bringing to an end a multi-year expansion fueled by strong credit growth. The economy now faces strong headwinds from the ongoing financial turmoil that has triggered a sharp decline in the volume of capital inflows, and from the sharp economic slowdown in the euro-area and the region that is increasingly taking a toll on export demand.
2. The mission expects a considerable decline in economic activity in 2009. While GDP growth estimates at this point are subject to an unusual degree of uncertainty, the GDP growth projection of -2 percent in the revised budget, although possible, would require a recovery starting in the second half of the year. In the mission’s view, downside risks dominate and economic activity could contract more sharply. Domestic demand would be the key driver, with weakening private consumption and a large drop in investment. Import contraction is expected to outpace the fall in exports, and the current account deficit would narrow to about 6.5 percent of GDP. Growth is expected to remain sluggish in 2010, with the strength and pace of recovery depending, inter alia, on regional economic and financial conditions.
3. Croatia’s financial system has weathered relatively well the first impact of the global storm thanks to skillful management and timely measures. In particular, financial market jitters and a sudden deposit outflow in the second half of October 2008 was arrested and reversed quickly by measures to increase deposit insurance coverage. Moreover, a revised and more realistic budget was adopted in April 2009. However, a tight financing-negative growth environment in the period ahead threatens to exacerbate long-standing domestic imbalances. Private sector indebtedness (mostly external or foreign currency denominated) swelled during a period of ample liquidity, with a large part of the financing supporting nontradable sectors and private consumption. External financing needs are very large and fragile balance sheets constrain policies.
4. Challenging times require strong policies. In the near-term, maintaining stability will require implementation of prudent fiscal, monetary, and financial policies, and preparedness to respond quickly if tail risks materialize. To bolster confidence, it is essential that short-term measures be complemented by reforms to address long-standing competitiveness issues and increase the economy’s growth potential.
I. Preserving exchange rate stability
5. In the fragile environment of recent months, liquidity pressures in the banking sector have intensified. This reflected curtailed external funding possibilities, large government financing needs and a re-orientation of corporates toward domestic financing. Central bank’s liquidity management operations through repo auctions and Lombard loans and relaxation of reserve and liquidity requirements have helped to alleviate tensions. But interbank money market rates have been very volatile, often hovering well above the refinancing rates of the CNB.
6. The mission acknowledges the difficult trade-offs involved in deciding on the exchange rate policy for the period ahead. Rising unit labor costs and structural weaknesses of the Croatian economy in combination with exchange rate depreciations in some neighboring countries risk to erode competitiveness. With significant private sector balance sheet vulnerabilities, a sharp depreciation would have devastating effects on unhedged corporates and households, and indirectly on financial institutions. The continuation of the current exchange rate regime underlines thus the importance of rising flexibility elsewhere, in particular, swift progress with structural reforms and adequate external financing.
7. In addition, monetary policy and liquidity conditions will need to remain tight at this stage, complemented by prudent fiscal and financial sector policies (discussed below). The CNB should continue to maintain monetary aggregates under control and limit the creation of kuna liquidity. This would help prevent further financial euroization that increases currency risks, undermines the effectiveness of monetary policy, and limits policy options down the road. The central bank should move to policy easing only if balance of payments pressures abate.
8. This said, the CNB should be prepared to intervene, if necessary, in case of an adverse liquidity shock. To this end, the mission welcomes the simplification and enhanced access of banks to emergency liquidity assistance from the CNB.
II. Securing adequate external financing
9. Croatia’s ability to cover its gross external financing needs will be severely tested in 2009. Although the current account deficit is projected to shrink from nearly 10 percent to around 6.5 percent of GDP in 2009, a sharp drop in FDI and reduced financing flows to Croatian banks and corporations risk leaving large financing gaps. High debt rollover rates are needed to protect external and financial stability.
• General government. A reorientation of financing to foreign sources would help deflect financing pressures on the economy. In this context, a successful eurobond placement in May would demonstrate market confidence in the authorities’ policies and serve as an important benchmark for corporate foreign borrowing. It would also allow more space for domestic bank lending to the private sector.
• Banks. Banks were able to achieve rollovers of at least 100 percent of their liabilities in the difficult post-October 2008 period, but the situation could become more challenging in the time ahead. This could be particularly the case of liabilities to non-parent banks. High rollover rates will not only help the balance of payments but, equally important, would reduce banks’ liquidity risk and constraints. To this end, the CNB should continue to monitor banks’ liquidity management closely and at a high frequency; and to maintain already established close cooperation with home supervisors of foreign parent banks. Negative spillover from neighboring countries will remain a considerable risk.
• Corporates. Rollover risks may become most pronounced in the corporate sector, particularly public sector enterprises, including shipyards. In this regard, the authorities’ efforts to increase HBOR’s resources through multilateral loans to help SMEs and the export sector are welcome. It will be important to follow developments closely, using the CNB’s monitoring system to obtain relevant information on banks and the most important corporates.
III. Crisis proofing the financial system
10. The economic slowdown is likely to be challenging for domestic borrowers and preventive measures would help deal with weaker credit portfolios.
• Enhance banks’ capital buffers. Although bank solvency ratios remain satisfactory, (with the aggregate capital adequacy ratio of the banking sector at 14.5 percent well above the regulatory minimum), the economic downturn will impair bank credit quality and increase vulnerabilities. The most recent stress test results reaffirm banks’ vulnerability primarily to exchange rate depreciation and also to output contraction.. The mission thus encourages the authorities to undertake a diagnostic review of the financial conditions of all individual Croatian banks. Banks with potential recapitalization needs should be required to present a viable program to raise their capital buffers. To avoid a negative impact on credit growth, the increase in CAR should be achieved by further injections by shareholders. In this relation, the mission endorses the current intention of the largest banks to restrict dividend payments. The CNB should continue to monitor closely bank risk management practices and lending standards to address any emerging risks.
• Improve interagency coordination. Many elements of the contingency framework to deal with banks in distress are consistent with international best practices. An interagency memorandum of understanding for dealing with systemic crisis, currently under preparations, is expected to be adopted by end-May 2009. Recent amendments to the laws on credit institutions and deposit insurance addressed a number of weaknesses. For example, the legal protection of the CNB was strengthened and the timeline for payments of insured deposits was shortened. The mission also welcomes the authorities’ intention to adopt a memorandum of understanding on crisis preparedness and management between various agencies dealing with financial stability issues (Ministry of Finance, CNB, HANFA, and deposit insurance fund). Having an ex ante formalized mechanism for communication among authorities should facilitate effective action.
• Upgrade the framework for resolution of troubled assets. The authorities should proceed with the adoption of the new foreclosure law to speed up the resolution of corporate and household bankruptcies. An efficient foreclosure framework, including through the introduction of private bailiffs, would complement the voluntary restructuring of problem loans through refinancing and lengthening of maturities, which is already contemplated by banks as a first line of defense against the anticipated increase in distressed assets.
IV. Buttress confidence with sustainable fiscal consolidation
11. The revised budget deficit target of 1.6 percent of GDP for the general government is appropriate under current circumstances. Croatia’s vulnerable external position, tight domestic financing conditions, and the need to preserve space for crisis-related contingencies leave little room for more stimulus to cushion the economic slowdown.
12. Budget execution is now key to achieve this target. The mission welcomes the recent health sector reforms to improve cost recovery and the adoption of tax identification numbers that would allow stronger tax compliance and better targeting of social benefits. Wage growth restraint was inevitable, given little options to reduce other spending in 2009, absent structural reforms. As the budget relies on cuts across a broad range of spending items, tight rein of spending commitments would be crucial to avoid the re-emergence of public sector arrears. These can have damaging ripple effects throughout the economy, undermining payment discipline.
13. Additional measures would be needed were revenue to fall short of budget projections. The recent sharp declines in revenues, particularly VAT, show their sensitivity to the economic cycle, and the budget is optimistic in the VAT collection projections. To prevent a higher deficit, the authorities should consider contingency measures and be prepared to act quickly with a supplementary budget. Possible measures include curtailing subsidies and advancing the restructuring of loss-making SOEs; improving cost recovery for social services; containing the growth of privileged pensions; better targeting social benefits; and scaling back the public investment program. The authorities should also develop a strategy to contain a possible decline in taxpayers’ compliance, including by public enterprises. Enforcement needs to focus on highest revenue risks and improving tax administration.
14. In the same context, it will be key to limit the response of the authorities to calls for support of various economic sectors. The authorities should also refrain from changing the second pillar of the pension system, which could have a devastating effect on already battered capital markets and erode investor confidence. Instead, the pay-as-you-go Pillar I of the pension system should be reformed to ensure its sustainability.
15. Ultimately, the budget deficit will be limited by the government’s ability to finance it without putting domestic financial markets under stress. The gross financing requirement amounts to about 6 percent of GDP. The February syndicated loan and the planned eurobond placement in May would partially cover these needs. However, large issuance of short-term treasury bills, increasingly FX denominated, placed with banks would increase the government’s rollover needs while crowding out private sector credit. In this regard, the mission welcomes the government’s efforts to increase absorption of EU and World Bank funds for its capital spending.
V. Structural Reforms to Boost Croatia’s Growth Potential
16. The economy needs to emerge from the current juncture more resilient and dynamic. Output and export growth has been lackluster in recent years, and Croatia performs below its potential and its peers. With the economy performing below potential in the near term, output gaps will widen and levels of unemployment will increase. Experience with past financial crises suggests that the risk of a permanent loss in potential output is considerable. To achieve growth rates of 4-5 percent over the medium-term in an environment of reduced capital inflows competitiveness of the economy needs to improve. Reforms are needed to raise labor productivity, reduce impediments to investment, and reorient the economy towards the tradable sector.
17. Now, therefore, it is the time to tackle long-standing structural issues. The mission welcomes the authorities’ intention to persevere with the reorganization and privatization of the shipyards within 2009. There is also room in 2009 for starting with a civil service reform; and rationalization of the structure of government operations. The objective needs to be a smaller, better paid, more dynamic and efficient civil service at all levels of government. These initiatives would not only be important to make progress in rolling back the weight of the public sector in Croatia’s economy, but also to buttress confidence in Croatia’s ability to withstand the crisis out of its own means. In addition, renewed impetus will be needed to: (i) promote labor market reforms; (ii) accelerate effective reform of health, education, social benefits and assistance; and, more generally, (iii) improve the business environment.
The mission is grateful to the authorities for their open discussions, excellent cooperation, and warm hospitality.