Croatia—2010 Article IV Consultation Concluding Statement
May 12, 2010
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.
I. Context—The impact of the global economic crisis
The global economic and financial crisis has significantly affected the Croatian economy. Reduced private capital inflows and external demand aggravated Croatia’s existing imbalances. With a large current account deficit, a high level of external debt, and significant balance sheet exposures to interest and exchange rate risks, market confidence in Croatia deteriorated sharply in early 2009. Financial asset prices collapsed, and sovereign spreads shot up.
The authorities moved swiftly to support macroeconomic and financial stability. The Croatian National Bank (CNB) appropriately addressed liquidity shortages in the banking sector through relaxation of regulatory requirements and repo auctions, while intermittent foreign exchange interventions alleviated pressures on the kuna. To offset the plunging revenues and contain the 2009 budget deficit to financeable levels, the authorities adopted three supplementary budgets with a number of short-term measures, including expenditure cuts, a wage and pension freeze, a VAT rate hike, and the introduction of a temporary “solidarity tax” on incomes and pensions. Nevertheless, the general government overall fiscal deficit widened to just under 4 percent of GDP (including the payment for a called guarantee of a public shipyard). Public debt increased to 35 percent of GDP or to 50 percent of GDP including the stock of government guarantees.
The strong policy response has helped improve financial market sentiment. The kuna has retracted its losses, official reserves have been replenished, and bond spreads have declined considerably. The authorities successfully tapped international capital markets twice in 2009. Liquidity pressures have abated as domestic deposits have been stable, while credit lines to domestic subsidiaries from foreign parent institutions have been maintained. Banks have weathered the crisis relatively well and have been able to maintain adequate capitalization, although credit quality has worsened significantly and profitability has declined, largely reflecting an increase in provisioning for nonperforming loans..
The economic downturn has nevertheless been severe. Private sector credit growth fell sharply as the uncertain macroeconomic environment lowered demand for new loans, and banks tightened underwriting standards. Exports plunged on the back of weak external demand, though the decline was more than offset by a reduction in imports. As a result, the current account deficit has nearly halved in 2009 to 5.2 percent of GDP. Real GDP fell by 5.8 percent in 2009, led by large drops in investment and private consumption. Registered unemployment rate increased sharply, reaching 17 percent. Headline inflation declined to 1 percent in March 2010, consistent with a significant negative output gap.
II. Outlook—Fragile recovery with downside risks
Economic activity is expected to start improving in the second half of 2010. Performance indicators in the first months of this year remain mixed: while the fall in industrial production has stopped, the construction sector and retail services continue to contract. We expect private consumption and investment to be dampened by declining disposable income and profits, further increase in unemployment, weak credit conditions, and high private sector indebtedness. The recovery—mainly driven by net exports and inventories’ restocking—is thus likely to be fragile. Overall, we expect zero economic growth and average inflation of about 2 percent in 2010. The current account deficit is expected to remain broadly unchanged.
Risks to the near-term outlook are tilted to the downside. External vulnerabilities remain substantial, with a large stock of external debt and sizable external financing needs in 2010. So far the continued support of foreign parent banks has helped alleviate capital account pressures. However, Croatia remains vulnerable to general contagion risks from adverse market sentiment in the region, which could lead to the tightening of financial constraints. Against this background, liquidity conditions in the banking system warrant careful monitoring.
The sizable fiscal consolidation envisaged in the original 2010 budget appropriately addresses financing constraints and crowding out concerns, but will be challenging to achieve without additional expenditure measures. The planned changes in personal income taxation (PIT), the early withdrawal of the solidarity tax, and a somewhat weaker growth than previously envisaged will have negative impact on revenues. The mission thus projects the 2010 general government fiscal deficit to reach 3.6 percent of GDP. While the mission sees merit in the planned reduction in the PIT rates given that they are high relative to Croatia’s peers, limited fiscal space and large financing needs imply that expenditure consolidation and structural reforms should be pursued first. The public sector financing gap is expected to be substantial but manageable in light of the recent strong demand for government securities. However, financing is susceptible to exchange rate and rollover risks. Additional risks arise from the likely execution of government guarantees as well as possible revenue underperformance in the event of longer-than-expected recession.
The authorities’ measures to stimulate credit to the economy require caution. The moderate pace of the recent monetary easing has been adequate so far against the background of a stable foreign exchange market and subdued inflation outlook. However, in the current uncertain macroeconomic environment, the demand for loans remains weak. While the credit support measures include safeguards to prevent weakening of the credit underwriting standards, close supervision of the quality of the issued loans should be ensured. In addition, the fiscal risks from the rising stock of the government’s contingent liabilities also require special attention. Given the slow take off of the credit support schemes, we would advise against further monetary easing in the short term as confidence remains brittle and the financing outlook is susceptible to risks. Furthermore, the proposed scheme to exchange debt of some troubled companies to the government into equity should not go against the spirit of intended privatization efforts and only be used for companies with viable restructuring plans.
Preserving financial sector stability will be instrumental to economic recovery. Asset quality is expected to worsen further in 2010 in light of economic stagnation, though the results of recent stress tests undertaken by the CNB show that most banks would be able to withstand a significant rise in nonperforming loans without a need to raise new capital. Nevertheless, continued vigilance is required and the mission supports the decision to raise the minimum capital adequacy requirement from 10 percent to 12 percent beginning April 1, 2010, to ensure a broadly unchanged level of capital buffers in the context of adopting the Basel II framework.
III. The Challenges—How to build a more resilient economy
Croatia’s robust pre-crisis growth was built on domestic demand boom fueled by abundant capital inflows. This led to rapid credit growth, a buildup of external liabilities, and large current account deficits. Capital inflows were to an important extent debt creating, while much of FDI inflows went into the financial and wholesale/retail trade sectors. Notwithstanding prudential measures aimed at restraining credit growth, the predominantly foreign-owned banking system facilitated an overly rapid financial deepening, with most credit concentrated in the nontradable sector, exacerbating its bias in the structure of the economy. At the same time, the long period of nominal exchange rate stability and weak export performance raise concerns about the adequacy of Croatia’s competitiveness. Furthermore, relatively high labor costs and long-standing structural weaknesses (particularly labor market inflexibility, the large share of the public sector in the economy, and the unfavorable business environment) have hampered the emergence of a dynamic export-oriented private sector.
Looking ahead, attaining sustainable medium term growth will require a considerable policy shift, as recognized in the authorities’ recently adopted Economic Recovery Program. Heightened global risk aversion makes it unlikely that capital inflows will return to pre-crisis levels, thus curbing future credit and domestic demand growth. In the medium-term, growth is unlikely to exceed 3 percent. Attaining higher and sustainable growth rate in the long run will require concerted efforts focusing on (i) income and structural policies to enhance competitiveness and rebalance economic growth in favor of tradable sectors, and (ii) medium-term fiscal consolidation to remove existing inefficiencies, reduce vulnerabilities, and provide adequate room for policy maneuver in the future. A joint implementation of these policies would bolster market confidence, lay a strong foundation for sustainable income catch-up, and contribute to the moderation of external imbalances.
The mission acknowledges the difficult trade-offs in deciding on the appropriate exchange rate policy. Our estimates, which are subject to significant uncertainties, suggest that the exchange rate could be slightly overvalued. However, the balance sheet deterioration and the recessionary impact in the event of even a moderate nominal depreciation of the kuna would be significant given large private and public sector foreign currency exposures. Furthermore, competitiveness gains from exchange rate realignment would fully materialize only when the growth in trading partners improves and the structure of Croatia’s economy becomes more outward oriented. The CNB therefore intends to continue pursuing a stable exchange rate policy.
Boosting external competitiveness will require costly, but necessary internal adjustment. With realistic prospects of euro adoption only in the medium-to-long term, such adjustment will likely involve a period of inflation below that of trading partners , slower growth in the near term, and ensuing bank balance sheet costs through higher nonperforming loans. This internal adjustment should be achieved through competitiveness-enhancing income policies relying on wage restraint, with public sector taking the lead, and through productivity-enhancing structural reforms.
Medium-term fiscal policy should aim to create adequate space for countercyclical maneuver, eliminate inefficiencies in spending, and ensure debt sustainability. Our estimates suggest that with unchanged policies, the fiscal balance of the general government would stay above 3.5 percent of GDP throughout the medium term, and public debt would rise to 44 percent of GDP by 2015. Taking into account the existing stock of contingent liabilities, total debt of the public sector would reach 60 percent of GDP. It would therefore be appropriate to pursue fiscal consolidation over the medium-term that would bring the overall fiscal balance to zero and put the public debt-to-GDP ratio on a downward trajectory. This would create room for countercyclical fiscal policy and reduce the risks associated with rising debt. In view of Croatia’s relatively high tax burden (including fees and charges), this adjustment should be primarily expenditure-based and supported by structural reforms.
The mission is encouraged that the principles of the Economic Recovery Program go to the heart of many of the reform areas outlined above. At this time, as the authorities are working on refining the parameters of the various measures, the fiscal and growth impact of the package cannot yet be quantified. We urge the authorities to frontload measures that would reduce public expenditure and improve efficiency of the economy. These include reducing the size of the public administration, completing reforms in pension, health and social assistance expenditures, stepping up privatization, and reforming the labor law to introduce greater labor market flexibility and participation. Only after implementing these reforms would there be room to reduce the tax burden of the economy, which should help to further stimulate long-term growth. The decision to adopt a Fiscal Responsibility Law is a move in the right direction, and we encourage the authorities to set the target at cyclically adjusted zero balance. We recognize that the success of the ERP will require considerable political consensus. Its timely execution would be key to instill market confidence.
The authorities’ medium-term strategy—anchored in EU accession—calls for a strong policy response to pave the way for a robust recovery. Croatia’s economic integration with the EU provides the country with an opportunity to speed up income convergence to the levels of advanced EU economies. Yet to reap this benefit and ensure high and sustainable economic growth in the long term, sound macroeconomic policies and wide-ranging structural reforms are required. When the global crisis unfolded, the authorities responded swiftly with measures to support financial stability. With a post-crisis scenario of lackluster growth and an increasing debt overhang, equal determination is needed in the implementation of policies to facilitate development of a more resilient economy.
We thank the authorities and all our interlocutors for the excellent cooperation and the constructive and friendly discussions we have had in the past two weeks.