Mission Concluding Statement 

November 12, 2010

1. Croatia’s economy is in need of far reaching and challenging reforms to improve its weak macroeconomic outlook over the medium term. Structural weaknesses, reflected in low competitiveness and high underlying fiscal deficits will likely result in a protracted period of slow growth and rising debt. Given the stable exchange rate policy, which reflects high euroization and foreign debt levels, the required improvement in competitiveness can only be achieved through internal adjustment. This entails maintaining inflation and/or wage growth relative to productivity below that of trading partners for a sustained period of time. To achieve price and cost adjustment, complementary macro-critical reforms are needed in the labor market, public administration, pensions, health care system, and privatization. Successful implementation of these reforms, which relies on building a broad-based consensus, would bring significant future benefits to the people of Croatia in the form of higher economic growth, job creation and improved standards of living. This would also allow the economy to reap the maximum benefits of EU accession.

What needs to be done? Full and speedy implementation of structural reforms outlined in the Economic Recovery Program (ERP) to boost competitiveness and spur growth

2. The ERP represents a commendable effort in diagnosing the underlying structural weaknesses and effectively outlines many of the reforms needed to tackle these problems.

Implementation has made progress in two important areas:

• Labor force participation. The harmonization of retirement age for women and men, increased penalty for early retirement, introduction of bonus for late retirement, decreased unemployment benefits beyond 90 days of joblessness, and incentives for job training, should contribute to increasing labor force participation. However, the changes in the pension parameters fall short of those set out in the ERP, and are not sufficient to ensure the sustainability of the pension system.

• Private sector participation. Streamlining of business registration, reduction of non-tax revenues (which are an administrative burden on the private sector), and judicial reforms to strengthen contract enforcement and bankruptcy procedures for companies, will help enhance private sector participation in the economy. Nevertheless, much needs to be done to improve investor confidence and unleash the true potential of the private sector (including reforms specified below).

Implementation of other key reforms is required in the following areas:

• Ensure sustainability of pension and health expenditures. Measures to ensure sustainability of the pension system, including gradually harmonizing pensions granted under different terms, and further rationalization of the hospital network will be important.

• Streamline and improve efficiency of the public sector. While measures have been taken to consolidate public administration agencies, reforms to reduce public sector employment and cut subsidies to enterprises need to be accelerated. In addition, minority and majority non-strategic government-owned companies should be privatized.

• Enhance labor market flexibility. To improve competitiveness, greater flexibility in employment and wage agreements is needed to ensure that wage growth does not exceed productivity growth. Reforms have yet to commence in this key area.

• Improve the fiscal policy framework. Given the stable exchange rate, fiscal policy is the main macroeconomic policy tool. The mission welcomes the authorities’ intention to put in place a fiscal responsibility law. To ensure that such a law puts Croatia's public debt on a declining path and creates adequate fiscal space, it would be important to implement expenditure consolidation prior to its adoption. In addition, it should target a cyclically-adjusted balanced budget once the initial consolidation is completed. Setting the target on overall deficit on ESA95 basis would help ensure consistency with the rules under the Stability and Growth Pact.

Near term outlook: sluggish recovery with weak medium-term prospects

3. The recovery is more delayed than previously expected. Continued weak consumption and an investment slump resulted in a larger-than-expected 2½ percent GDP drop (year-on-year) in the first half of 2010, on the back of sharply rising unemployment and continued weak credit growth. The mission forecasts a GDP contraction of almost 2 percent in 2010, although the pace of decline appears to be moderating in the second half of the year on account of signs of improving consumer sentiment and a mild recovery in credit growth. Real exports remain feeble, reflecting low competitiveness and a narrow export base. As a result, Croatia is one of the few countries among its peers where output is still falling in 2010. High private sector indebtedness is weighing on domestic demand, as households and firms go through the necessary deleveraging process.

4. A return to positive but subdued growth is likely in 2011. The mission projects growth of about1½ percent in 2011. This is based on a modest recovery in investment and consumption spending, if the mild improvement in credit growth (particularly to corporates) and the recent uptick in consumer confidence are sustained. The contribution of external demand to growth is also projected to strengthen, but only moderately. Unemployment is expected to remain elevated through 2011, followed by a steady but slow decline thereafter.

5. The current account deficit is expected to narrow in 2010 to about 2¾ percent of GDP. The improvement in the current account deficit reflects continued import contraction associated with weak domestic demand. Exports of goods and services showed signs of improvement during the first half of 2010, with gains in shipyards and an increase in “stay over” visitor arrivals. The current account deficit is nevertheless projected to widen to close to 4 percent of GDP in 2011 due to increasing imports. External financing needs remain large over the near term, mostly reflecting corporate sector’s debt repayment, with external debt close to 100 percent of GDP.

6. Downside risks to the economic outlook are significant. These are linked to the large external financing requirement and the pace of private sector deleveraging. Furthermore, delayed fiscal consolidation may lead to higher risk premia and borrowing costs for both the public and the private sectors. While parent banks appear committed to maintaining their exposure to local subsidiaries and corporate clients, a change in sentiment could have a significant impact on the domestic financial sector and the economy. Furthermore, the economy may stagnate if the recovery in domestic demand is more delayed than anticipated.

Fiscal policy: stronger measures are needed to reverse the rise in public debt

7. Measures announced in the supplementary budget fell short of what was necessary to contain the deterioration in the fiscal position in 2010. Consequently, the fiscal deficit is projected to reach 5.4 percent of GDP in 2010 (on ESA95 basis), and the broader public sector deficit over 6 percent of GDP (including HABOR and HAC). This reflects weaker growth, a bigger-than-anticipated drop in profit tax collection, payment for shipyard guarantees, and front-loading of income tax rate reductions. The supplementary budget did not incorporate the expenditure measures envisaged under the Economic Recovery Program (ERP) and did not keep expenditures frozen as intended, due to concerns about the social impact. As a result, public sector debt is projected to increase to 40 percent of GDP, or about 55 percent of GDP including public guarantees.

8. The expenditure freeze envisaged for 2011 budget requires additional ex ante fiscal measures worth about 0.7 percent of GDP, including wage and pension freeze. Based on the policies in the medium term fiscal guidelines, the mission estimates a widening of the deficit to 6 percent of GDP (ESA95 basis). This projection is based on (i) an expected revenue decline resulting from the withdrawal of temporary tax measures, (ii) the full year impact of personal income tax reductions, and (iii) no reduction in public sector employment. The authorities’ intention to keep expenditure unchanged in nominal terms requires agreement and legislation to freeze wages and pensions, and fending off new spending pressure. Additional widening of the fiscal deficit could arise from a slower-than-expected recovery and higher-than-budgeted spending for called guarantees on the shipyards. Contingency measures for expenditure cuts in case of unforeseen revenue shortfall should therefore be specified.

9. The authorities’ objective to reduce the fiscal deficit to about 2 percent of GDP by 2013 is broadly appropriate, but will need implementation of expenditure-saving measures. We urge the authorities to identify and implement fiscal measures to reach this goal, and continue the consolidation to reduce the overall deficit to zero by 2015 as the output gap closes. This would require a reduction in expenditure through implementation of the measures planned in the ERP (in particular public sector retrenchment, privatization, and implementation of pension and health sector reforms), a more flexible wage-setting mechanism, and better targeting of social benefits. Such a consolidation would increase Croatia’s policy space to smooth economic cycles, and put public debt on a downward path.

Financial sector: Preserving stability is key

10. Preserving banking sector soundness will be a pre-condition for economic recovery. System-wide capitalization, liquidity, and profitability indicators are satisfactory. However, the quality of bank assets continue to deteriorate, and the credit to households remains almost flat, while credit to corporate is growing modestly, partly due to measures to stimulate lending adopted earlier in 2010. Regarding the proposed scheme to exchange debt of troubled companies to the government into equity (model C), the mission reiterates its position that it goes against the spirit of intended privatization efforts and should only be used for companies with viable restructuring plans.

11. Regulatory or fiscal changes affecting banks should be carefully designed so as not to endanger the macroeconomic recovery. In particular, any regulatory tightening or the introduction of a bank levy should avoid adverse macroeconomic implications, including restricting the availability of credit to the economy and should be in coordination with the EU.

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The mission is grateful to the authorities for their excellent cooperation, open discussions, and warm hospitality.