Croatia—2011 Article IV Concluding Statement
May 20, 2011
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. While the worst of the recession is over, Croatia is yet to see signs of a sustained economic recovery. Financial market conditions have stabilized since the peak of the crisis, but domestic demand continued to contract throughout 2010, with no pickup in production indicators, a deep slump in labor markets, and low confidence. Due to a narrow export base and weak competitiveness, Croatia was not able to take full advantage of the growth rebound in its trading partner countries, and GDP declined in 2010. Croatia’s recovery is thus lagging behind the new member states of the European Union (EU).
2. Long-standing challenges are weighing down Croatia’s economic outlook. Medium-term growth prospects are weak due to deep-rooted structural rigidities and competitiveness problems. Meanwhile, vulnerabilities are high. Fiscal deficits and public debt have been rising. High external indebtedness is particularly worrisome given the narrow export base. Large balance sheet exposures to foreign currency risks reinforce the authorities’ preference for a stable exchange rate. At the same time, limited policy space is compromising Croatia’s ability to withstand shocks.
3. What needs to be done? Implementation of a consistent set of macroeconomic, structural, and financial sector policies is urgently needed to ensure sustained growth.
To address competitiveness problems, priority needs to be given to structural policies and fiscal consolidation.
• Structural reforms in the areas of labor markets, public administration, and costs of doing business are required to enable a more flexible wage-setting, improve the business environment, and enhance the private sector’s role in the economy. Croatia’s wage levels, which are high relative to both its income and productivity levels, need downward correction to facilitate an internal adjustment given the stable exchange rate regime.
• Fiscal policy should prevent a further rise in the deficit in 2011 by identifying additional spending cuts, and, in the medium term, reverse the rise in the public debt and create policy space for macroeconomic management by pursuing an expenditure-based consolidation.
To enhance resilience against shocks, there is merit to gradual strengthening of foreign exchange reserves, and maintaining strong prudential policies.
• Monetary policy should continue aiming at gradual strengthening of foreign exchange reserves, which would help enhance the country’s buffers to better absorb shocks. If inflationary pressures arise or exchange rate expectations become unanchored, monetary policy will need to be tightened.
• Financial sector policies should continue to contain credit and liquidity risks through strong prudential measures and supervision, and coordination with home supervisors. In light of relatively high and still growing non-performing loans, though at a slower pace than before, the CNB should pay close attention to the level of loan loss provisions which have been on a declining trend since the beginning of the crisis.
4. The recovery is expected to be sluggish and medium-term growth prospects are weak. Following a GDP decline of 1¼ percent in 2010, the mission projects a modest recovery of 1 percent in 2011, mainly driven by external demand. Continued household deleveraging, banks’ risk aversion, weak confidence, and high unemployment rate are likely to contain domestic demand growth. Inflation is projected to increase to 3¼ percent in 2011 on account of rising food and commodity prices. Current account deficit, which has declined considerably over the past few years, is expected to widen somewhat to about 2¼ percent of GDP in 2011 largely due to rising import costs. External financing needs will increase to over 30 percent of GDP. In the medium-term, without corrective policies, GDP growth is projected to gradually reach 3 percent by 2015 as low confidence will restrict capital inflows, and poor competitiveness will keep external sector’s contributions low.
5. Risks to the outlook are tilted to the downside. In the near term, downside risks arise from high commodity prices and contagion from euro area periphery countries. In light of the high financing requirements, a shift in investor sentiment could trigger lower rollover of external debt and balance of payments pressures. Upside risks include a more robust global growth, and success in attracting investor interest for infrastructure projects recently announced by the government. In the medium term, EU accession provides opportunities for greater inflows and growth, but would require additional efforts to enhance the absorption capacity.
Wage and Structural Policies
6. High wages and structural weaknesses have held down Croatia’s export and growth performance. Rigid labor markets have kept wages high and uncompetitive relative to other countries in the region. Generous social benefits have stunted labor force participation and labor’s contribution to growth. Similarly, many aspects of Croatia’s business costs are higher than those of its regional peers. Privatization and enterprise restructuring, which remain incomplete almost two decades after the beginning of transition, have kept productivity growth meager. Public sector is large, intrusive in terms of regulations, and imposes cumbersome fees on the private sector. As a result, Croatia’s export growth and penetration in EU markets were among the slowest in Emerging Europe during the last decade.
7. To correct these long-standing structural problems, the government adopted the Economic Recovery Program (ERP), a comprehensive package of reforms, early last year. Measures included in the ERP aimed to address key reform needs, and progress has been achieved in some of the main areas. Pension laws were amended to equalize the statutory retirement age of women and men by 2030, increase penalties for early retirement, and introduce incentives to delay retirement. Duration of pre-retirement unemployment benefits, and benefits after 3 months of unemployment, were reduced. The law on civil service employment was modified to allow more flexibility in dismissal of workers. These reforms should help increase labor force participation and reduce pension system deficits, though they do not ensure the long-term sustainability of the PAYGO system. Non-tax fees, which act as a deterrent to private investment, were reduced by 25 percent, and privatization efforts were re-started. However, efforts to implement other measures, such as introduction of legislation to achieve greater labor market flexibility, were strongly resisted by social partners.
8. The mission urges forceful implementation of the remaining key reforms. Priority should be given to: (i) changing labor laws to induce a more competitive wage setting environment; and (ii) reducing the size of public administration. Other critical actions include: (i) improving the business environment through reduction of entry and exit costs and of non-tax fees; and (ii) completing privatization of companies with majority and minority government stakes. Croatia’s broadly-stable exchange rate policy makes these reforms all the more necessary to achieve adjustment of domestic wages and prices to more competitive levels. The mission acknowledges that pursuing these reforms is challenging, but sees them as necessary to reap the maximum benefits from EU accession.
9. Fiscal position worsened in 2010. The general government’s budget deficit widened to 5 percent of GDP from about 4 percent in 2009 (ESA95 methodology). Despite increased VAT and excise rates, overall revenues declined on account of a sharp drop in profit tax collection and reduction in personal income tax rates from mid-2010. Wage and pension freeze and cuts in capital spending helped reduce nominal expenditures slightly below their 2009 level, but were insufficient to offset the revenue losses. On a cyclically-adjusted basis, fiscal deficit widened by ¼ percent of GDP. Broader public sector deficit (including HAC and HBOR) reached 5¼ percent of GDP and public debt 40 percent of GDP (or 58 percent including public guarantees).
10. To buttress confidence, the mission urges implementation of additional measures that would prevent widening of the deficit in 2011. The 2011 budget targets a general government deficit of 5 percent of GDP. With current policies, the mission projects the deficit to reach 5¾ percent in 2011 and public debt 47 percent of GDP (including assumed debt of the shipyards). Declining tax revenues from the removal of the crisis tax, a full-year impact of personal income tax rate reductions, and low corporate profitability are expected to more than offset savings from wage and pension freeze, reduced health expenditures, and lower subsidies. Financing needs are likely to be manageable given excess liquidity in the banking system, and the recent Eurobond issuance. However, the continued widening of the deficit poses market risks. Therefore, the mission recommends keeping the overall deficit (excluding unbudgeted repayments of shipyards’ debt due to the sector’s restructuring) at its 2010 level in relation to GDP. In this regard, it is reassuring that the authorities have identified some contingency measures. The mission also encourages continued under-execution of expenditures which was experienced during the first quarter of 2011. The mission also urges the authorities to resist any pre-election spending pressures.
11. For the medium-term, the mission welcomes the introduction of the Fiscal Responsibility Law (FRL) and recommends an expenditure-based consolidation to reach a cyclically-balanced fiscal position by 2016. Without additional reforms, the fiscal deficit is expected to remain sizable and gradually decline to 3½ percent of GDP by 2016. Public debt is projected to reach 54 percent of GDP and 70 percent of GDP including guarantees. In the mission’s view, the adjustment envisaged under the FRL (a reduction in expenditures by 1 percent of GDP per annum until a zero primary balance is reached) is insufficient to create adequate fiscal space, as the cyclically-adjusted deficit would not be eliminated in the medium term, and public debt would remain high. The mission therefore advocates this pace of fiscal consolidation to continue until a cyclically-adjusted balanced budget is achieved. In addition, early adoption of fiscal measures to underpin such a consolidation path will be crucial to make the FRL targets credible and instill market confidence. Priority areas include; (i) a reduction in public sector employment and wages, and (ii) completing pending reforms in pension, health, and social assistance expenditures.
Monetary and Exchange Rate Policy
12. Foreign currency buffers of the economy should be maintained. During the peak of the crisis in 2008/09 and again in late 2010, the CNB resisted exchange rate depreciation through sales of foreign exchange reserves, and relaxation of foreign currency related prudential measures. Going forward, the mission sees limited scope for the use of such measures given that official reserves are relatively low, and large prudential foreign currency buffers, which were built up before the crisis, have been significantly reduced.
13. The CNB should aim to gradually strengthen foreign exchange reserves to counter risks from external vulnerabilities. One way to achieve this in a transparent manner would be through small daily preannounced purchases of foreign currency, unless sustained depreciation pressures occur. This would imply an accommodative monetary policy, which is appropriate in the presence of a large output gap and low core inflation. If inflationary pressures emerge or exchange rate expectations become unanchored, monetary policy will need to be tightened.
Financial Sector Policies
14. The banking sector has withstood the recession relatively well. Asset quality deteriorated, with the nonperforming loan (NPL) ratio reaching 11 percent in December 2010 and corporate sector’s NPL ratio 18 percent. Nevertheless, the banking sector remains sufficiently capitalized and profitable. As of end-2010, the aggregate capital adequacy ratio stood at 18 percent, well above the regulatory minimum and higher than in the pre-crisis period. Profitability indicators started to recover in recent months, but remained below their pre-crisis levels.
15. Nevertheless, there are risks to systemic financial stability. The main risk arises from weak growth prospects and further deterioration in asset quality, which would put pressure on profitability and capitalization. The mission recommends paying close attention to the provisioning of NPLs, which has shown a declining trend in the last few years. There is also liquidity risk related to significant dependence on parent banks for financing. However, the experience during the crisis has shown that strategic relationship with parents helped mitigate this risk. Also, while the absence of subsidiaries with parents in debt-distressed Euro zone periphery reduces Croatia’s exposure to contagion risks, dependence on external financing exposes the local banking sector to third-party risks through higher funding costs or lower flows.
16. The banking sector appears sufficiently resilient to withstand possible shocks. According to the CNB’s latest stress tests, profits of most banks should be sufficient to fully absorb losses from the increase in the NPL ratio to 15 percent. Even in the event of a more severe deterioration in credit quality, the system-wide capitalization ratio would remain above the prudential minimum with the exception of some smaller banks. In this regard, should there be a need to recapitalize state-owned banks, this should be accompanied by comprehensive restructuring programs. With respect to the liquidity risk, banks’ resilience would largely depend on parent banks maintaining open credit lines.
17. Systemic financial stability should continue to be safeguarded through strong regulation and supervision. The mission welcomes the proactive approach of the CNB to ensure effective bank regulation and supervision. In this regard, the intention of the CNB to gradually introduce counter-cyclical capital buffers in the medium term is appropriate. The mission encourages continued supervisory cooperation between CNB and HANFA (supervisor of nonbank financial institutions) as well as between CNB and home supervisors of foreign parent banks.
18. The mission cautions against certain official credit-support schemes that could increase contingent liabilities of the public sector or undermine lending standards. The scheme involving swap of debt of troubled private companies to the government into equity should be limited only to corporates with viable restructuring plans. Given the temporary nature and small size of the government guarantees on mortgage interest payments, this scheme should not lead to lowering of credit standards.
19. Any potential fiscal changes affecting banks should not undermine financial stability or endanger macroeconomic recovery. Introduction of any additional taxation of banks would need to be coordinated with the EU and carefully designed to avoid triggering capital outflows. The mission understands that a levy on banks is currently not being considered by the government, but periodic reemergence of talks on such a levy creates uncertainty about the operating environment for the banking sector.
The mission is grateful to the authorities for the excellent cooperation, open discussions, and warm hospitality.