Croatia-Concluding Statement of IMF Staff Visit
February 3, 2012
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.
Croatia faces considerable economic challenges. Growth prospects are weak due to deep-rooted structural rigidities and competitiveness problems. Meanwhile, vulnerabilities are significant, with high external indebtedness and unsustainable public debt dynamics in the absence of fundamental policy changes. Strong linkages to the euro area imply that Croatia is highly susceptible to spillovers from the euro area crisis. The immediate policy priorities should include launching a credible medium-term fiscal consolidation to retain market confidence and restore debt sustainability. In this regard, the mission supports the authorities’ intention to start fiscal consolidation in 2012 and encourages them to rapidly pursue legal and institutional changes necessary for a full implementation of the envisaged spending cuts. The mission also urges acceleration of structural reforms to boost the export and growth potential of the economy.
Recent economic developments and outlook
1. After two years of recession, Croatia’s growth remained stagnant in 2011. Private sector deleveraging and high unemployment continued to weigh on domestic demand, while exports were subdued due to weak competitiveness and a slender export base. Nevertheless, a marked import contraction resulted in a small current account surplus. The mission estimates GDP growth in 2011 at ¼ percent, with Croatia’s growth performance lagging behind new member states of the European Union (EU).
2. Under unchanged policies, economic prospects for 2012 and the medium term are weak. With current policies, the mission projects a GDP decline of about 1 percent in 2012, reflecting continued weakness of domestic demand due to corporate deleveraging and household debt overhang. Recovery in external demand is likely to stall as the euro area enters a recession. This projection does not take into account the newly announced public investment projects, as their timing, import content, and growth impact are unclear at this time. Moreover, their financing would need to mainly come from external sources to ensure adequate liquidity for the private sector. Over the medium term, weak competitiveness will constrain growth in the absence of structural reforms. Domestic-demand driven growth fueled by large capital inflows during the pre-crisis years is no longer a viable option, as foreign financing will likely remain subdued. Rebalancing of the economy towards external demand is needed to return to a sustainable growth path.
3. The outlook is subject to significant downside risks. Direct financial and trade linkages to the euro area imply that Croatia is highly exposed to further spillover risks, particularly lower rollover rates, higher cost of funding, and weaker exports. The ensuing weaker GDP growth and revenues would exacerbate fiscal financing pressures. The impact would be substantially magnified by the high vulnerabilities arising from external debt of about 100 percent of GDP, sizable external financing needs, and large foreign currency indebtedness. Nevertheless, strong policy implementation could help improve confidence.
Fiscal consolidation is needed to ensure sustainable debt dynamics
4. Pro-cyclical fiscal tightening measures during the peak of the crisis were insufficient to avoid a significant deterioration in the public finances. Fiscal deficit of the general government (on ESA95 basis, which includes the balances of central government, local governments and extra-budgetary funds, payment of pensioners’ debt, and payments of called guarantees) widened from 1.3 percent of GDP in 2008 to 4.9 percent of GDP in 2010 despite the significant measures taken in 2009-10. The fiscal deficit deteriorated further to an estimated 5.6 percent of GDP in 2011. This reflected a decline in revenues on account of a drop in VAT and excise tax collections, the abolishment of the crisis tax, and the full-year impact of the reduction in income tax rates, which was not fully offset by expenditure reduction. Public debt reached about 45 percent of GDP (and above 60 percent of GDP including contingent liabilities).
5. Public debt dynamics are unsustainable under unchanged policies. Without fiscal adjustment, the budget deficit is projected to remain close to 6 percent of GDP in the medium term, due to rising interest costs and elevated mandatory spending. In this case, public debt would rise to about 70 percent of GDP in the medium term (over 85 percent of GDP including contingent liabilities). This would worsen market sentiment, with a rise in public and private sector interest rates or curtailment of financing and BOP pressures.
6. To achieve medium-term debt sustainability, the pace of fiscal consolidation implied by the Fiscal Responsibility Law (FRL) is broadly appropriate, but needs to continue until the overall budget is balanced on cyclically-adjusted terms. To prevent a worsening of market sentiment, Croatia needs to credibly demonstrate its commitment to medium-term fiscal consolidation, starting from the 2012 budget. Implementation of the FRL, which mandates a reduction of general government expenditures by 1 percent of GDP per year until a primary balance is reached, would help stabilize public debt, but at a too high level (around 55 percent of GDP, excluding public guarantees). This would keep vulnerabilities elevated and imply higher borrowing costs for both public and private sectors. The mission thus recommends that the fiscal consolidation implied by the FRL continues until a cyclically-adjusted overall (rather than primary) balanced budget is achieved to stabilize public debt at a lower level. This will reduce Croatia’s vulnerabilities and help create fiscal space to absorb costs related to EU accession and population ageing.
7. Fiscal consolidation should aim at reducing mandatory spending. An expenditure-based consolidation is appropriate as Croatia’s tax burden is already among the highest in the region, while mandatory spending accounts for a very large portion of the total. Expenditure cuts should focus on reduction in public sector employment, wage moderation/freeze, further reforms of pension and health systems, and decrease in subsidies. The authorities should also prepare contingency measures in the event that additional spillovers from the euro area crisis erode revenues and financing. These measures should aim at further containing the public sector wage and pension bill.
8. In this context, the fiscal consolidation envisaged in the 2012 Fiscal Guidelines, if fully implemented, would be a step in the right direction. If the envisaged spending cuts (amounting to 4.6 billion kuna) are executed in full and the planned changes in taxation are broadly neutral, the mission estimates that the 2012 deficit of the general government (on ESA 95 basis) would be reduced by about 1 percent of GDP to 4.6 percent of GDP. However, changes to the legal and institutional frameworks are a prerequisite for full implementation of the spending cuts. The mission encourages the government to urgently pursue these changes to avoid the risks of accumulating arrears or some expenditure measures being challenged in courts. The general government debt is estimated to reach 52 percent of GDP by year-end (assuming the guaranteed debt of shipyards are converted into public debt in the course of the year), and general government debt including contingent liabilities would reach 67 percent of GDP. Furthermore, the investment projects by public enterprises financed by borrowing would increase the deficit of the broader public sector, while adding any associated guarantees to the existing stock of contingent liabilities.
9. The envisaged 2012 fiscal consolidation measures should be framed within the context of a medium-term plan to give credibility to the FRL. This requires preparing and legislating specific measures and policy changes to deliver the planned fiscal consolidation aimed at reducing mandatory spending. Such a plan should also include a clear strategy regarding the evolution of the tax system. In this regard, the proposed decrease in direct taxation (health contributions) and increase in indirect taxation (VAT) is broadly appropriate to reduce the labor costs and should help stimulate job creation, provided that it is revenue neutral. However, the compensation of lower income households for the VAT increase should be considered in the broader context of the entire tax-benefit system.
Wage and structural policies should be accelerated to enhance growth potential
10. Croatia’s export and growth performance is constrained by relatively high wages and pervasive rigidities. Labor force participation is low due to the generous social benefits system. The labor market is one of the most uncompetitive in the region and wages are high relative to income and productivity. Insufficient progress has been made in privatization and enterprise restructuring, curtailing productivity growth and private sector development. As a result, the public sector remains large with intrusive regulations, and imposes cumbersome fees on the private sector. These structural weaknesses have restrained Croatia’s export growth and penetration in EU markets, which was among the lowest in Emerging Europe during the last decade.
11. Implementation of long overdue structural reforms is necessary to improve competitiveness and attain sustainable medium-term growth. First, an internal devaluation via reduction in prices and wages to more competitive levels is needed in light of the stable exchange rate regime, which would be costly to adjust given the economy’s large net foreign currency exposure. Second, priority must be given to structural reforms aimed at (i) increasing labor market flexibility by changing labor laws to induce more competitive wage setting and by reducing hiring and firing costs; (ii) boosting labor force participation through reforms of the social protection system; and (iii) reducing public sector employment and improving efficiency. Other critical actions include accelerating privatization of companies with government stakes and further improving the business climate, including through elimination of non-tax fees. The mission urges speedy implementation of these reforms to help mitigate the contractionary effects of fiscal consolidation. Improved competitiveness would help boost export growth and attract foreign capital, which will contribute to rebalancing the economy towards external demand and achieving a sustainable private sector-driven growth path.
Strong regulation and supervision are key to support the financial sector resilience
12. The largely foreign-owned banking sector has to date withstood the turbulence in the euro zone financial markets and the negative effects of the domestic recession without any systemic stress. The aggregate bank capitalization remains strong and the liquidity of banks is satisfactory. Despite the steady rise in nonperforming loans that requires increased provisioning, bank profitability is good reflecting an increase in net interest rate income and operational restructuring in some banks.
13. Nevertheless, risks to systemic financial stability remain. The sizable dependence of banks on external financing exposes them to the risk of contagion from the euro area (interest and rollover risks), especially if concerns about the sovereign debt adversely affect the euro area parents of Croatian banks. Potential difficulties in obtaining refinancing at affordable interest rates could lead to excessive or disorderly deleveraging, complicating macroeconomic recovery. In the context of weak growth prospects, the risk of further deterioration in asset quality also remains material.
14. Systemic financial stability should continue to be safeguarded through strong regulation and supervision. The CNB should continue to closely monitor liquidity and credit developments in all banks, and stand ready to quickly intervene if needed. In the past, several counter-cyclical policy measures implemented by the CNB have helped banks to cope with the boom and bust cycle. There may be scope for further use of some of these macro-prudential tools to preserve financial stability.
The mission is grateful to the authorities for the excellent cooperation, open discussions, and warm hospitality.