Republic of Croatia: Concluding Statement of the 2014 Article IV Consultation Mission
March 3, 2014
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.
Economic conditions remain very difficult, with real GDP projected to contract for the 6th consecutive year in 2014. Fiscal policy has run out of space, while monetary policy is constrained by the need to prevent a contractionary revaluation of foreign currency indexed debts. To improve growth prospects, structural reforms are key that accelerate debt restructuring, enhance the capacity of the economy to adapt, and boost investment and labor market participation. At the same time, gradual fiscal consolidation is needed to preserve access of the economy to financing at acceptable conditions and to boost confidence in macroeconomic management. The banking system has remained stable, liquid, and on average well-capitalized.
Recent Developments, Outlook and Risks
1. Croatia remains stuck in an unusually drawn out recession. In 2013, real GDP contracted for the 5th consecutive year. Unemployment has risen to 16½ percent (ILO standardized rate). Domestic demand remains depressed as corporations and households focus on reducing excess debt levels accumulated during the boom period in the mid 2000s. Exports and FDI are also feeble, reflecting poor trading partner growth and structural weaknesses. Macroeconomic policies that could revive growth rapidly are beyond reach. Fiscal policy has run out of space (see below), and is now subject to the European Union’s Excessive Deficit Procedure. Monetary policy is constrained by the need to keep the kuna-euro exchange rate stable, so as to prevent a revaluation of euro-indexed debts.
2. External financing conditions have remained manageable thus far, but Croatia’s country risk premium has increased relative to peers. The kuna-euro exchange rate depreciated marginally in the past 12 months, consistent with the central bank’s use of the kuna-euro exchange rate as monetary anchor. The banking system has remained stable, liquid and, on average, well capitalized, despite the difficult economic environment.
3. Growth prospects remain subdued in the short term, but a gradual recovery is expected from 2015.
- For 2014, IMF staff forecasts a real contraction of ½-1 percent of GDP. Domestic demand would remain weak, reflecting continued private sector debt reduction and the impact of fiscal consolidation. Exports, however, would benefit from the projected pick-up in the euro area. Inflation would remain subdued.
- From 2015 out forecast is for a gradual recovery, as the impact of private sector deleveraging would begin to recede. Staff estimates Croatia’s long-term potential growth at around 2 percent (2.3 percent in per-capita terms).
- Risks to the forecast are considerable and mostly to the downside. Fiscal adjustment could trigger a larger private demand compression than projected. Conversely, insufficient fiscal consolidation could trigger concerns about sustainability of the public finances and undermine investor confidence. Private sector deleveraging could remain a drag on demand for longer than projected. Finally, tighter global liquidity conditions and a re-pricing of risk could complicate external financing, affecting especially Croatian sovereign debt. On the upside, foreign direct investment could pick up more rapidly than foreseen, reflecting in part recent policy initiatives to facilitate investments (see below).
4. With many of Croatia’s economic problems owing to the persistent economic contraction, reviving economic growth and generating employment is a high priority. To this end, both weak domestic demand and long-standing structural impediments to growth need to be addressed.
5. High private sector debt remains a key obstacle to the recovery. Paying debt down is a slow and painful process during which demand will remain subdued. Orderly debt restructuring for over-indebted corporations and households provide the main prospect for accelerating the normalization in demand. In this context, the corporate pre-bankruptcy procedure introduced in 2012—that has thus far enabled the write-off of corporate debts of about 2 percent of GDP—is a useful tool that should be strengthened, including by encouraging broad and balanced participation by creditors. In addition, the authorities may want to give consideration to a personal bankruptcy regime, while being mindful of fair burden sharing between debtors and creditors.
6. The authorities have made commendable progress in enhancing the efficiency and growth capacity of Croatia’s economy.
- The labor market’s capacity to adapt to economic conditions has been strengthened with the easing of hiring restrictions enacted in 2013. Similarly important is the second phase of labor reform that is currently under consideration of the assembly, and that would lower the cost of work force restructuring as well as enhance working hour flexibility. These measures create, in the short term, uncertainty for some employees and are therefore understandably contested. Such cost need to be weighed, however, against potentially large medium term benefits from changing the perception of Croatia’s labor market as employment unfriendly, as is reflected in standard employment protection indices. In implementing the reform, it will be critical to ensure fair application of the revised rules and to prevent abuse.
- Croatia’s employment ratio is the second lowest in the EU, reflecting both cyclical unemployment and structural work disincentives emanating from the design of the social welfare and pension systems. While the welfare reform enacted in December 2013 improves the targeting of some benefits, further steps are necessary, such as eliminating overlap of transfers granted by the central and local governments, and extending means-testing to other programs, including for war veterans. More progress is also needed to reduce incentives for early retirement.
- Productivity enhancing investments have been facilitated by the strategic investment and investment promotion laws passed in late 2013 and by complementary regulatory measures, including by removing administrative hurdles at the local level. Looking ahead, additional steps to enhance the business climate should include swift implementation of judicial reform to ensure speedier repossession of non-cash collateral. Further restructuring of state-owned enterprises (see below) is also required.
Advancing Sustainable Fiscal Consolidation
7. After a good attempt at consolidation in 2012, in the deficit (cash basis) widened again in 2013 to around 5½ percent of GDP, reflecting weak revenues, the assumption of debts and arrears from public hospitals and state-owned enterprises, and fiscal costs related to EU accession. Public debt now exceeds 60 percent of GDP and is increasing rapidly. A positive development has been the instatement of fiscal cash registers that broaden the revenue base, especially for value-added tax.
8. While very difficult to implement in an environment of economic contraction, sustained and predictable fiscal consolidation is critical to strengthen confidence in macro-economic management, boost sentiment, and retain the economy’s access to financing at acceptable conditions. A structural reduction in the general government deficit of about three percent of GDP is needed to ensure the return to a sustainable fiscal stance. To avoid an excessive fiscal contraction in the short term, IMF staff recommends stretching adjustment over three years in roughly equal annual portions. Adjustment should be supported by high-quality measures, with an emphasis on the revenue side in 2014—given the still weak economy—and a gradual switch to expenditure consolidation in 2015 and 2016. To maximize the positive impact on confidence, adjustment would best follow a comprehensive three-year plan whose main parameters are known in advance. As regards the medium term, structural balance should be restored gradually, with a view to achieving a sustained reduction in public sector debt and regain flexibility to react to economic shocks.
9. Staff’s assessment of fiscal policy in 2014 is based on the broad parameters of a planned budget revision that the authorities shared with IMF staff. The revised budget still needs to be approved by the cabinet and the assembly. Further, it does not yet include possible restructuring cost for the state cargo railway company, as the restructuring plan is subject to EU approval. With these caveats, the planned revision includes:
- Structural (i.e. durable) adjustment measures of 1.1-1.3 percent of GDP (full-year impact 1.3-1.6 percent), two-thirds of which are on the revenue side. The largest individual measure is an increase in health insurance contributions; others include cuts in subsidies and rationalization measures in public hospitals.
- These structural savings need to be assessed against arrears in the health sector, however, that are accumulating at a pace of about ½ of a percent of GDP per year and represent permanent spending unless addressed through a reform restoring financial balance within the sector (see below).
- Measures whose structural character is less clear of 0.7-0.9 percent of GDP, such as cuts in capital and material expenditures, and the repatriation of dividends from state-owned enterprises. Again there are offsets, notably the one-off clearance of additional health sector arrears amounting to another ½ of a percent of GDP.
- The transfer of assets of the pillar II pension fund in an amount 0.9 percent of GDP (related to privileged pensions) into the budget. While the transfer is formally recorded as revenue and thus reduces the headline cash deficit, it is substantially a financing operation.
Taken together, staff estimates net structural adjustment contained in the revised budget at 0.8-1.1 percent of GDP (annual impact), resulting in a projected 2014 cash deficit of 4-4½ percent of GDP.
10. Provided these plans are implemented as foreseen and without delay, and the quantification of the measures’ budgetary impact is realistic—which IMF staff could not verify in all cases—the revised budget constitutes a substantive first step toward budgetary consolidation. As regards the composition of adjustment, the revision focuses appropriately on revenue measures that should have a relatively modest short-term impact on growth. However, the hike in health contributions (back to the level prevailing in 2012) raises labor cost and therefore undermines efforts to strengthen cost competitiveness. Alternative revenue measures—such as introducing a modern property tax, revoking the tax credit for reinvested profits, taxing interest income, or broadening the base for personal income tax—appear superior, and should be considered either to modify the planned 2014 revision or for the 2015 and 2016 budgets. On the expenditure side, further cuts to inefficient spending are called for, such as poorly targeted subsidies and transfers, as are reforms to put the pension system on a more sustainable footing.
11. Restoring financial balance in the health sector is an urgent priority. While the central government has taken some steps to improve cost control—such as taking over the administration of hospitals whose arrears were cleared by the government—it is not clear whether administrative measures alone will suffice. Revenue measures—such boosting receipts from co-payments—and/or expenditure cuts—by increasing the efficiency of health services—may need to be considered. On a related issue, plans to move the health insurance fund out of the treasury and grant it autonomy in contracting health services need to be prepared very carefully, to avoid unintended additional fiscal burdens to the government.
12. State-owned enterprises (SOEs) are a persistent source of contingent liabilities to the government. The authorities have started tackling this issue, appropriately focusing on some of the most difficult sectors first, such as shipyards, railways, and air and road transportation. Progress in this area is commendable, even if restructuring and privatization has often been possible only at substantial costs to the government, notably the assumption of SOEs’ debts. Restructuring and resolution efforts need to continue, based on a comprehensive review of state-owned enterprises’ finances.
Maintaining Monetary and Financial Stability
13. Monetary policy has continued to use the kuna-euro exchange rate as anchor, reflecting the high degree of euroization in the banking system. Within the constraints set by this anchor, the central bank has allowed some limited exchange rate flexibility. Monetary policy is conducted with a relatively limited but effective set of instruments, notably variations in mandatory reserves and liquidity regulations, and occasionally foreign exchange interventions. The central bank has appropriately created substantial excess liquidity in the banking system, with a view to keeping domestic financing conditions accommodative. It also continues to employ macro-prudential tools—such as tying reductions in banks’ reserve requirements to increases in corporate lending—to strengthen the countercyclical character of its policy. Nonetheless, credit to the private sector has remained subdued, reflecting primarily weak aggregate demand.
14. While the set of monetary policy instruments is appropriate at this juncture, the central bank should stand ready to adapt its toolkit as needed. In particular, in case financial or inflationary pressures were to reemerge at some stage, fine-tuning of liquidity could be conducted more flexibly and accurately through open market operations than regulatory instruments. As regards foreign exchange interventions, preserving their effectiveness requires inter alia maintenance of adequate foreign currency reserves. While reserves coverage has indeed increased to a level at or only slightly below IMF adequacy metrics, and the central bank is confident to have full control over possible pressure points, there is value in continuing to build reserves until coverage is squarely within the comfort range.
15. Notwithstanding the protracted recession, Croatia’s banking system has remained stable, liquid and well-capitalized, even though financial strength varies across banks. The banking system’s aggregate capital adequacy ratio is, at almost 21 percent, the highest in the region. Reported profitability has fallen, reflecting inter alia commendable changes to loan classification rules that bring loan-loss provisioning closer in line with peers. Some caution appears warranted regarding the recent increase in bank loans to state-owned enterprises, lest to under appreciate risks to both banks and the government.
We thank the authorities for their hospitality and for constructive discussions.