Press Information Notice: IMF Concludes Article IV Consultation with Croatia

July 27, 1998

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On July 10, 1998, the Executive Board concluded the Article IV consultation with Croatia1.


Since Croatia introduced its stabilization program in October 1993: hyperinflation was stopped by the successful implementation of an exchange rate anchor, with little damage to output; real economic growth turned positive in 1994 and has remained robust since then; inflation has stayed at moderate levels; and international reserves of the Croatian National Bank (CNB) have increased almost steadily.

Progress was also made in the period 1993 to early 1997 on structural reform with, for example, the privatization of small and medium-sized enterprises, the entering into rehabilitation of four large state-owned banks, the reduction and simplification of tariffs, and the introduction of a new bankruptcy law. Over the last year, further advancements have been made in the structural area with the introduction of a single-rate VAT, the commencement of a voucher privatization scheme, preparation for a comprehensive reform of the pension system, approval of legislation to separate the post and telecommunications functions of Croatian Post and Telecom, and further progress in rehabilitating the four state banks, including the sale of the Bank Rehabilitation Agency’s equity in one of these banks to foreign strategic investors.

In 1997, real GDP increased by an estimated 6½ percent, led by a rapid expansion in private domestic demand, including consumption. Notwithstanding the rebound in activity and an increase in nominal wages rates of about 15 percent during 1997, inflation remained moderate, with retail prices rising by 3.9 percent during 1997 as rapid growth in imports helped to deflect upward pressure on prices. The strength of private consumption was fueled by: (i) rapid growth in wages (with especially large increases in the state-enterprise sector); (ii) strong consumer credit growth; (iii) cuts in personal income taxes; and (iv) one-off factors, namely the pre-announced elimination of a temporary tax exemption on car imports and the anticipation of the introduction of the VAT, both of which led buyers to advance purchases into 1997.

On the external side, the current account deficit more than doubled to an estimated 12½ percent of GDP in 1997, of which roughly 2 percentage points could be considered to reflect the one-off factors mentioned above. Exceptionally strong import growth (17 percent in U.S. dollar terms and 32½ percent in kuna terms) was the main source of the widening. Merchandise export growth was lackluster (minus 7½ percent in U.S. dollar terms and positive 4 percent in kuna terms), while tourism receipts continued to rebound from earlier, war-affected levels (rising by almost 30 percent in U.S. dollar terms in 1997). The current account deficit was readily financed, allowing international reserves to increase to US$2.5 billion (2.7 months of imports of goods and nonfactor services) and the exchange rate was little changed, but the external debt ratio increased by nearly 10 percentage points of GDP to 33 percent of GDP. Much of this foreign borrowing was contracted by large state-owned enterprises (which were able to access the syndicated loan market without explicit government guarantees), commercial banks, and the government.

Key macroeconomic factors which contributed to the widening of the current account deficit were:

Strong consumer demand, fueled by rapid growth in wages, and a surge in bank credit. Domestic bank credit to the private sector grew by 42 percent in 1997 (with a 94 percent increase in credit to households). With a view to slowing the growth in bank credit, the CNB introduced (with effect from April 1998) reserve requirements on banks’ foreign liabilities.

An underlying easing of fiscal policy in 1997, reflected in the widening by 2.2 percentage points of GDP of the deficit of the consolidated central government (on an accrual basis, excluding privatization receipts) to 3.5 percent of GDP. The revised budget for 1998 foresees a tightening of the fiscal deficit by 2.3 percentage points of GDP (on an accrual basis, excluding privatization receipts) relative to the previous year, reflecting primarily the strong revenue performance of the newly-introduced VAT.

A deterioration in the saving-investment balance of the large public enterprises reflecting deficiencies in financial discipline, including large wage increases. In response, the government issued a decree at end 1997 that sought to impose tight limits on wages in 10 large public enterprises.

While progress with structural reform has been made in several areas, further efforts are needed in key areas (notably improving banking supervision, privatization of state-owned banksand large public enterprises, and completing trade reform consistent with the requirements for accession to the WTO). Problems in a regional private bank (the fifth largest bank in Croatia) underscored weaknesses in banking and banking supervision. Abnormally high deposit rates at some banks raised concerns about these banks engaging in excessively risky activities. In the enterprise sector, past delays in effective privatization and in advancing plans for the restructuring of the large public enterprises appear to have impaired corporate governance. This is evidenced by the poor financial discipline exhibited by many state-owned enterprises, reflected, for example, in large wage increases, surplus labor, high overdue payables/receivables, and the deterioration in the saving-investment balances of the largest ones.

Executive Board Assessment

Directors commended the authorities for the success thus far of their exchange-rate-based stabilization efforts. Real growth had remained robust since 1994, inflation had stayed low, and international reserves had increased. In addition, Directors welcomed efforts to advance structural reforms, most recently in the area of rehabilitating the state-owned banks and moving ahead with voucher privatization. However, many Directors stressed that Croatia now faces a difficult external economic situation that requires decisive and early corrective action.

Directors expressed serious concern about the unsustainably large current account deficit in 1997. They noted that rapid growth in wages and bank credit, as well as poor overall state enterprise performance and an expansionary fiscal stance, had contributed to this outcome. Directors were also concerned about emerging difficulties in the banking sector and the sluggishness of structural reform in several areas, most notably in the enterprise sector. Against this background, while welcoming the measures undertaken thus far by the authorities, Directors agreed that more decisive measures needed to be taken quickly—including macroeconomic adjustment and acceleration of public enterprise restraint and restructuring, and banking sector reform—to ensure the sustainability of Croatia’s external position and to promote macroeconomic stability and durable growth.

As regards fiscal policy, Directors commended the authorities’ fiscal consolidation efforts and resoluteness in introducing the single rate VAT at the beginning of the year. However, several Directors were concerned that the authorities’ policy package for 1998 did not go far enough to return the current account of the balance of payments to a sustainable path, while some other Directors did not regard the fiscal policy stance as the root cause of the problems. Nevertheless, Directors saw further fiscal adjustment as the most appropriate available means to help bring about the needed external adjustment. Moreover, Directors noted that the cost of financial sector reforms assumed by the government would require offsetting measures to prevent a deterioration of the fiscal situation.

Directors cautioned that the need for fiscal adjustment will be even larger if it is not accompanied by greater financial discipline in the public enterprise sector. They urged faster progress on privatization as it was the best way to improve corporate governance, particularly when it involved strategic investors. In the interim, Directors supported placing limits onborrowing by the state enterprise sector, while at the same time seeking to lower operating costs and improving the monitoring and evaluation of borrowing and investment plans. There was some concern that public enterprise foreign borrowing may be perceived by some lenders and borrowers to carry an implicit government guarantee.

Directors underscored the need for a firm grip on wage policy, both in the budgetary sphere and in the state enterprise sector. They noted that wage restraint in the budgetary sector will be very important, not only for its demonstration effects, but also because of the limited room for maneuver elsewhere in the budget in the context of heavy demands for social spending and reconstruction. In this regard, Directors were concerned that the 1999 government wage bill was already poised to increase significantly as a result of carry-over effects. This unfortunate outcome could only be avoided through meaningful civil service reform and retrenchment. Directors also supported strict implementation of a wage freeze in the state enterprise sector to safeguard against an unwanted erosion of competitiveness and profitability.

Turning to financial matters, Directors expressed concern about recent stresses in the banking sector. They advised the authorities to close unviable banks within the context of a unified market-based banking strategy. Directors were also troubled by the rapid expansion in bank credit which, coupled with large-scale foreign borrowing, had effectively removed hard budget constraints on the nongovernment sector and could increase Croatia’s vulnerability to shifts in market sentiment. While welcoming the measures taken since September to tighten the monetary stance, Directors thought that monetary policy may need to be tightened further to support external adjustment within the framework of keeping the exchange rate within narrow bounds. In this context, Directors cautioned that providing liquidity to unviable banks would be inconsistent with overall monetary and external objectives, as well as with sound banking principles. Directors welcomed the indication that the authorities are prepared to take corrective measures if needed.

Directors welcomed the preparation of the new banking law and urged the authorities to accelerate its introduction. This law would help promote independence and authority of the supervisory and regulatory functions, and would be an important element of a unified market-based banking strategy. In addition, Directors stressed the urgent need to further improve the central bank’s internal supervision capabilities and strengthen enforcement of prudential and monetary policy regulations, noting the various measures already taken by the Croatian authorities in this respect.

Croatia: Selected Economic Indicators

  1993 1994 1995 1996 1997

Real economy (percentage change)  
Real GDP -8.0 5.9 6.8 6.0 6.5
Unemployment rate (year average; percentage of labor force) 1/ 14.8 14.5 14.5 16.4 17.5
Consumer prices (Dec/Dec) 1149.2 -3.0 3.7 3.4 3.9
Consolidated central government balance (percent of GDP) 2/  
Cash basis -0.8 1.6 -0.9 -0.4 -1.3
Accrual basis, excluding privatization receipts 3/ -1.1 1.2 -2.1 -1.3 -3.5
Monetary sector (end of period; percentage change)  
Broad money 1092.6 73.8 40.4 49.1 37.6
Credit to consolidated central government ... -106.4 1168.1 -3.5 -49.9
Other credit 4/ ... 34.4 18.8 3.1 44.1
Deposit money bank interest rates (end of period; percent)  
Average deposit rate 27.4 5.0 6.1 4.2 4.4
Average credit rate 59.0 15.4 22.3 18.5 14.1
External sector  
Trade balance (percent of GDP deficit -) -8.8 -9.1 -17.2 -18.5 -26.9
Current account balance (percent of GDP deficit -) 5.5 5.4 -6.8 -4.5 -12.5 -
Total external debt (percent of GDP; end of period) 27.1 22.5 20.8 23.4 33.0
Official reserves (US$ billion; end of period) 616 1405 1895 2314 2539
Reserve cover (months of imports of goods and nonfactor services) 1.2 2.4 2.4 2.8 2.7
Short-term debt in percent of reserves (end of period) 8.1 2.6 11.0 15.3 17.4
Broad money/official reserves (end of period) 2.5 2.2 2.4 2.9 3.2
Real effective exchange rate (1995=100; end of period) 5/ 100.9 97.5 98.6 99.9 101.7

Sources: Croatian authorities: Information Notice System; and IMF staff estimates.

1/ Registered unemployment rate. For 1997, data refers to December. According to the new Labor Force Survey, ILO standards, the unemployment rate was 10 percent and 9.9 percent in 1996 and 1997, respectively.
2/ Includes extrabudgetary funds.
3/ Cash deficit adjusted for net change in arrears and excluding privatization receipts.
4/ In 1996, HRK 6.6 billion in loans to enterprises were written off in connection with the rehabilitation of banks and Paris and London Club reschedulings. Abstracting from this write-off, credit is estimated to have grown by 30 and 36 percent in 1996 and 1997, respectively.
5/ Based on consumer price

1Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.


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