IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of Croatia

Public Information Notice (PIN) No. 07/22
February 22, 2007

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2006 Article IV Consultation with Croatia is also available.

On February 16, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Croatia.1


Croatia has experienced solid growth and low inflation in recent years, with GDP growth averaging around 4¾ percent in 2001-06 and headline inflation contained to 2-4  percent. But domestic demand pressures and higher international energy prices caused the current account deficit to widen in 2005-06.

Although external competitiveness appears adequate, export growth has been significantly below the average in Croatia's peer countries, which have been more successful in attracting greenfield foreign direct investment. Survey measures of competitiveness underscore structural weaknesses in the business environment.

Policies in 2004-06, supported by a precautionary Stand-By Arrangement, sought to mitigate external vulnerabilities by lowering Croatia's current account deficit and stabilizing the external debt-to-GDP ratio. The authorities largely relied on fiscal adjustment, accompanied by measures by the Croatian National Bank (CNB) to safeguard financial sector stability and discourage external debt accumulation by banks. Reform of pension indexation, wage moderation, and investment cuts contributed to a reduction in the fiscal deficit from 6.1 percent of GDP in 2003 to an estimated 2.8 percent in 2006. However, despite these countervailing policy efforts, gross external debt and the current account deficit remain high.

While bank restructuring and privatization have strengthened the financial sector, strong credit expansion and foreign exchange-induced credit risk have raised concerns. Large foreign banks own over 90 percent of the system, which is well developed by regional standards. Financial soundness indicators show adequate capitalization and asset quality. But intense competition among banks and easy access to credit from foreign parents has contributed to a vigorous credit expansion that gained momentum over 2005-06. The pace of the ongoing credit expansion increases the potential for asset quality to deteriorate in the event of a downturn. Moreover, most households also seem exposed to currency risk: the bulk of long-term bank loans to households are linked to foreign currencies; and, even though households' foreign-currency deposits are sizeable in the aggregate, borrowers and savers may only partly overlap. Concerned about safeguarding financial stability, the CNB responded with a series of measures to slow the bank-related portion of capital inflows: a progressive increase in its marginal reserve requirement on banks' foreign borrowing, broadening its base, and issuing various prudential measures and guidelines.

The large role of the state, slow progress in key structural reforms, and less-than-satisfactory conditions for doing business have constrained economic performance. While recent progress in some transition indicators has been significant, privatization and reform of state-owned enterprises has lagged because of legal disputes, resistance of vested interests, onerous investment and employment conditions, and a legal framework favoring insiders—a bias that the pending draft privatization law could worsen. In addition, conditions for doing business are hampered by the heavy administrative burden and difficulties enforcing property rights, with many problems at the local level.

The consultation focused on the interrelated issues of how to raise economic growth in Croatia and addressing vulnerabilities.

Executive Board Assessment

Croatia's recent economic growth has been solid and inflation contained, and its progress with the EU accession process has boosted investment prospects. However, the high external debt-to-GDP ratio, the increase in short-term external debt, and the widening current account deficit are sources of concern. Directors welcomed the improvements in policies in recent years, but noted that continued efforts will be needed to address significant external vulnerabilities. They stressed the importance of faster and deeper structural reforms if Croatia is to boost potential growth. Progress in these areas should be high on the agenda of the next government.

To address external vulnerabilities and reduce the burden of the large government on economic growth, Directors recommended more ambitious fiscal consolidation than the authorities' medium-term plans currently envisage. In this connection, it will be essential to resist spending pressures in the run-up to elections in late 2007—including through off-budget proposals to address spending demands—and to ensure a fiscal deficit in 2007 no larger than the budget target. Measures are also needed to reduce public expenditure permanently, with a view to providing room for cutting taxes, including social security contributions, in order to boost growth while lowering the budget deficit. Action on the fiscal front will also help narrow the large current account deficit and ensure a sustainable debt path. With Croatia's expenditure-to-GDP ratio well above that of peers, Directors saw considerable scope for savings, and encouraged the next government to make significant progress in this area.

Directors agreed that the present monetary framework remains appropriate for Croatia. Given the high degree of euroization, the openness of the economy, and adequate external competitiveness, they supported the tightly managed exchange rate. At the same time, noting the constraints this places on monetary policy, Directors emphasized the importance of other supporting policies, including structural reforms, to strengthen competitiveness; fiscal consolidation, to redress macroeconomic imbalances; and strong financial sector supervision, to address possible balance-sheet currency and maturity mismatches.

Directors welcomed the progress achieved by the authorities in improving financial sector supervision and regulation. They commended the Croatian National Bank's efforts over the past few years to strengthen the prudential regulation of banks—which remain profitable and well capitalized—as well as the recent establishment and development of the independent nonbank supervisor. Directors shared the authorities' concerns about the prudential and macroeconomic risks of the ongoing rapid growth in bank credit. They commended the Croatian National Bank for standing ready to address risks associated with bank foreign borrowing and rapid credit growth. They nevertheless expressed reservations about the recent reintroduction of direct credit controls, whose impact, including undesirable side-effects, will need to be monitored closely. Directors encouraged the authorities to consider tighter prudential measures that would also raise credit quality and reduce vulnerabilities.

Directors called for significant improvements in the business environment. Reducing the administrative burden, legal uncertainties, and corruption will be critical in the coming years for attracting a much-needed increase in greenfield foreign direct investment required to boost exports and economic growth while lessening vulnerabilities. Noting the slow pace of recent structural reforms, Directors stressed the urgency of restructuring the loss-making shipyards, reforming the remaining public enterprises, and removing impediments to privatization.

Republic of Croatia: Selected Economic Indicators

  2003 2004 2005 2006 2007
        Proj. Proj.

Output, unemployment, and prices

(Percentage change)

Real GDP

5.3 3.8 4.3 4.6 4.7

Unemployment (survey-based, in percent)

14.3 13.8 12.7 ... ...

CPI inflation (average)

1.8 2.1 3.3 3.3 2.7

Savings and investment

(In percent of GDP)

Domestic investment

30.5 31.2 31.4 33.3 33.5

Of which: fixed capital formation

28.6 28.6 28.6 30.6 30.9

Domestic saving

24.4 26.2 24.9 25.2 25.2


1.8 2.8 3.1 3.6 3.7


22.6 23.4 21.9 21.6 21.4

General government and HBOR operations 1/


General government revenue

45.1 45.4 44.9 45.0 44.9

General government expense and net lending

51.3 50.2 49.0 47.8 47.6

Overall general government balance

-6.1 -4.8 -4.1 -2.8 -2.8

Overall general government financing requirement 2/

-6.1 -4.8 -4.1 -3.8 -3.9

Overall HBOR balance (net of budget transfers)

-0.6 -0.4 -0.1 -0.2 -0.6

Fiscal and quasi-fiscal balance

-6.8 -5.2 -4.2 -3.0 -3.4

General government debt

40.9 43.7 44.3 42.5 41.9

Money and credit

(End of period; change in percent)

Credit to the nongovernment sector

14.7 12.8 16.7 21.1 ...

Broad money

11.0 8.6 10.5 15.3 ...

Base money 3/

23.8 19.9 20.7 18.1 ...

Interest rates

(End of period; in percent)

Average kuna deposit rate (unindexed)

1.7 1.8 1.6 ... ...

Average kuna credit rate (unindexed)

11.5 11.4 9.9 ... ...

Balance of payments

(In millions of euros)

Current account balance

-1,596 -1,404 -1,994 -2,762 -3,031

(In percent of GDP)

-6.1 -4.9 -6.4 -8.1 -8.3

Capital and financial account

4,015 2,385 3,943 5,578 4,605

Overall balance

1,239 -118 1,002 1,458 374

Debt and reserves

(End of period; in millions of euros)

Gross official reserves

6,554 6,436 7,438 8,896 9,270

In months of following year's imports of goods and NFS

4.9 4.4 4.5 5.0 4.9

External debt service to exports ratio (in percent)

20.1 21.7 24.2 26.4 26.0

Total external debt (in percent of GDP)

75.5 80.2 82.5 84.0 84.9

Net external debt 4/

32.9 37.5 42.9 44.4 45.3

Sources: Croatian authorities, and IMF staff estimates.

1/ Revenue in 2004 includes HRK 197 million in GSM license fees from an auction held in December 2004 but received in February 2005. For 2007, refers to the budget.

2/ Includes estimated 1 percent of GDP for "pensioners' debt" repayment under the cash option in 2006 and 2007.

3/ Includes commercial banks' statutory reserves in foreign currency (general and marginal reserve requirements).

4/ Net of official reserves and commercial bank foreign assets.

1 Under 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 Executive Directors, and this summary is transmitted to the country's authorities.


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