Statement by an IMF Staff Visit to CroatiaPress Release No. 07/118
June 1, 2007
An IMF staff team visited Zagreb during May 24-29, 2007 to review recent economic developments since the Article IV Consultation mission in late 2006, and to present staff's analytical work on how to increase potential growth and reduce external vulnerabilities. The attached summary of the staff studies was distributed at two presentations; it includes links to the full studies, which are available in both Croatian and English.
Both real GDP and domestic demand growth are now, and will in the near term likely remain, significantly faster than projected at the time of the Article IV mission. Moreover, faster growth has contributed to government revenues this year that have been well above expectations through most of May. While these developments are largely positive, the current account deficit can be expected to widen this year by even more than previously projected. Meanwhile, though its rate of increase has recently slowed, the ratio of external debt to GDP has yet to stabilize.
In these circumstances, key conclusions from the Article IV consultation and the recently presented staff studies remain pertinent. While much has been achieved on the fiscal front in recent years—notably a significant reduction in the fiscal deficit and improved budgetary processes and transparency—we continue to recommend saving government revenue overperformance this year, for several reasons.
• With monetary policy constrained by the tightly managed exchange rate, and private sector spending growing at a strong pace, fiscal policy has to take the lead in dampening domestic demand to address external vulnerabilities related to the high and widening current account deficit and expanding external debt.
• Revenue overperformance provides an excellent opportunity to press ahead with a much-needed continuation of fiscal adjustment in the medium term, at a time when additional pressures on the current account have emerged.
• Permanent expenditure commitments above this year's budgeted levels would make the task of lowering the deficit in future years much more difficult, all the more so if made on the basis of cyclically high, and therefore temporary, revenues. In this context, satisfying recent demands to offset the parametric reform of the pension system could damage the long-term health of the public finances.
• Finally, Croatia should be reducing the level of general government spending, which is already high and well above the average of new EU members. Indeed, our analysis indicates that a key element of permanently increasing economic growth is reducing the size of government.
Accelerated structural reforms are also essential if Croatia is to strengthen competitiveness, boost exports, attract greater "greenfield" foreign direct investment, and raise real GDP growth on a sustainable basis. Otherwise, surges in growth to rates above 4-4½ percent (our current estimate of potential growth) will be accompanied by risks of a larger current account deficit and higher external debt. In this context, the importance of reforms to reduce the role of the state in the economy and to improve the business environment cannot be emphasized enough.
INTERNATIONAL MONETARY FUND
Summary of IMF Staff Studies
May 29, 2007
Four IMF staff studies analyze how to accelerate economic growth on a sustainable basis and reduce external and financial vulnerabilities in Croatia. The titles of the studies are: (1) Economic Growth in Croatia: Potential and Constraints; (2) Economic Effects of Reducing the Size of the Government in Croatia: A Note Based on the IMF's Global Fiscal Model; (3) External Debt and Balance-Sheet Vulnerabilities in Croatia; and (4) Bank Stability and Credit Risk in Croatian Banks. The full studies are available at http://www.hnb.hr/mmf/clanak-iv/2007/h-odabrana-pitanja.pdf (in Croatian) and http://www.imf.org/external/pubs/ft/scr/2007/cr0782.pdf (in English).
Raising the economy's actual and potential growth will require significant productivity-enhancing reforms. The first study estimates that on current policies, Croatia's potential growth rate is 4-4½ percent. Absent reforms, growth above this range cannot be sustained. To increase growth to a higher rate in line with the authorities' aspirations, the analysis highlights the critical need to improve the business environment through further measures to reduce the administrative burden, legal uncertainties, and corruption. It also emphasizes the importance of attracting more greenfield foreign direct investment, and reforms to reduce the role of the state in the economy through more ambitious fiscal consolidation and faster privatization.
A significant reduction in public expenditure would be needed to simultaneously provide room for cutting taxes to boost growth and lowering the budget deficit to narrow the current account deficit. Using the IMF's Global Fiscal Model, the second study suggests that a strategy of cutting expenditure and taxes (notably social security contribution rates or the corporate income tax), while also reducing the deficit, would stimulate investment and labor supply. This would lead to higher output and consumption, and a lower current account deficit. With Croatia's expenditure-to-GDP ratio well above regional peers, there is surely scope for significant expenditure savings.
The balance-sheet vulnerabilities that have emerged in recent years call for policies that foster macroeconomic stability by reducing the external imbalances and avoiding sharp adjustments in exchange and interest rates. The balance-sheet analysis presented in the third study documents the surge in Croatia's external borrowing and deepening financial euroization. These developments have led to large net liability positions on the part of the private non-financial sector that are sensitive to changes in exchange and interest rates. The resulting vulnerabilities imply an important role for prudential supervision to prevent an excessive build-up of banks' foreign currency exposures to unhedged clients. This requires accurate information on the financial positions of firms and households.
Banks, on the other hand, should build buffers by raising capital or provisions on unidentified losses, rather than relying on collateral as much as they do now. The fourth study finds that rapid credit growth has raised banks' susceptibility to an economic downturn. It also finds that that Croatian banks are not necessarily passing on the higher risk of foreign exchange-linked loans to unhedged clients by charging higher interest rates, possibly due to the strong competition among the top banks. Both results call for building up provisions or raising capital, a conclusion consistent with analysis undertaken at the Croatian National Bank.