## 1. Investment Push for Faster Convergence

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### Context and macro backdrop
- Growth has hovered around 3 percent for five consecutive years, supported by strong consumption, tourism, and a modest recovery in investment.
- Fiscal performance has remained strong reflecting buoyant revenues and declining interest payments.
- Private and public debt are falling but remain elevated.
- The country submitted its formal application to enter ERM II in July 2019. The authorities expect SSM/SRM membership by mid-2020 and currently see 2023 as the earliest time for euro accession.
- Parliamentary elections are to be held in the autumn of 2020 amid indications of increasing political fragmentation. The government assumed the rotating presidency of the EU Council in the first half of 2020.
- The government repealed recent pension reforms (which would have increased the retirement age and penalized early retirement) and has agreed to generous public sector wage increases; other reforms have stalled (Annex I).

### Recent developments (key findings)
- Growth and labor market:
  - Growth for 2019 is expected at 2.9 percent, up from 2.7 percent in 2018, driven by consumption and tourism.
  - Unemployment continued to fall to about 6.7 percent and is now near the EU average.
- Prices and wages:
  - Despite private sector wages growing at above 8 percent (including a 9 percent increase in the minimum wage), average inflation remained low at 0.8 percent in 2019.
- Fiscal and external:
  - General government registered a fiscal surplus of 0.3 percent of GDP in 2018; staff projects a balanced budget for 2019.
  - Public debt is projected to fall at end-2019 to 71.5 percent of GDP.
  - The current account is estimated to have remained in surplus in 2019.
  - Gross external debt is projected to decline to 75.9 percent of GDP in 2019 from 82.7 percent in 2018.
- Reserves and banking:
  - The CNB accumulated reserves: gross reserves increased by €1.1 billion (end-November 2019); CNB purchased €1.1 billion in 2019 versus €1.8 billion in 2018.
  - Banking system liquidity is high; headline credit growth to the private sector decelerated in 2019, while bank lending to households remained strong driven by general-purpose cash loans.
  - NPL ratio declined from 10.2 percent in September 2018 to 7.6 percent in September 2019; provision coverage increased, largely due to a large sale of less provisioned non-financial corporation loans in Q3 2019.
- Monetary and institutional:
  - Legislative amendments to allow the asset quality review (AQR) have been adopted and amendments are expected to come into force in May 2020.
  - Four large foreign-owned banks and the state-owned Postal Bank are currently subject to an AQR.
  - Monetary policy has been appropriately accommodative given the exchange rate anchor; exchange rate stable and international reserves have continued to grow.

### Outlook and risks
- Growth drivers and constraints:
  - Tourism will support potential in the next few years, but aging and migration trends will pressure employment growth; potential output will depend on productivity growth.
- External and fiscal vulnerabilities:
  - Near-term external risks from global trade tensions remain elevated given significant trading with Italy and Germany.
  - External debt in percent of exports remains the second highest in the CESEE region.
  - Reform standstill and fiscal risks have been exacerbated as elections approach; realization of contingent liabilities related to shipyards or SOEs cannot be discounted.
- Fiscal stance and projection:
  - With the output gap closed (or very nearly so), further loosening of spending risks turning fiscal stance procyclical and could lead to more volatile growth than in the baseline.
  - Staff projects that, assuming no new offsetting policy measures, revenue and expenditure ratios will remain constant in percent of GDP (except for declining interest payments and minor changes in public investment related to EU funds' disbursement calendar) until budget balances again in 2025; public debt projected to reach 61.8 percent of GDP in 2025.

### Policy discussions and short-term fiscal recommendations
- Overall focus: reap full benefits of euro adoption—enshrining fiscal discipline, improving budget quality, and investing for the future; align priorities for the next programming period of EU funds with medium-term objectives.
- Short-term fiscal stance and 2020 measures:
  - Staff projects the 2020 budget measures will turn the budget balance for 2020 into a deficit of 0.3 percent of GDP, making fiscal policy procyclical.
  - Identified 2020 measures total HRK 5,050 million, equivalent to 1.22 percent of GDP, with details preserved as in the source:
    - Revenues:
      - Income tax cuts for the young: -750 million kuna, -0.18% of GDP
      - Profit tax exemption: -200 million kuna, -0.05% of GDP
      - Increase in income tax threshold: -500 million kuna, -0.12% of GDP
      - VAT reduction for food and restaurants: -900 million kuna, -0.22% of GDP
      - Additional excise taxes on tobacco, alcohol and sugar: 400 million kuna, 0.10% of GDP
    - Expenditures:
      - Additional wage increase (from 5 to 6.12 percent): -1,120 million kuna, -0.27% of GDP
      - Increase in teachers' salary coefficients: -400 million kuna, -0.10% of GDP
      - Other salary increases (police, customs, doctors): -390 million kuna, -0.10% of GDP
      - Pension reform roll back: -430 million kuna, -0.10% of GDP
      - Increase in parental leave benefits: -160 million kuna, -0.04% of GDP
      - Cost of EU Presidency: -600 million kuna, -0.14% of GDP
      - Total: -5,050 million kuna, -1.22% of GDP
  - Staff advised against any additional tax cuts at this stage and recommended allowing automatic stabilizers to operate first in case of an external downturn; limited discretionary stimulus appropriate only in a severe downturn given high debt ratio.

### Medium-term priorities and structural reform recommendations
- Fiscal medium-term:
  - Target a structurally balanced budget by containing wage bill pressures and enhancing budget quality.
  - Hold the line on further wage bill pressures: public wage bill and the public “wage premium” (nearly 10 percent) exceed EU averages; staff encouraged resisting further wage pressures and revising public wage grid to reward merit; any additional wage increases should be accompanied by optimization of staffing levels.
  - Improve budget quality and flexibility: public expenditures have tilted toward rigid current expenditures over the last ten years; Croatia remains among countries with highly rigid expenditures.
- SOEs, healthcare, and pensions:
  - SOEs: staff encouraged (a) improving financial transparency; (b) continuing to separate core from non-core state assets; (c) improving management of essential SOEs; and (d) divesting non-core assets.
  - Healthcare: health sector arrears continue at nearly 2 percent of GDP and constitute a significant fiscal risk. Staff recommended increasing efficiency, reducing costs associated with overcapacity, exploring new permanent sources of revenue, and closing healthcare gaps in the medium-term.
  - Pensions: repeal of the 2018 pension reform returns retirement age to 65 from 67, lowers early retirement penalties, and reduces early retirement age to 60 from 62 (with 35 years of service). Staff recommended strengthening the second pillar, facilitating voluntary work beyond age 65, increasing female labor participation, and reducing “push” factors driving emigration.
- Public investment and EU funds:
  - Align EU funds of the next Programming Period (2020–2027) with medium-term objectives and prioritize where larger gaps exist.
  - Improve public investment assessment and management across all levels of government and strengthen the PPP framework; caution against PPP pitfalls including control and transparency of local government finances.
- ICT, human capital, and GVCs:
  - Invest in ICT, fiber internet access, and ultra-fast broadband; digitalize the public sector; improve business climate for IT startups; consider prudent tax-credits for R&D.
  - Complement education curriculum reform with expanded access to vocational training and produce a larger share of STEM university graduates to support next-generation manufacturing, ICT, and business services.
- Business environment:
  - Eliminate barriers to regulated professions and remaining parafiscal fees; implement construction permit reforms and adapt legislation for the EU Digital Single Market; enhance attractiveness for inward FDI.

### Monetary, ERM II, and banking preparations
- Authorities envisage ERM-II and Banking Union membership by mid-2020, and euro-adoption no earlier than 2023.
- CNB interventions: in 2019, the CNB purchased foreign exchange three times to keep appreciation pressures at bay and reduce exchange rate volatility.
- Banking system: remains profitable, liquid, and well-capitalized; consolidation reduced credit institutions from 30 at end-2017 to 23 in early December 2019.
- Supervisory concerns: deposit concentration, interest rate risk, exposure to Swiss franc borrower lawsuits (dependent on Supreme Court ruling in early March 2020).
- Average capital base: capital adequacy ratio (CAR) of 22.7 percent (September 2019).
- CNB macroprudential actions:
  - Recommended that debt service of general-purpose cash loans with maturities over five years follow similar rules as housing loans (February 2019).
  - Implemented supervisory measures: higher provisions, higher risk-weights, and claw-back of management bonuses if these loans prove riskier.
  - Developing a comprehensive database to start collecting data in September 2020.

### Banking, credit composition, and household lending
- Bank lending to non-financial corporations (NFCs):
  - Bank lending to NFCs has declined to about 22 percent of GDP; expected to modestly pick up.
- Bank lending to households:
  - Stabilized around 33 percent of GDP.
  - New lending mainly driven by general-purpose cash loans (typically Kuna denominated, long-term, long interest rate fixation, uncollateralized, more expensive than housing loans).
  - Rapid growth of general-purpose cash loans; their NPL ratio has not declined faster due to “denominator effects”.

### Housing market and related programs
- Housing price dynamics:
  - Average housing prices grew 8.0 percent (yoy, September 2019).
  - In Zagreb, housing prices grew 12.2 percent (yoy, September 2019).
- Drivers: higher real wages, better employment prospects, growing consumer confidence, declining interest rates, and tourism.
- Tourism-driven real estate: short-term rental investments have grown rapidly; favorable flat-tax on short-term rentals relative to long-term rentals noted.
- Government support: housing loan subsidy program for young first-time house buyers introduced in 2017 and reduction of the real estate transfer tax since 2019.
- Government home subsidy program features:
  - Subsidized loan amount cannot exceed €100,000.
  - Maturity cannot be shorter than 15 years.
  - Subsidy originally limited to four years in 2017, later extended to five years, extendable by two years for each additional child.
  - Budgeted subsidy for the entire period amounted to HRK 178 and 168 million in, respectively, 2017 and 2018.
- Staff recommended monitoring housing prices holistically and welcomed CNB research efforts to better gauge housing affordability.

### Macroprudential and legal framework recommendations
- Credit registry:
  - Should promptly be made fully operational; it stopped operating after GDPR transposition in May 2018.
  - In August 2019, limited information about defaulted borrowers began to be shared.
  - Amendments to the Credit Institution Act, to become effective in May 2020, are expected to provide additional assurances and enable the registry to become fully operational.
  - Staff recommended broadening coverage to include non-bank debt.
- If lending migrates to other forms of household credit, additional supervisory responses warranted consideration, including capturing all loans under the indirect debt-service-to-income rule.
- Enhance efficiency of bankruptcy procedures (e.g., facilitating out-of-court settlements) to help private sector deleveraging.
- Consider including all debt in an extended debt-service-to-income ratio.

### Financial intermediation, judicial, and insolvency findings
- Financial intermediation costs in Croatia remain high compared to peers.
- Banks are digitalizing, closing branches, and reducing staff to lower costs.
- Costs related to uncertain contract enforcement, including debt recovery and Swiss franc loan lawsuits, remain high.
- Insolvency framework developments:
  - Personal insolvency law of 2016 not widely used; streamlined personal insolvency procedure introduced in 2018 more successful.
  - General insolvency law amended in 2017 to facilitate restructuring of viable companies.
  - 2018 amendments to the enforcement Law and government-facilitated write-off of debt up to HRK 10,000 may have contributed to fewer individuals having blocked accounts.
- Gradual improvements in judicial procedures: backlog reduction, merging of local and municipal courts, increased use of e-communication, progress in registration of titles.

### Staff appraisal and consolidated policy guidance
- Macroeconomic context: Croatian economy strengthened over the last five years due to strong budget management and Central Bank policies; public debt has fallen and interest rates have declined; strong tourism has helped external accounts.
- Fiscal policy guidance:
  - Preserve hard-won fiscal gains; support government decision to withhold the planned reduction in the overall VAT rate.
  - Hold back on any other tax reductions at this stage.
  - Shift spending priorities towards more and better public investment.
  - Better absorption of EU funds could ease the shift but cannot substitute for deeper reforms in public administration, pensions, healthcare, and fiscal/territorial relationships.
- Structural and business climate reforms:
  - Accelerate digital public services, eliminate barriers to regulated professions and parafiscal fees, renovate railways and water/waste infrastructure, and upgrade technological infrastructure.
  - Align education policies across levels to support labor market needs.
- Institutional recommendation:
  - Next Article IV consultation recommended on the standard 12-month cycle.

---

### Box 1 — Investment push scenario and empirical multipliers
- Rationale:
  - Croatia’s income per capita stood at 61 percent of EU average in 2018, only 2 points better than in 2007; average “catch-up” in CESEE during the last decade was nearly 10 percentage points.
  - Public investment fell from around 6 percentage points of GDP pre-crisis to about 3.5 percent post-recession.
- Scenario and impact:
  - A gradual public investment push equivalent to 2 percentage points of GDP between 2021 and 2024 would bring public investment close to pre-crisis levels.
  - Under scenario assumptions, a 2 percentage point of GDP public investment push (spread over 4 years and financed from cuts in spending on goods and services) could help Croatia reach a level of income per capita of approximately 73 percent of the EU average by 2030.
  - This would bridge around 10 percentage points of the current average per person income gap with the EU by 2030, almost a decade earlier than the current trend.
- Financing and composition:
  - Croatia spends comparatively more than the EU average in current spending on goods and services (2.4 percent more), public wages (1.4 percent more), and social benefits (1.3 percent more).
  - A public investment boost of 2 percentage points of GDP equals 4 percent of overall government revenues (as stated).
  - Scenario finances the investment push by reductions in current spending (specifically cuts in goods and services) without issuing additional public debt or increasing taxes.
- Empirical cumulative public investment multipliers (percent of GDP) reported by horizon:
  - time t: 0
  - 2 years: 0.31
  - 3 years: 0.85
  - 4 years: 1.36
  - 5 years: 1.69
  - 6 years: 1.39
  - 7 years: 0.85
  - 8 years: 0.33
  - further horizons / values shown: 0.2, 0.6, 0.9, 1.0, 0.8, 0.4, 0.1, -0.5
- Implementation caveat: Success depends on improved public investment management capacities and cost-effective delivery; scenario captures demand-side effects only.

### Annex II — Public Debt Sustainability Analysis (selected projections and indicators)
- Key finding: Public debt has declined almost 12 percentage points since its peak in 2014 and remains on a declining path.
- Baseline debt path (selected nominal gross public debt, percent of GDP):
  - 2018: 71.7
  - 2019: 74.7
  - 2020: 71.5
  - 2021: 69.1
  - 2022: 67.0
  - 2023: 67.1
  - 2024: 65.0
  - 2025: 63.3
  - 2025 (end of table projection): 61.8
- Public gross financing needs (percent of GDP, selected):
  - 2018: 15.3
  - 2019: 6.5
  - 2020: 8.9
  - 2021: 11.4
  - 2022: 11.5
  - 2023: 8.4
  - 2024: 8.5
  - 2025: 8.1
  - 2025 (final projection year): 9.8
- Real GDP growth (percent) in projections:
  - 2018: -0.3
  - 2019: 2.7
  - 2020: 2.9
  - 2021: 2.7
  - 2022: 2.5
  - 2023: 2.2
  - 2024: 2.1
  - 2025: 2.0
- Effective interest rate (percent):
  - 2018: 4.5
  - 2019: 3.1
  - 2020: 3.3
  - 2021: 3.2
  - 2022: 3.4
  - 2023: 3.4
  - 2024: 3.5
  - 2025: 3.7
  - Final projection: 3.8
- Market indicators:
  - Sovereign spreads (as of table): EMBIG (bp) 93; 5Y CDS (bp) 46.
- Vulnerabilities and stress tests:
  - Slower output growth by one standard deviation: primary deficit deteriorates in 2022 to about -0.9 percent of GDP and debt sharply increases to over 76.7 percent, before improving thereafter; gross financing needs around 13.8 percent of GDP in 2021.
  - Combined macro-fiscal shocks: public debt would peak at nearly 77 percent of GDP (about 165 percent of public revenues), and gross financing needs close to 14 percent of GDP in 2021–22.
- Debt profile:
  - Central government debt accounts for 80 percent of general government gross debt.
  - More than 95 percent of outstanding debt matures beyond one year; sovereign bond maturities mostly 5–10 years.
  - About 38 percent of public debt is denominated in foreign currency (mostly euro-denominated).

### External sector: current account, reserves, and external indebtedness
- Current account:
  - The CA has been in surplus since 2014, driven by buoyant tourism receipts which more than offset the rising goods trade deficit.
  - The CA surplus was 1.9 percent of GDP in 2019 (the same as in 2018).
  - Projection for 2020: CA surplus is projected to decline from 1.9 percent of GDP in 2019 due to increased imports from strong domestic demand and higher bank profit transfers to foreign parents.
  - Medium-term: CA projected to move towards a small deficit as tourism receipts taper off while imports remain strong.
- Trade and external metrics (2019 levels):
  - Exports of goods (plus services): 23.9 percent of GDP in 2019 (exports of goods presented as 51.6 percent in source parenthesis).
  - Imports of goods (plus services): 43.4 percent of GDP in 2019 (imports of goods presented as 52.9 percent in source parenthesis).
- External debt and NIIP:
  - External debt projected to end 2019 at 75.9 percent of GDP, down from 82.7 percent of GDP in the previous year.
  - NIIP declined from -65 percent of GDP in 2017 to -58 percent of GDP in 2018; projected around -53 percent of GDP by 2019.
- Reserves:
  - In 2019, gross official reserves increased to €18.5 billion (34 percent of GDP).
  - Reserves projected to increase to nearly €28 billion in 2025 under the baseline scenario.
- REER and valuation:
  - Adjusted CA norm: -0.1
  - Adjusted CA balance: 0.2
  - CA gap: 0.3
  - REER gap (percent): CA model: -0.7; External sustainability approach: -11.6; REER index model: 1.0
  - Staff judges Croatia’s external position in 2019 to be broadly in line with fundamentals and medium-term policies.

### Risk Assessment Matrix — selected risks and policy responses
- Global risks (examples with likelihood and impact):
  - Rising protectionism: Short to medium term / High likelihood / Medium to Low impact — recommend growth-friendly fiscal consolidation; improve competitiveness.
  - Sharp tightening of global financial conditions: Short term / High likelihood / Medium to High impact — recommend fiscal consolidation; FX intervention if necessary; encourage hedging.
  - Weaker-than-expected global growth: Short to medium term / High likelihood / Medium to High impact — recommend allowing automatic stabilizers; diversify economy; accelerate structural reforms.
  - Lower and inefficient absorption of EU funds: Medium term / Medium likelihood / Low impact — recommend accelerate reforms to improve absorption.
  - Erosion of the fiscal stance: Short term / High likelihood / High impact — recommend resist wage/benefit increases and avoid further tax concessions.
- Domestic risks (examples):
  - Further reform standstill: Medium term / High likelihood / High impact — recommended policy: use ERM II accession opportunity to strengthen commitments to reform.
  - Negative demographics: Short to medium term / High likelihood / High impact — recommended policy: reform labor market; increase labor force participation; invest in human capital.
- RAM methodology note:
  - “Low” = probability below 10 percent; “medium” = between 10 and 30 percent; “high” = between 30 and 50 percent.
  - “Short term (ST)” = within 1 year; “medium term (MT)” = within 3 years.

_1hrvea2020001 - 1. Investment Push for Faster Convergence_

### 1. Investment Push for Faster Convergence ______________________________________________________ 24

### 1. Investment Push for Faster Convergence

### Context
- Growth has hovered around 3 percent for five consecutive years, supported by strong consumption, tourism, and a modest recovery in investment.
- Fiscal performance has remained strong reflecting buoyant revenues and declining interest payments.
- Private and public debt are falling but remain elevated.
- The country submitted its formal application to enter ERM II in July 2019. The authorities expect SSM/SRM membership by mid-2020 and currently see 2023 as the earliest time for euro accession.
- Parliamentary elections are to be held in the autumn of 2020 amid indications of increasing political fragmentation. The government assumed the rotating presidency of the EU Council in the first half of 2020.
- The government repealed recent pension reforms (which would have increased the retirement age and penalized early retirement) and has agreed to generous public sector wage increases; other reforms have stalled (Annex I).

### Recent developments (key findings)
- Growth for 2019 is expected at 2.9 percent, up from 2.7 percent in 2018, driven by consumption and tourism.
- The current account is estimated to have remained in surplus in 2019.
- Unemployment continued to fall to about 6.7 percent and is now near the EU average.
- Despite private sector wages growing at above 8 percent (including a 9 percent increase in the minimum wage), average inflation remained low at 0.8 percent in 2019.
- General government registered a fiscal surplus of 0.3 percent of GDP in 2018; staff projects a balanced budget for 2019.
- Public debt is projected to fall at end-2019 to 71.5 percent of GDP.
- The CNB accumulated reserves: gross reserves increased by €1.1 billion (end-November 2019); CNB purchased €1.1 billion in 2019 versus €1.8 billion in 2018.
- Gross external debt is projected to decline to 75.9 percent of GDP in 2019 from 82.7 percent in 2018.
- Banking system liquidity is high; headline credit growth to the private sector decelerated in 2019, while bank lending to households remained strong driven by general-purpose cash loans.
- NPL ratio declined from 10.2 percent in September 2018 to 7.6 percent in September 2019; provision coverage increased, largely due to a large sale of less provisioned non-financial corporation loans in Q3 2019.

### Outlook and risks
- Tourism will support potential in the next few years, but aging and migration trends will pressure employment growth; potential output will depend on productivity growth.
- Crucial areas for productivity growth where Croatia lags the EU include human and technological capital; deficiencies can spur outward migration, labor shortages, “brain drain”, and sustainability challenges for healthcare and pension systems.
- Near-term external risks from global trade tensions remain elevated given significant trading with Italy and Germany.
- External debt in percent of exports remains the second highest in the CESEE region.
- Reform standstill and fiscal risks have been exacerbated as elections approach; realization of contingent liabilities related to shipyards or SOEs cannot be discounted.
- With the output gap closed (or very nearly so), further loosening of spending risks turning fiscal stance procyclical and could lead to more volatile growth than in the baseline.
- Staff projects that, assuming no new offsetting policy measures, revenue and expenditure ratios will remain constant in percent of GDP (except for declining interest payments and minor changes in public investment related to EU funds' disbursement calendar) until budget balances again in 2025; public debt projected to reach 61.8 percent of GDP in 2025.

### Policy discussions and recommendations
- Overall focus: reap full benefits of euro adoption—enshrining fiscal discipline, improving budget quality, and investing for the future; align priorities for the next programming period of EU funds with medium-term objectives.
- Short-term fiscal stance:
  - Staff projects the 2020 budget measures will turn the budget balance for 2020 into a deficit of 0.3 percent of GDP, making fiscal policy procyclical.
  - Identified 2020 measures total HRK 5,050 million, equivalent to 1.22 percent of GDP, with details preserved as in the source:
    - Revenues:
      - Income tax cuts for the young: -750 million kuna, -0.18% of GDP
      - Profit tax exemption: -200 million kuna, -0.05% of GDP
      - Increase in income tax threshold: -500 million kuna, -0.12% of GDP
      - VAT reduction for food and restaurants: -900 million kuna, -0.22% of GDP
      - Additional excise taxes on tobacco, alcohol and sugar: 400 million kuna, 0.10% of GDP
    - Expenditures:
      - Additional wage increase (from 5 to 6.12 percent): -1,120 million kuna, -0.27% of GDP
      - Increase in teachers' salary coefficients: -400 million kuna, -0.10% of GDP
      - Other salary increases (police, customs, doctors): -390 million kuna, -0.10% of GDP
      - Pension reform roll back: -430 million kuna, -0.10% of GDP
      - Increase in parental leave benefits: -160 million kuna, -0.04% of GDP
      - Cost of EU Presidency: -600 million kuna, -0.14% of GDP
      - Total: -5,050 million kuna, -1.22% of GDP
  - Staff advised against any additional tax cuts at this stage and recommended allowing automatic stabilizers to operate first in case of an external downturn; limited discretionary stimulus appropriate only in a severe downturn given high debt ratio.
- Medium-term priorities:
  - Target a structurally balanced budget by containing wage bill pressures and enhancing budget quality.
  - Hold the line on further wage bill pressures: public wage bill and the public “wage premium” (nearly 10 percent) exceed EU averages; staff encouraged resisting further wage pressures and revising public wage grid to reward merit; any additional wage increases should be accompanied by optimization of staffing levels.
  - Improve budget quality and flexibility: public expenditures have tilted toward rigid current expenditures over the last ten years; Croatia remains among countries with highly rigid expenditures.
  - Fiscal reforms needed for budget flexibility:
    - State-Owned Enterprises (SOEs): SOEs span beyond natural monopolies into manufacturing, construction, hotels; state ownership is fragmented and heterogeneous; many SOEs show low productivity and profitability due to inefficient use of labor and weak governance. Staff encouraged: (a) improving financial transparency; (b) continuing to separate core from non-core state assets; (c) improving management of essential SOEs; and (d) divesting non-core assets. Some progress likely on (b) and (d) to meet ERM II commitments, but more is needed and political conditions are not supportive.
    - Healthcare: Health sector arrears continue at nearly 2 percent of GDP and constitute a significant fiscal risk. Staff reiterated recommendations to increase efficiency, reduce costs associated with overcapacity, explore new permanent sources of revenue, and close healthcare gaps in the medium-term.
    - Pensions: The repeal of the 2018 pension reform will not significantly affect short-term fiscal balances but may have medium-term effects by encouraging early retirement. Pension spending is already high despite low coverage ratios. Authorities should strengthen the second pillar, facilitate voluntary work beyond age 65, increase female labor participation, and reduce “push” factors driving emigration.

_1hrvea2020001 - 1. Investment Push for Faster Convergence_

### 15.      The authorities highlighted their commitment to prudent fiscal policy, as exemplified by the

### 1hrvea2020001 - 15.      The authorities highlighted their commitment to prudent fiscal policy, as exemplified by the

### Fiscal policy, pensions, and budget priorities
- Authorities reversed the announced VAT reduction in view of growing spending pressures.
- Wage demands occurred in the context of strong growth, elections and Unions’ mobilization capacity—factors which were also crucial to reverse the pension reform.
- Authorities forecast fiscal surpluses until 2022, assuming reduced spending-to-GDP ratios for the wage bill and social benefits.
- Authorities saw merit in improving the quality of the budget and increasing public investment as part of a wider strategy to accelerate Croatia’s real income convergence with more advanced Europe.
- There could be room for efficiency gains in some SOEs, but any major reforms would have to wait till parliamentary elections are completed.
- Pension reform repeal (authorities’ action):
  - On October 10, 2019, the government repealed the pension reform adopted late-2018.
  - The statutory retirement age now reverts to 65 years from 67 years.
  - The penalty for early retirement reduces to 0.2% of the pension for each month of early retirement (from 0.3%).
  - The early retirement age reduces to 60 years from 62 years (with 35 years of service).

### Structural reforms: objectives and recommended areas
- Deep reforms are needed to optimize benefits of currency union and to prepare for ERM II and Banking Union transition.
- Croatia’s convergence with the EU average has stagnated in the last decade; demographic trends and emigration require creating a broader economic base beyond tourism.
- Reforms to improve the business environment:
  - Progress made on business regulations and administrative burden, but barriers to regulated professions and remaining parafiscal fees remain high.
  - The “START” initiative allows simple electronic procedures to start a business.
  - Need to implement recent changes on construction permits and adapt legislation to facilitate integration in the EU’s Digital Single Market.
  - Improve business digitization and digitization of public services.
- Recovering “lost opportunities” in Global Value Chains (GVCs):
  - Croatia’s low integration in GVCs is commonly attributed to later EU accession compared with regional peers.
  - Staff recommended enhancing attractiveness for inward FDI and addressing necessary conditions for further attracting FDI.

### Public investment, capital stock renovation, and PPPs
- Staff recommended a public investment push to raise productivity and accelerate real income convergence with the EU average.
- A gradual increase of public investment could help Croatia bridge around 10 percentage points of the current average per person income gap with the EU by 2030.
- Prioritize EU funds of the next Programming Period (2020–2027) where larger gaps exist.
- Caution against potential pitfalls of PPPs, including issues related to control and transparency of local government finances.
- Croatia has a high per capita stock of public capital due to good transportation infrastructure (especially roads) and ongoing renovation of ports, but port productivity requires complementary investment in railways (particularly for freight).
- Investments in solid waste and waste-water treatment are high priority areas.
- Delivering investments efficiently requires improvements in public investment assessment and management across all levels of government and strengthening of the PPP framework.

### ICT, digital readiness, and near-shoring opportunities
- Croatia ranks well on availability of mainstream technologies (fixed broadband, mobile phones) but low in readiness for newer technologies.
- Croatia ranks low in the DESI-connectivity index for broadband deployment and quality.
- Staff encouraged more public investment in ICT, fiber internet access, and ultra-fast broadband to enhance digital competitiveness.
- Additional measures: digitalizing the public sector, improving the business climate for IT startups, and prudent tax-credits for R&D.
- “Near-shoring” in manufacturing, enabled by better technologies and more capital-intensive factories, represents an opportunity to integrate into next-generation European value chains.

### Human capital and education reforms
- Upgrading technologies needs to be matched by updating workers’ skills.
- Croatia’s progress is uneven:
  - Despite one of the lowest pupil-to-teacher ratios in Europe, mathematical, problem-solving, and natural science skills are stagnating.
  - High likelihood of excess capacity in a context of a declining population.
- Croatia produces a stratum of highly qualified STEM university graduates but ranks low in skills of the current and future labor force.
- Recommendations:
  - Complement ongoing educational curriculum reform with expanded access to vocational training to improve the efficiency of secondary education.
  - At the tertiary level, produce a larger share of STEM university graduates to position Croatia as a hub in next-generation manufacturing, ICT, and business services.

### Authorities’ views on reforms and Doing Business
- Authorities highlighted the 2020 Doing Business index where Croatia advanced by 7 positions (to 51st out of 190 ranked economies).
- Government intends to put additional efforts to facilitate starting a company and implement legislative changes to smooth processing of construction permits.
- Authorities emphasize reinvigorating structural reforms, including reducing national fragmentation and public service reform.
- Authorities welcomed the mission’s recommendation to rebalance public expenditures towards investment.

### Monetary policy, ERM II, and Banking Union preparations
- Legislative amendments to allow the asset quality review (AQR) have been adopted and amendments are expected to come into force in May 2020.
- Four large foreign-owned banks and the state-owned Postal Bank are currently subject to an AQR.
- Authorities envisage ERM-II and Banking Union membership by mid-2020, and euro-adoption no earlier than 2023.
- Monetary policy has been appropriately accommodative given the exchange rate anchor; exchange rate stable and international reserves have continued to grow.
- In 2019, the CNB purchased foreign exchange three times to keep appreciation pressures at bay and reduce exchange rate volatility.
- Inflation has been low and is expected to remain subdued.
- Banking system liquidity is high; there are no immediate plans to reduce required reserves or the obligation to maintain 17 percent of all foreign currency (FX) denominated liabilities in liquid FX assets, as they are not currently constraining lending.

### Banking system health and risks
- Banking system remains profitable, liquid, and well-capitalized but subject to lingering uncertainties.
- Consolidation: industry declined from 30 credit institutions at end-2017 to 23 in early December 2019.
- NPLs have further declined, mainly due to NPL sales.
- CNB is monitoring deposit concentration and interest rate risk as low rates on savings deposits increase the share of demand deposits.
- Exposure to Swiss franc borrower lawsuits could affect profitability; outcome depends on the Supreme Court ruling of a model case in early March 2020.
- Average capital base: capital adequacy ratio (CAR) of 22.7 percent (September 2019).

### Bank lending trends and household credit
- Bank lending to non-financial corporations (NFCs):
  - Expected to modestly pick up following legacy problems.
  - Number of companies with blocked accounts has decreased and aggregate debt of NFCs has diminished as percent of GDP.
  - Bank lending to NFCs has declined to about 22 percent of GDP.
  - Banks expect moderate lending growth to NFCs in 2020.
- Bank lending to households:
  - Stabilized around 33 percent of GDP.
  - Composition shifted: new lending mainly driven by general-purpose cash loans (typically Kuna denominated, long-term, long interest rate fixation, uncollateralized, more expensive than housing loans).
  - Rapid growth of general-purpose cash loans; their NPL ratio has not declined faster due to “denominator effects”.
  - In February 2019, the CNB recommended that the debt service of general-purpose cash loans with maturities over five years should follow similar rules as housing loans.
  - Accompanying supervisory measures: higher provisions, higher risk-weights, and claw-back of management bonuses if these loans prove riskier.

### Macroprudential recommendations and reforms
- Credit registry:
  - Should promptly be made fully operational; it stopped operating after GDPR transposition in May 2018.
  - In August 2019, limited information about defaulted borrowers began to be shared.
  - Amendments to the Credit Institution Act, to become effective in May 2020, are expected to provide additional assurances and enable the registry to become fully operational.
  - Staff recommended broadening coverage of the credit registry to include non-bank debt.
- General-purpose cash loans should be monitored closely; CNB recommendations and supervisory measures have coincided with a slowdown in their growth rates.
- If lending migrates to other forms of household credit, additional supervisory responses warrant consideration, including capturing all loans under the indirect debt-service-to-income rule.
- CNB is building its own comprehensive database, which will start collecting data in September 2020, to better calibrate possible macro-prudential measures.

### Housing market dynamics and recommendations
- Housing prices have begun to accelerate, mainly in the capital and coastal areas:
  - Average housing prices grew 8.0 percent (yoy, September 2019).
  - In Zagreb, housing prices grew 12.2 percent (yoy, September 2019).
- Drivers: higher real wages, better employment prospects, growing consumer confidence, declining interest rates, and tourism.
- Tourism-driven real estate: investment properties for short-term rentals have grown rapidly, facilitated by a favorable flat-tax on short-term rentals compared to higher taxation on long-term rentals.
- Government policies supporting demand: housing loan subsidy program for young first-time house buyers introduced in 2017 and reduction of the real estate transfer tax since 2019.
- CNB’s housing price index indicates real estate prices are beginning to reach pre-crisis levels.
- Staff recommended monitoring housing prices holistically—consider mortgage lending, general-purpose loans that might be diverted to real estate, government housing subsidies, tourism impacts, and rental taxation policies on housing supply.
- Mission welcomed CNB research efforts to better gauge housing affordability.

*Source: IMF staff report excerpt (1hrvea2020001 - 15).*

### 26.      Financial intermediation costs are still high compared to peers. Croatian Banks are

### 26.      Financial intermediation costs are still high compared to peers. Croatian Banks are

### Findings on financial intermediation and judicial/enforcement framework
- Financial intermediation costs in Croatia remain high compared to peers.
- Banks are digitalizing, closing branches, and reducing staff to lower costs.
- Costs related to uncertain contract enforcement, including debt recovery, remain high; lingering lawsuits of Swiss franc loans are cited as a case in point.
- Gradual improvements:
  - Backlog of old court cases is slowly being reduced.
  - Merging of local and municipal courts and increased use of e-communication has helped optimize case load.
  - Some progress in accelerating registration of titles at the property registry and the cadaster.
- Insolvency frameworks and procedures:
  - Personal insolvency law of 2016 has not been widely used.
  - Streamlined personal insolvency procedure introduced in 2018 has been more successful.
  - General insolvency law amended in 2017 to facilitate restructuring of viable companies to avoid liquidation.
  - 2018 amendments to the enforcement Law and government-facilitated write-off of debt up to HRK 10,000 may have contributed to fewer individuals having blocked accounts.
- Despite these reforms, insolvency costs and operating costs of Croatian banks remain high.

### Housing, household credit, and related programs
- Government home subsidy program (introduced 2017):
  - Subsidized loan amount cannot exceed €100,000.
  - Maturity cannot be shorter than 15 years.
  - Subsidy originally limited to four years in 2017, later extended to five years, extendable by two years for each additional child.
  - Budgeted subsidy for the entire period amounted to HRK 178 and 168 million in, respectively, 2017 and 2018.
  - Rules amended in 2018 to promote less developed areas.
  - The program continues.
- Note: The decline in household credit in late 2015 is mainly due to the conversion of Swiss franc indexed loans (CNB note).
- ESRB Risk Dashboard, December 2019: using four different evaluation methods, residential property prices generally were not yet over-valuated (Q1 2019 data).

### Insolvency and intermediation cost indicators (select metrics cited)
- R² = 0.57 (reported in figure annotation).
- Recovery ratio and EU resolving insolvency comparisons include HRV as a datapoint (figures referenced).
- Operating and staff expenses of EU banks, 2019:Q2: staff expenses and operating expenses shown as percent of assets with HRV indicated in the dataset (figures referenced).

### Authorities’ views and supervisory adjustments
- Authorities committed to closely monitor general-purpose cash loans and housing prices.
- Main reason for recommendation on general-purpose cash loans over five years: they were being used to substitute housing loans or top-up housing loans.
- CNB is prepared, if necessary, to extend the debt-service-to-income ratio to all loans.
- CNB is enhancing analytical tools by developing a more comprehensive database to better calibrate macro-prudential measures.
- Authorities expect further digitalization will help reduce financial intermediation costs, including by more efficient legal procedures.

### Staff appraisal and policy recommendations
- Macroeconomic context:
  - Croatian economy has strengthened over the last five years due to strong budget management and Central Bank policies.
  - Public debt has fallen and interest rates have declined, enabling consumption-led private sector expansion; strong tourism has helped external accounts.
  - Croatia has barely reduced its distance with the EU average in income per capita in the last decade; emigration of the young continues to pose challenges.
- Fiscal policy guidance:
  - Hard-won fiscal gains are fragile and should be carefully preserved.
  - Staff supports the government’s decision to withhold the planned reduction in the overall VAT rate.
  - Staff recommends holding back on any other tax reductions at this stage to avoid reigniting deficits.
  - Recommend shifting spending priorities towards more and better public investment.
  - Better absorption of EU funds could ease the shift but cannot substitute for deeper reforms in public administration, pensions, healthcare, and fiscal/territorial relationships.
  - State-owned enterprise management and performance needs modernization.
  - Accelerate digitalization of public administration and use technological improvements to better target social benefits.
- Structural and business climate reforms:
  - Continue enhancing digital public services and adapt legislation to facilitate integration in the EU’s Digital Single Market.
  - Eliminate barriers to regulated professions and remaining parafiscal fees.
  - Renovate “hard” physical infrastructure (e.g., railways for freight, solid and waste water treatment) and upgrade “soft” technological infrastructure to position Croatia in next-generation European value chains (ICT and business services).
  - Align education policies across primary, secondary, tertiary, and continuing education with these needs.
- Macroprudential and financial stability recommendations:
  - Constant consideration of macroprudential action to prevent excessive lending, given strong bank lending to the private sector—primarily households.
  - Monitor house price pick-up in capital and coastal areas; if real estate prices accelerate or migration to other household lending forms occurs, stronger supervisory responses should be considered.
  - Credit register needs to become fully operational again to prevent a build-up of systemic risk.
  - Consider including all debt in an extended debt-service-to-income ratio.
  - Enhance efficiency of bankruptcy procedures (e.g., facilitating out-of-court settlements) to help private sector deleveraging.
- Institutional recommendation:
  - Next Article IV consultation recommended on the standard 12-month cycle.

*Source: IMF staff report excerpt (Republic of Croatia).*

### Box 1. Investment Push for Faster Convergence

### Box 1. Investment Push for Faster Convergence

### Overview and rationale
- Croatia’s convergence with the EU average has stagnated in the last decade:
  - In 2018, Croatia’s income per capita stood at 61 percent of EU average, only 2 points better than in 2007.
  - This was the third slowest among CESEE countries, with the average “catch-up” during the last decade at nearly 10 percentage points.
- This stagnation has coincided with a reduction of capital spending coupled with sharply increased current spending.
  - Average public investment before the crisis was around 6 percentage points of GDP, but in the aftermath of the recession, it came down to about 3.5 percent.

### Key findings and projections
- A gradual public investment push equivalent to 2 percentage points of GDP between 2021 and 2024 would bring the level of public investment close to pre-crisis levels.
- Under assumptions described below, a public investment push of 2 percentage points of GDP (spread over 4 years and financed from cuts in spending on goods and services) could help Croatia reach a level of income per capita of approximately 73 percent of the EU average by 2030.
  - This would bridge around 10 percentage points of the current average per person income gap with the EU by 2030, almost a decade earlier than the current trend.
- The scenario is based on historical public investment multipliers during normal times and takes into account Croatia’s initial level of capital stock.
- The scenario estimates demand-side effects only and does not estimate permanent supply-side effects which could have a longer-term impact.

### Fiscal composition and financing
- Croatia spends comparatively more than the EU average in three areas of current spending:
  - goods and services: 2.4 percent more
  - public wages: 1.4 percent more
  - social benefits: 1.3 percent more
- A public investment boost of 2 percentage points of GDP equals:
  - 4 percent of overall government revenues (if 2 percentage points of GDP are 4 percent of revenues as stated).
- Financing approach in the scenario:
  - Finance the 2 percentage point public investment push by reductions in current spending (specifically cuts in spending on goods and services).
  - Do so without issuing additional public debt or increasing taxes.

### Implementation requirements and risks
- Progress of this magnitude cannot be realized if public investment is not delivered carefully and cost-effectively.
- Public investment management capacities need to improve at all levels of government to secure efficient investment implementation.
- The scenario does not capture potential permanent supply-side gains; careful delivery is essential to realize the projected convergence gains.

### Empirical inputs and multipliers
- The analysis uses historical public investment multipliers (net of goods & services multipliers) for Croatia, cumulative by time horizon. The reported cumulative multipliers (percent of GDP) at successive horizons are:
  - time t: 0
  - 2 years: 0.31
  - 3 years: 0.85
  - 4 years: 1.36
  - 5 years: 1.69
  - 6 years: 1.39
  - 7 years: 0.85
  - 8 years: 0.33
  - (further horizons / values shown): 0.2, 0.6, 0.9, 1.0, 0.8, 0.4, 0.1, -0.5

### Summary policy implication
- A fiscally-neutral reallocation that shifts 2 percentage points of GDP from current spending (notably goods and services) to public investment over 2021–24 could materially accelerate Croatia’s catch-up to the EU average, conditional on strengthened public investment management and cost-effective delivery.

*Source: Box 1. Investment Push for Faster Convergence, IMF staff analysis.*

### Annex II. Public Debt Sustainability Analysis

### Annex II. Public Debt Sustainability Analysis

### Overview and key findings
- Public debt has declined almost 12 percentage points since its peak in 2014 and remains on a declining path.  
- Under the baseline scenario, debt is expected to be at 71.5 percent of GDP at end-2019 and to reach 61.8 percent of GDP in 2025.  
- Gross financing needs are below the high-risk threshold but remain elevated: 9 percent of GDP in 2019.  
- Projections are vulnerable to growth prospects and contingent liabilities (state guarantees for shipyards, payment of healthcare arrears); divestment of state assets could reduce debt further.  
- Financing conditions have improved, lowering risk premia; the interest rate on Croatia’s sovereign is approaching its medium-term growth rate and is likely to close at the end of the projection period.

### Definitions, debt profile, and vulnerabilities
- Definitions and coverage:
  - Gross debt statistics cover the general government (central, local, social security funds and state-owned enterprises).  
  - Instruments included: cash and deposits, debt securities and credits and loans.
- Debt profile and developments:
  - Central government debt accounts for 80 percent of general government gross debt.
  - More than 95 percent of outstanding debt matures beyond one year; sovereign bond maturities mostly 5–10 years.
  - About 38 percent of public debt is denominated in foreign currency (mostly euro-denominated).
  - Debt denominated in euro increased due to issuance of domestic and foreign euro bonds, syndicated loans in domestic market, and project loans from IFIs.
  - Since its peak in 2014, public debt has declined more than 12 percentage points.
  - Significant progress in financial restructuring of the road sector; gross financing needs remained at 9 percent of GDP in 2019 due to payment of state guarantees to Uljanik shipyards.
- Debt management strategy:
  - Authorities’ 2017–2020 debt management strategy aimed to reduce the debt-to-GDP ratio below 60 percent of GDP by 2022, including further reducing short-term debt and currency and interest rate risks.
- Vulnerabilities:
  - Heat map: stock of debt remains high but gross financing needs have declined since 2015 and are no longer above the 15 percent high-risk threshold.
  - Debt profile improvements: longer maturities, improved market perception, reduced share of short-term debt, and changes in non-resident holdings.

### Baseline scenario assumptions and path
- Fiscal path:
  - Preliminary data put the 2019 general government budget balance at around 0 percent of GDP, including the second payment of state guarantees for Uljanik shipyards of about 0.3 percent of GDP.
- Growth:
  - Real GDP growth is estimated at 2.9 percent for 2019. Going forward, growth is expected to converge towards its potential rate of about 2.0 percent.
- Risk balance:
  - Main downside risk is lower-than-expected output growth; past fiscal overperformance mitigates the balance of risks.
  - A neutral interest rate-growth differential combined with consolidation could produce faster debt contraction than previously projected.
  - Gross financing needs are projected to decline owing to lower deficits, recent refinancing at longer maturities, and favorable interest rates, despite gradual normalization of global monetary conditions.

### Shocks and stress tests (selected results)
- Slower output growth:
  - Underperformance of real GDP growth by one standard deviation results in the primary deficit deteriorating in 2022 to about -0.9 percent of GDP and debt sharply increasing to over 76.7 percent, before improving thereafter.
  - Gross financing needs would be around 13.8 percent of GDP in 2021 and decline slowly going forward.
- Combined macro-fiscal shocks:
  - If shocks to real GDP growth, the primary balance, real exchange rate, and real interest rate occur simultaneously, public debt would peak at nearly 77 percent of GDP (about 165 percent of public revenues), and gross financing needs would be close to 14 percent of GDP in 2021–22.

### Key projection and market indicator series (selected)
- Nominal gross public debt (percent of GDP):  
  - 2018: 71.7  
  - 2019: 74.7  
  - 2020: 71.5  
  - 2021: 69.1  
  - 2022: 67.0  
  - 2023: 67.1  
  - 2024: 65.0  
  - 2025: 63.3  
  - 2025 (end of table projection): 61.8
- Public gross financing needs (percent of GDP):  
  - 2018: 15.3  
  - 2019: 6.5  
  - 2020: 8.9  
  - 2021: 11.4  
  - 2022: 11.5  
  - 2023: 8.4  
  - 2024: 8.5  
  - 2025: 8.1  
  - 2025 (final projection year): 9.8
- Real GDP growth (percent):  
  - 2018: -0.3  
  - 2019: 2.7  
  - 2020: 2.9  
  - 2021: 2.7  
  - 2022: 2.5  
  - 2023: 2.2  
  - 2024: 2.1  
  - 2025: 2.0
- Effective interest rate (percent):  
  - 2018: 4.5  
  - 2019: 3.1  
  - 2020: 3.3  
  - 2021: 3.2  
  - 2022: 3.4  
  - 2023: 3.4  
  - 2024: 3.5  
  - 2025: 3.7  
  - Final projection: 3.8
- Sovereign spreads (as of table): EMBIG (bp) 93; 5Y CDS (bp) 46.
- Change in gross public sector debt (percent of GDP) (2018–2025 cumulative): change in gross public sector debt columns show a cumulative change of -9.8 for the projection period; identified debt-creating flows cumulative -7.5; primary deficit cumulative -9.1.

### Alternative scenarios and composition
- Alternative scenarios presented include Historical Scenario and Constant Primary Balance Scenario with differing assumptions on Real GDP growth, Inflation, Primary Balance, and Effective interest rate.
- Composition highlights:
  - By maturity: predominance of medium and long-term debt; short-term share reduced.
  - By currency: mix of local-currency and foreign-currency denominated debt with about 38 percent foreign-currency share noted above.

*Prepared by IMF staff. Source: IMF staff projections and analysis as presented in Annex II. Public Debt Sustainability Analysis.*

### 1.      Current Account. The current account (CA) has been in surplus since 2014, driven by

### 1. Current Account

### Key findings
- The current account (CA) has been in surplus since 2014, driven by buoyant tourism receipts which more than offset the rising goods trade deficit.
- Overall trade growth since EU accession in 2013:
  - Exports of goods (plus services): 23.9 percent of GDP in 2019.
  - Exports of goods: 51.6 percent of GDP in 2019 (presented as 23.9 (51.6) percent of GDP in source).
  - Import of goods (plus services): 43.4 percent of GDP in 2019.
  - Imports of goods: 52.9 percent of GDP in 2019 (presented as 43.4 (52.9) percent of GDP in source).
- Croatia’s current account surplus increased to 3.4 percent of GDP in 2017 (largely explained by one-off bank provisions for losses associated with exposure to Agrokor) but has since waned.
- The CA surplus was 1.9 percent of GDP in 2019 (the same as in 2018).
- Projection for 2020: CA surplus is projected to decline from 1.9 percent of GDP in 2019 due to:
  - Imports increase from strong domestic demand.
  - Bank transfer of profits to foreign parent banks projected to increase.
- Medium-term projection: CA projected to move towards a small deficit as tourism receipts taper off while imports remain strong in line with projections on consumption and investment.

---

### 2. Capital and Financial Flows

### Key findings
- The capital and financial account are projected to decline by 1.1 percentage points of GDP in 2019.
- In 2019:
  - The capital account increased by 0.5 percent of GDP.
  - The financial account deteriorated by 1.3 percent of GDP.
- External debt reduction continued, supported by fiscal consolidation and lower interest rates.
  - External debt projected to end 2019 at 75.9 percent of GDP, down from 82.7 percent of GDP in the previous year.
- The government has been able to borrow on favorable terms given ample global liquidity and better ratings.

---

### 3. External Balance Sheets

### Key findings
- Overall external indebtedness projected to continue to decrease in 2019.
- Decrease mainly due to general government and central bank; banks and other sectors increased gross external debt in nominal terms, although intercompany lending for direct investment declined somewhat.
- NIIP changes:
  - NIIP declined from -65 percent of GDP in 2017 to -58 percent of GDP in 2018.
  - NIIP in 2010 was around -94 percent of GDP.
  - Improvement attributed to sustained current account surpluses, EU funds absorption, and GDP growth.
  - NIIP projected to remain around -53 percent of GDP by 2019.
- Assessment: The current path of the NIIP does not imply risks to external sustainability or a need for substantial adjustment.

---

### 4. Reserve Adequacy

### Key findings and projections
- In 2019, gross official reserves increased gradually to €18.5 billion (34 percent of GDP) in part due to the current account surplus, EU funds, and interventions.
- This increase kept official reserves above the ARA metric in 2019 and improved margins relative to short-term debt as well as a ratio of months of next year’s imports of goods and nonfactor services.
- Reserves are projected to increase to nearly €28 billion in 2025 under the baseline scenario.

---

### 5. Consistency with Fundamentals and Medium-Term Policies

### Findings and computed balances
- The CA is projected to register a surplus of 1.9 percent of GDP in 2019 against the initial EBA-lite derived CA norm of -2.4 percent.
- The residual was small (-1.1 percent).
- Staff estimates a cyclically-adjusted CA balance of 0.2 percent of GDP, accounting for booming tourism and some modest further external deleveraging.
- The EU accession adjustment to the CA norm implies a multilaterally-consistent cyclically-adjusted CA norm of -0.1 percent of GDP.
- The CA gap is computed as 0.3 percent of GDP.

---

### 6. Exchange Rate Valuation (REER) and Model Results

### Model results, 2019 (percent unless stated otherwise)
- Adjusted CA norm (multilaterally-consistent cyclically-adjusted current account norm, including staff adjustment for EU accession): -0.1
- Adjusted CA balance: 0.2
- CA gap: 0.3
- REER gap (in percent):
  - CA model (after adjustments): -0.7
  - External sustainability (ES) approach: -11.6
  - REER index model: 1.0
- Notes:
  - Positive REER gap value indicates overvaluation.
  - ES result is based on stabilizing the NIIP at the end-2018 level.
- Interpretation: The various models yield mixed empirical results regarding the kuna’s valuation:
  - CA model implies a slight undervaluation of 0.7 percent (after adjustments).
  - REER index model suggests a slight overvaluation of 1.0 percent with an estimated residual of zero percent.
  - ES approach assesses the REER to be undervalued by almost 11.6 percent.
  - Given NIIP is higher than -60 percent of GDP and headed to -53 percent of GDP over the medium-term, staff does not view external sustainability as a concern.
- Conclusion: Croatia’s external position in 2019 is judged to be broadly in line with levels consistent with fundamentals and medium-term policies.

---

### 7. Competitiveness and Structural Challenges

### Key findings
- Broader competitiveness challenges persist and underscore the need for productivity-boosting structural reforms.
- Specific observations:
  - Labor costs increased less than in comparator countries, partially reflecting real per worker compensation.
  - Productivity growth continues to improve mildly.
  - FDI inflows remain low relative to peers.
  - Non-price indicators (Doing Business Report; World Economic Forum’s Global Competitiveness Report) point to the need for structural reforms.

*Prepared by Olamide Harrison and Tonny Lybek.*

### Annex V. Risk Assessment Matrix

### Annex V. Risk Assessment Matrix

### Global risks — descriptions, relative likelihood, impact, and recommended policy response
- Rising protectionism and retreat from multilateralism / Short to medium term / High / Medium to Low  
  - Impact if realized: Global imbalances and fraying consensus about the benefits of globalization lead to escalating and sustained trade actions and spreading isolationism. This threatens the global trade system, regional integration, labor mobility, as well as global and regional policy and regulatory collaboration. Croatia’s goods trade is not large and therefore the impact would not be as high as in countries with larger goods exports.  
  - Recommended policy response: Growth-friendly fiscal consolidation; Continue to improve competitiveness and reduce non-price trade costs.

- Sharp tightening of global financial conditions / Short term / High / Medium to High  
  - Impact if realized: Higher debt service and refinancing risks; stress on leveraged firms, households, and vulnerable sovereigns; capital account pressures; and a broad-based downturn.  
  - Recommended policy response: Continue fiscal consolidation; Use FX intervention if necessary to counter disorderly market conditions; Encourage further development of hedging instruments; Encourage lowering unhedged borrowing.

- Weaker-than-expected global growth / Short to medium term / High / Medium to High  
  - Impact if realized: Weaker economic growth in key trading partners, Italy and Germany, weaker goods exports and tourism, would weigh on economic growth and perpetuate economic vulnerabilities.  
  - Recommended policy response: Allow automatic stabilizers to operate; Diversify the economy; Accelerate structural reforms; Improve competitiveness; Build reserve buffers.

- Intensification of geopolitical tensions and security risks / Short term / High / Upside risk as Croatia may benefit  
  - Impact if realized: Leads to social and economic disruption in these regions. If tensions happen in nearby competitors, this would promote tourist flows to more stable regions like Croatia.  
  - Recommended policy response: Continue fiscal consolidation and build buffers.

- Lower and inefficient absorption of EU funds / Medium term / Medium / Low  
  - Impact if realized: Growth will be impacted by slow absorption of growth-enhancing investment.  
  - Recommended policy response: Accelerate reforms to improve absorption and invest on new technologies and improve labor force skills.

- Erosion of the fiscal stance / Short term / High / High  
  - Impact if realized: Add to deficit in structural forms, lead to slowdown in reducing public debt and prolong the convergence gap.  
  - Recommended policy response: Resist call from trade and labor union to increase wages and benefits; Avoid extending further tax exceptions and concessions.

- Risk assessment methodology note:  
  - “Low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent.  
  - “Short term (ST)” and “medium term (MT)” are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.  
  - The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). Non-mutually exclusive risks may interact and materialize jointly.

### Domestic risks — descriptions, relative likelihood, impact, and recommended policy response
- Further reform standstill / Medium term / High / High  
  - Impact if realized: Busy political calendar in 2020 has complicated implementation of reforms. Lack of meaningful reform will affect growth through lower investment, and labor productivity.  
  - Recommended policy response: Use the opportunity ahead of the ERMII accession and strengthen national commitments to reform.

- Negative demographics / Short to medium term / High / High  
  - Impact if realized: This will continue to impact the labor force, wages, and the sustainability of social welfare system.  
  - Recommended policy response: Further reform the labor market; Increase the labor force participation; Invest in improving the human capital.

*Source: Republic of Croatia — Annex V. Risk Assessment Matrix (IMF staff report).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1hrvea2020001.pdf_