## 1. Croatia: Potential Real GDP Growth ## Source details **Canonical URL:** [1. Croatia: Potential Real GDP Growth](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07198.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07198.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07198.pdf.json) --- ### Major recent macroeconomic outcomes and vulnerabilities - Real GDP growth averaged 4.8 percent annually over 2002–06, compared with a peer country average over 2002–06 of nearly 6 percent. - Real GDP growth averaged about 3¼ percent annually over 1997–2001. - Real export growth averaged 6 percent annually during 2002–06, versus a peer country average of over 10 percent. - Export growth averaged 6½ percent over 1997–2001. - External debt: - 61½ percent of GDP at end-2001 - nearly 80 percent of GDP by end-2004 - 85 percent of GDP at end-2006 - Current account deficit: - averaged 6 percent of GDP during 2001–05 - widened in 2006 to 7.6 percent of GDP - Foreign direct investment (FDI): - Total FDI into Croatia averaged just below 5 percent of GDP annually during 2002–06 - Greenfield FDI was well below potential; Croatia underperformed in attracting new greenfield projects relative to peers - Financial sector received a very large share of FDI: 30 percent of total inflows over 1993–2006 and over 40 percent of FDI each year in 2004–06 ### Structural and institutional characteristics relevant for growth - Strengths (compared with other transition economies): - Potential for convergence: GDP per capita (in purchasing power standards) reaches 48 percent of the euro area average - Public sector investment: spending considerably more as a share of GDP than other SEE and CEE countries - Monetary policy: low inflation, broadly in line with most of the rest of Europe - Demographics: high dependency ratio but similar to rest of Europe - Infrastructure: EBRD indicators close to other transition economies - Human capital: enrollment ratios and spending per student close to rest of Europe for primary and secondary education; overall labor force education does not give particular reason for concern - Health: population health indicators generally favorable, though public health spending is relatively high as a share of GDP - New economy / IT: use and production of information technology broadly as developed as in the CEE - Financial sector: more advanced banking sector than most SEE and CEE countries; limited presence of the state in the sector - International trade: indicators suggest a very open economy - Weaknesses (compared with other transition economies): - Private sector investment and FDI: shares of GDP below those in other CEE countries, especially greenfield FDI - Government size: general government spending as a share of GDP well above levels in SEE and CEE countries (note: empirical evidence cited finds a negative impact of public spending on growth above a threshold of 35 percent of GDP) - Transition progress: lags behind CEE countries in large-scale privatization, enterprise restructuring, competition policy, and price liberalization; greater role of the state than in the rest of Europe - Business environment: less friendly than in CEE countries and the euro area - Legal system: property rights, contract enforcement, and corruption indicators less favorable than in CEE and the euro area - Labor market: relatively high unemployment (notably long-term and youth unemployment) and low labor force participation; indicators suggest more rigid labor market than SEE and CEE countries ### Objectives and analytical questions of the paper - Assess the medium-term pace of economic growth Croatia can expect. - Identify ways to increase the pace of growth by diagnosing constraints and proposing policy responses. - Determine the extent to which recent growth is driven by fundamentals versus temporary factors. - Evaluate how structural reforms and macroeconomic stabilization have affected potential growth and what further reforms could raise the growth rate and promote income convergence to the EU. ### Methods used to estimate potential growth - Hodrick-Prescott (HP) filter (univariate statistical trend extraction) - Cobb-Douglas two-factor production function estimation (capital and labor, constant returns to scale) - Simulation using coefficients from a cross-country growth regression (growth empirical model), with scenarios reflecting different stages of transition ### Quantitative estimates of potential real GDP growth - HP filter estimate: 4.4 percent (real GDP growth of 4.4 percent for 2006 taken as estimate of potential growth) - Cobb-Douglas production function estimate: 4.3–4.4 percent - Growth regression (scenario-dependent estimates): - assuming most of transition is still ahead: 5.1 - assuming the transition process had reached a mid-point: 4.2 - assuming the transition process has been completed: 3.2 - Average of estimates (taking the middle estimate from the growth regression): 4.3 percent ### Interpretation and implications from the estimates - On current productivity trends, Croatia’s potential growth is between 4 and 4½ percent. - Potential growth estimates are necessarily tentative for transition economies due to data limitations, structural change during transition, and relatively short time series; using multiple methodologies provides a cross-check on results. - Estimates of potential output can guide medium-term projections, cyclically-neutral budget calculations, assessment of whether actual growth is sustainable, and the design and prioritization of reforms to raise growth. ### Data sources and capital stock methodologies - All data sources are from the IMF World Economic Outlook (WEO, Winter 2007), except: - Average wages: Croatian National Bank (CNB). - Historical capital stock: two alternative series: - CNB estimates for 1994–2005 using the perpetual inventory method. - CROSTAT direct calculations of capital stock by sector for 1999–2003 (preliminary). - For years outside the CROSTAT and CNB direct periods, capital stock is estimated using the perpetual-inventory method, using WEO data for investment and assuming a rate of capital depreciation of 2.7 percent (CROSTAT estimate). - Note: CROSTAT direct capital stock data are preliminary and may change; results are discussed for both methodologies. ### Key assumptions used in estimates - Employment income share = total wage bill (average wage × total employment) / nominal GDP. - Future years: Croatia’s average wage assumed to grow by 6 percent (equal to its average growth in recent years). - Resulting employment income share: about 0.47–0.51, depending on year. - Capital income share (constant returns to scale): one minus employment income share = 0.49–0.53. - Assumption: current TFP trend growth continues in the medium term. - Labor market reform context: reforms introduced in 2003 to increase labor market flexibility. ### Production-function based estimates: GDP growth and contributions for Croatia - Using CNB capital stock estimates: - Real GDP growth: 3.6 4.7 4.4 - Contributions: - Capital: 3.2 2.7 2.8 - Labor: -1.0 0.9 0.5 - Productivity: 1.5 1.1 1.1 - Using CROSTAT capital stock estimates: - Real GDP growth: 3.6 4.7 4.3 - Contributions: - Capital: 1.5 2.2 2.2 - Labor: -1.0 0.9 0.5 - Productivity: 3.2 1.6 1.6 - Interpretation: - Estimated potential growth for Croatia is between 4.3 and 4.4 percent. - Primary driver: capital accumulation. - Limited contribution from TFP growth in recent years; CROSTAT-based estimates suggest higher TFP contribution in the 1990s. - Very limited contribution from employment due to persistently high unemployment and relatively low labor participation. - Historical context: post-independence and post-war rebuilding and infrastructure investment contributed to high capital-driven growth in the 1990s; privatization and domestic/foreign investor interest contributed more recently, though private investment share in GDP remains below more advanced transition economies. ### Employment and potential near-term scenario - Present unemployment rate cited: 11 percent. - Scenario: If unemployment falls from 11 percent to 8 percent over the next three years, temporarily higher employment contribution would boost annual potential growth to 4.8 percent over this period. ### Cross-country econometric growth model (sample and specification) - Sample: 109 developed and developing economies over 1996–2005. - Empirical specification: Real GDP per capita growth_i = c + βX_i + u - Each country observation: either the average over 10 years or the initial value in 1996. - Preferred estimated equation (heteroskedasticity-consistent t-statistics in parentheses): - Real GDP per capita growth = 0.98(0.62) + 1.88(2.71) dummy for SEE and CEE - 0.49(-3.62) initial real GDP per capita - 0.43(-1.78) population growth + 0.14(3.58) investment/GDP - 0.02(-2.29) inflation rate + 0.001(3.18) credit to private sector/GDP + 0.43(2.30) index of economic freedom - 0.03(-3.85) cost of business start-up procedures (% of GNI per capita) - Regression diagnostics: - Number of observations: 109 - R2: 0.56 - Adjusted R2: 0.52 - F-statistic: 15.80 ### Main cross-country regression findings - Faster growth associated with: - Relatively low initial income level. - Low population growth rate (interpreted as a low dependency ratio). - High investment share (investment/GDP). - Low inflation rate. - More developed financial sector (credit to private sector/GDP). - Higher index of economic freedom. - Higher costs for starting new businesses are associated with slower growth. - Dummy for SEE and CEE transition economies significant: these economies have been growing faster than predicted by the model—by 1.9 percent in per capita GDP terms—interpreted as a possible transition “growth bonus.” - FDI-to-GDP ratio: positive and statistically significant only when cost of business start-up procedures is excluded (collinearity issue). ### Simulated potential growth for Croatia from the cross-country model - Using current values of independent variables yields: - Potential growth estimate: 5.1 percent (real GDP and real GDP per capita). - Adjusting for reduced transition “growth bonus”: - If the growth “bonus” is reduced by half: potential growth = 4.2 percent. - If the growth “bonus” is eliminated: potential growth = 3.2 percent. - Mid-estimate recommended: 4.2 percent (since transition process is still under way). ### Reform simulation and reform-impact scenarios - Baseline for simulations: potential growth = 4.2 percent. - If Croatia’s index of economic freedom and cost of starting a new business reach average CEE levels: - Potential growth increases to 4.6 percent. - If they reach average euro area levels: - Potential growth increases to 4.7 percent. - If they reach Ireland’s levels: - Potential growth increases to 5 percent. - Note: Further increases in potential growth could occur if accelerated reforms promote higher levels of FDI (especially greenfield FDI), but quantifying this is beyond the model’s scope. ### Growth diagnostics: identifying binding constraints - Diagnostic approach: distinguish low returns to activity vs. high cost of finance. - Finance constraints quickly excluded: - Bad international finance? No. - Croatia has enjoyed ample access to international finance; external debt has increased; bond spreads fallen to historically low levels. - Ease of access may reduce urgency for structural reforms. - Bad local finance? No. - Gross national saving averaged nearly 24 percent of GDP through 2002–06 (only Slovenia higher in CEE/SEE). - Bank credit to private sector: 72 percent of GDP as at end-2006. - Rapid credit growth and falling interest rates suggest financial intermediation not a binding constraint. - Focus shifts to low returns to economic activity: - Observations supporting low returns hypothesis: - Overall investment high by regional standards. - Private investment and real GDP growth slightly below average. - Export performance significantly below average. - Relatively low levels of FDI. - Next diagnostic step: distinguish low social returns (low total economic returns) versus low appropriability (low private returns despite potentially high social returns, e.g., due to taxes, corruption, market failures). ### Constraints on growth: geography, infrastructure, human capital - Geography and infrastructure readily ruled out as primary causes: - Tourism: tourist receipts account for over 20 percent of GDP. - Infrastructure: spending on highway construction (investment spending by the HAC and HC road funds) averaged nearly 2½ percent of GDP over 2002–06; infrastructure compares favorably by regional standards. - Human capital identified as a possible binding low social returns constraint: - Institute for Public Finance (IJV, 2004): “employees in the Republic of Croatia do not have the skills, knowledge, and abilities necessary to develop globally competitive products and to compete in the European Union.” - Activity rates are very low and have dropped for both men and women over the past five years. - Returns to education: Šošić (2004, in the IJV study) finds that the return on investment to education rose from 7.6 percent in 1996 to 10.5 percent in 2002, which is significantly above western and central European levels (around 6.5 percent). - Interpretation: High and rising returns to education are consistent with a limited supply of educated workers constraining economic growth. ### Appropriability, innovation, and public sector micro risks - Innovation and export discovery: - Klinger and Lederman (2006): for 1997–2002 Croatia ranked 23rd in identified cases of export “discoveries” among 73 countries; Croatia registered 47 identified cases. - Patents: Innovation measured by new patents is broadly in line with peer countries, though behind regional leaders Hungary and Slovenia. - World Economic Forum (2006) ranks Croatia weakly on FDI as a source of new technology, reflecting limited inflows of greenfield FDI. - Public sector macro vs micro risks: - Macro risks: “Financial/monetary” risks are low; the CNB has maintained broad exchange rate stability and low inflation since the mid-1990s. Following fiscal consolidation since 2004, Croatia would meet—or at least is within striking distance of—the Maastricht deficit and debt criteria. Public debt is high by regional standards but below the euro area average. - Micro risks: weak business environment suggests public sector “micro risks” are impeding growth significantly. ### Evidence on business environment weaknesses (micro risks) - Survey rankings: Croatia’s business environment is consistently ranked below the average of its peers in CEE countries and the euro area; mixed relative to SEE countries. - Doing Business 2006 rankings (selected): - Overall: 124 (2006 rank) vs 134 (2005 rank), Change in rank: 10 - Starting a business: 100 (2006) vs 112 (2005), Change: 12 - Dealing with licenses: 170 (2006) vs 171 (2005), Change: 1 - Employing workers: 130 (2006) vs 131 (2005), Change: 1 - Registering property: 109 (2006) vs 109 (2005), Change: 0 - Getting credit: 117 (2006) vs 117 (2005), Change: 0 - Protecting investors: 156 (2006) vs 156 (2005), Change: 0 - Paying taxes: 58 (2006) vs 72 (2005), Change: 14 - Trading across borders: 92 (2006) vs 140 (2005), Change: 48 - Enforcing contracts: 28 (2006) vs 28 (2005), Change: 0 - Closing a business: 80 (2006) vs 76 (2005), Change: -4 - Specific micro-risk areas: - Property rights and contract enforcement: enforcement remains slow; European Commission (2006) notes “slow and inefficient court proceedings, poor case management and low administrative and professional capacity.” - Administrative and regulatory burden: uncertainties and delays obtaining permits; numerous and nontransparent fees; complex local regulations conducive to corruption. - Employment protection legislation (EPL): Tonin (2005) finds Croatia has the second-strictest EPL in the sample of central and eastern European (non-OECD) countries and is also high by OECD standards; EPL is especially strict for temporary workers and acts as a disincentive to new job creation. - Corruption: Transparency International’s CPI: Croatia suffers from “serious”, though not “severe”, levels of corruption; World Economic Forum (2006) corroborates corruption concerns. - Tax burden: Corporate income tax rate: 20 percent. Social contribution rates: total 37 percent of gross earnings. 2006 study by the Economics Institute of Zagreb: “forward-looking” effective average tax rates on investment suggest Croatia’s tax burden is favorable and needs better communication to potential foreign investors. Global Competitiveness Report respondents cite the tax burden as the third most important problem for doing business (behind inefficient bureaucracy and corruption). ### Recent reforms to improve the business environment (central government measures) - hitro.hr launched in 2005: a “one-stop shop” to establish a business and platform for “e-government” services. - Trade and Investment Promotion Agency effectively established in late 2005 to assist foreign investors. - A working group (with USAID assistance) preparing a “regulatory guillotine” to propose elimination of obsolete/unnecessary regulations; report expected in July 2007. - Project launched in 2002 (with World Bank and EU assistance) to improve the land cadastre and registry system: pending land registration cases cut from 339,000 at end-2003 to 215,000 at end-2005; land registry data published on the internet in May 2005. - Government established “entrepreneurial zones” on land free of ownership uncertainty; consistent with EU rules, the zones do not provide any tax incentives. ### Diagnostic conclusions and policy implications - Binding constraints: - Primary binding constraint: public sector-related micro risks (property rights, inefficient bureaucracy, high regulatory burden, corruption) that worsen the business environment. - Secondary constraint: human capital problems (skills mismatch; limited supply of suitably educated workers). - Potential growth estimate: 4–4½ percent over the medium term is robust across methodologies (Hodrick-Prescott, production function, growth regression). - Sustaining higher growth: - Growth rates above 4–4½ percent cannot be sustained without further structural reforms to boost TFP and attract more greenfield FDI. - Reducing the role of the state through fiscal consolidation and privatization would help ensure macro stability, enhance market competition, and support private sector activity. - Structural reforms needed: facilitate start-up of new businesses, create efficient bureaucracy, increase labor market flexibility, and reform the judiciary. - Fiscal policy: significant expenditure reductions that could allow for lower fiscal deficit and tax cuts would yield full benefits only if the business environment is improved as well. ### The possible human capital constraint: findings and policy priorities - Key findings: - Growth will not necessarily be boosted simply by allocating more resources to education: Croatia already performs favorably on broader indicators of education and literacy. - The country faces a problem of insufficiently skilled employees that may constrain labor productivity and growth. - More difficult measures than increasing spending may be much more fruitful in addressing skills shortages. - Encouraging “lifelong learning” could boost labor productivity and growth. - Consolidating the numerous welfare benefits could help address disincentives to labor-market participation. - Policy recommendations and priorities: - Prioritize measures that improve the skill composition of the labor force rather than solely increasing education spending. - Promote “lifelong learning” policies to upgrade skills of existing employees and raise labor productivity. - Consider consolidating and reforming welfare benefits to reduce disincentives to labor-market participation and encourage workforce entry. - Combine human capital policies with broader structural reforms to address complementary constraints (for example, labor market regulations and business environment). ### Selected quantitative context (Croatia, 2001–05 and related indicators) - Real GDP growth, 2002–05: 4.7 - Real GDP per capita growth, PPP adjusted (in percent), 2002–05: 6.5 - Total factor productivity growth (in percent), 2002–05: 1.6 - Real GDP per capita, PPP adjusted, in percent of euro area, 2005: 42.7 - Gross fixed capital formation (in percent of GDP), 2002–05: 27.5 - private: 20.7 - public: 6.8 - Gross national saving (in percent of GDP), 2002–05: 23.6 - Foreign direct investment, inflows (in percent of GDP), 2002–05: 4.8 - General government balance (in percent of GDP), 2005: -4.1 - General government primary balance (in percent of GDP), 2005: -1.8 - General government, total expenditure and net lending (in percent of GDP), 2005: 49.0 - consumption: 20.4 - General government, gross debt (in percent of GDP), 2005: 44.3 - CPI inflation (in percent), 2005: 3.3 - Illiteracy rate (in percent of population older than 15): 1.9 - Primary school enrollment ratio (in percent of relevant age group), 2003: 87.3 - Secondary school enrollment ratio (in percent of relevant age group), 2003: 85.0 - Public spending on education (in percent of GDP), 2002: 4.5 - Expenditure per student, primary (in percent of GDP per capita), 2002: 24.0 - Expenditure per student, secondary (in percent of GDP per capita), 2002: 23.5 - Labor force with primary education (in percent of total), 2001: 20.1 - Labor force with secondary education (in percent of total), 2001: 60.4 - Labor force with tertiary education (in percent of total), 2001: 17.2 - Labor skills (percent of managers surveyed ranking this as a major business constraint), 2002: 8.7 - Unemployment rate (in percent), 2005: 12.7 - Youth unemployment rate (in percent of relevant age group), 2002: 36.9 - Labor force participation rate (in percent), 2004: 65.5 - Labor market regulations (index, increasing from 1 to 10), 2004: 5.5 *Source: _wp07198 - 1. Croatia: Potential Real GDP Growth (IMF working paper excerpts provided).* ### 1. Croatia: Potential Real GDP Growth.............................................................................. 10 ### 1. Croatia: Potential Real GDP Growth ### Major recent macroeconomic outcomes and vulnerabilities - Real GDP growth averaged 4.8 percent annually over 2002–06, compared with a peer country average over 2002–06 of nearly 6 percent. - Real GDP growth averaged about 3¼ percent annually over 1997–2001. - Real export growth averaged 6 percent annually during 2002–06, versus a peer country average of over 10 percent. - Export growth averaged 6½ percent over 1997–2001. - External debt: - 61½ percent of GDP at end-2001 - nearly 80 percent of GDP by end-2004 - 85 percent of GDP at end-2006 - Current account deficit: - averaged 6 percent of GDP during 2001–05 - widened in 2006 to 7.6 percent of GDP - Foreign direct investment (FDI): - Total FDI into Croatia averaged just below 5 percent of GDP annually during 2002–06 - Greenfield FDI was well below potential; Croatia underperformed in attracting new greenfield projects relative to peers - Financial sector received a very large share of FDI: 30 percent of total inflows over 1993–2006 and over 40 percent of FDI each year in 2004–06 ### Structural and institutional characteristics relevant for growth - Strengths (compared with other transition economies): - Potential for convergence: GDP per capita (in purchasing power standards) reaches 48 percent of the euro area average - Public sector investment: spending considerably more as a share of GDP than other SEE and CEE countries - Monetary policy: low inflation, broadly in line with most of the rest of Europe - Demographics: high dependency ratio but similar to rest of Europe - Infrastructure: EBRD indicators close to other transition economies - Human capital: enrollment ratios and spending per student close to rest of Europe for primary and secondary education; overall labor force education does not give particular reason for concern - Health: population health indicators generally favorable, though public health spending is relatively high as a share of GDP - New economy / IT: use and production of information technology broadly as developed as in the CEE - Financial sector: more advanced banking sector than most SEE and CEE countries; limited presence of the state in the sector - International trade: indicators suggest a very open economy - Weaknesses (compared with other transition economies): - Private sector investment and FDI: shares of GDP below those in other CEE countries, especially greenfield FDI - Government size: general government spending as a share of GDP well above levels in SEE and CEE countries (note: empirical evidence cited finds a negative impact of public spending on growth above a threshold of 35 percent of GDP) - Transition progress: lags behind CEE countries in large-scale privatization, enterprise restructuring, competition policy, and price liberalization; greater role of the state than in the rest of Europe - Business environment: less friendly than in CEE countries and the euro area - Legal system: property rights, contract enforcement, and corruption indicators less favorable than in CEE and the euro area - Labor market: relatively high unemployment (notably long-term and youth unemployment) and low labor force participation; indicators suggest more rigid labor market than SEE and CEE countries ### Objectives and analytical questions of the paper - Assess the medium-term pace of economic growth Croatia can expect. - Identify ways to increase the pace of growth by diagnosing constraints and proposing policy responses. - Determine the extent to which recent growth is driven by fundamentals versus temporary factors. - Evaluate how structural reforms and macroeconomic stabilization have affected potential growth and what further reforms could raise the growth rate and promote income convergence to the EU. ### Methods used to estimate potential growth - Hodrick-Prescott (HP) filter (univariate statistical trend extraction) - Cobb-Douglas two-factor production function estimation (capital and labor, constant returns to scale) - Simulation using coefficients from a cross-country growth regression (growth empirical model), with scenarios reflecting different stages of transition ### Quantitative estimates of potential real GDP growth - HP filter estimate: 4.4 percent (real GDP growth of 4.4 percent for 2006 taken as estimate of potential growth) - Cobb-Douglas production function estimate: 4.3–4.4 percent - Growth regression (scenario-dependent estimates): - assuming most of transition is still ahead: 5.1 - assuming the transition process had reached a mid-point: 4.2 - assuming the transition process has been completed: 3.2 - Average of estimates (taking the middle estimate from the growth regression): 4.3 percent ### Interpretation and implications from the estimates - On current productivity trends, Croatia’s potential growth is between 4 and 4½ percent. - Potential growth estimates are necessarily tentative for transition economies due to data limitations, structural change during transition, and relatively short time series; using multiple methodologies provides a cross-check on results. - Estimates of potential output can guide medium-term projections, cyclically-neutral budget calculations, assessment of whether actual growth is sustainable, and the design and prioritization of reforms to raise growth. *Source: _wp07198 - 1. Croatia: Potential Real GDP Growth* ### 18. We estimate the above equation for Croatia using multiple sources for capital ### _wp07198 - 18. We estimate the above equation for Croatia using multiple sources for capital ### Data sources and capital stock methodologies - All data sources are from the IMF World Economic Outlook (WEO, Winter 2007), except: - Average wages: Croatian National Bank (CNB). - Historical capital stock: two alternative series: - CNB estimates for 1994–2005 using the perpetual inventory method. - CROSTAT direct calculations of capital stock by sector for 1999–2003 (preliminary). - For years outside the CROSTAT and CNB direct periods, capital stock is estimated using the perpetual-inventory method, using WEO data for investment and assuming a rate of capital depreciation of 2.7 percent (CROSTAT estimate). - Note: CROSTAT direct capital stock data are preliminary and may change; results are discussed for both methodologies. ### Key assumptions used in estimates - Employment income share = total wage bill (average wage × total employment) / nominal GDP. - Future years: Croatia’s average wage assumed to grow by 6 percent (equal to its average growth in recent years). - Resulting employment income share: about 0.47–0.51, depending on year. - Capital income share (constant returns to scale): one minus employment income share = 0.49–0.53. - Assumption: current TFP trend growth continues in the medium term. - Labor market reform context: reforms introduced in 2003 to increase labor market flexibility. ### Production-function based estimates (Table 2): GDP growth and contributions for Croatia - Using CNB capital stock estimates: - Real GDP growth: 3.6 4.7 4.4 - Contributions: - Capital: 3.2 2.7 2.8 - Labor: -1.0 0.9 0.5 - Productivity: 1.5 1.1 1.1 - Using CROSTAT capital stock estimates: - Real GDP growth: 3.6 4.7 4.3 - Contributions: - Capital: 1.5 2.2 2.2 - Labor: -1.0 0.9 0.5 - Productivity: 3.2 1.6 1.6 ### Interpretation of production-function results - Estimated potential growth for Croatia is between 4.3 and 4.4 percent. - Growth drivers: - Primary driver: capital accumulation. - Limited contribution from TFP growth in recent years; CROSTAT-based estimates suggest somewhat higher TFP contribution in the 1990s. - Very limited contribution from employment due to persistently high unemployment and relatively low labor participation. - Historical context: - Post-independence and post-war rebuilding and infrastructure investment contributed to high capital-driven growth in the 1990s. - Public investment share in GDP much higher in Croatia than in other transition economies (Section B). - Privatization and domestic/foreign investor interest contributed more recently, though private investment share in GDP remains below more advanced transition economies. ### Employment and potential near-term scenario - Present unemployment rate cited: 11 percent. - Scenario: If unemployment falls from 11 percent to 8 percent over the next three years, temporarily higher employment contribution would boost annual potential growth to 4.8 percent over this period. ### Cross-country econometric growth model (sample and specification) - Sample: 109 developed and developing economies over 1996–2005. - Empirical specification: Real GDP per capita growth_i = c + βX_i + u - Each country observation: either the average over 10 years or the initial value in 1996. - Preferred estimated equation (heteroskedasticity-consistent t-statistics in parentheses): - Real GDP per capita growth = 0.98(0.62) + 1.88(2.71) dummy for SEE and CEE - 0.49(-3.62) initial real GDP per capita - 0.43(-1.78) population growth + 0.14(3.58) investment/GDP - 0.02(-2.29) inflation rate + 0.001(3.18) credit to private sector/GDP + 0.43(2.30) index of economic freedom - 0.03(-3.85) cost of business start-up procedures (% of GNI per capita) - Regression diagnostics: - Number of observations: 109 - R2: 0.56 - Adjusted R2: 0.52 - F-statistic: 15.80 ### Main cross-country regression findings - Faster growth associated with: - Relatively low initial income level. - Low population growth rate (interpreted as a low dependency ratio). - High investment share (investment/GDP). - Low inflation rate. - More developed financial sector (credit to private sector/GDP). - Higher index of economic freedom. - Higher costs for starting new businesses are associated with slower growth. - Dummy for SEE and CEE transition economies significant: these economies have been growing faster than predicted by the model—by 1.9 percent in per capita GDP terms—interpreted as a possible transition “growth bonus.” - FDI-to-GDP ratio: positive and statistically significant only when cost of business start-up procedures is excluded (collinearity issue). ### Simulated potential growth for Croatia from the cross-country model - Using current values of independent variables yields: - Potential growth estimate: 5.1 percent (real GDP and real GDP per capita). - Adjusting for reduced transition “growth bonus”: - If the growth “bonus” is reduced by half: potential growth = 4.2 percent. - If the growth “bonus” is eliminated: potential growth = 3.2 percent. - Mid-estimate recommended: 4.2 percent (since transition process is still under way). ### Reform simulation and reform-impact scenarios - Baseline for simulations: potential growth = 4.2 percent. - If Croatia’s index of economic freedom and cost of starting a new business reach average CEE levels: - Potential growth increases to 4.6 percent. - If they reach average euro area levels: - Potential growth increases to 4.7 percent. - If they reach Ireland’s levels: - Potential growth increases to 5 percent. - Note: Further increases in potential growth could occur if accelerated reforms promote higher levels of FDI (especially greenfield FDI), but quantifying this is beyond the model’s scope. ### Growth diagnostics: identifying binding constraints - Growth diagnostic decision: distinguish low returns to activity vs. high cost of finance. - For Croatia, right-hand side factors (high cost of finance) are quickly excluded: - Bad international finance? No. - Croatia has enjoyed ample access to international finance; external debt has increased; bond spreads fallen to historically low levels. - Ease of access may reduce urgency for structural reforms (see Box 1). - Bad local finance? No. - Gross national saving averaged nearly 24 percent of GDP through 2002–06 (only Slovenia higher in CEE/SEE). - Bank credit to private sector: 72 percent of GDP as at end-2006. - Rapid credit growth and falling interest rates suggest financial intermediation not a binding constraint. - Focus shifts to low returns to economic activity: - Observations supporting low returns hypothesis: - Overall investment high by regional standards. - Private investment and real GDP growth slightly below average. - Export performance significantly below average. - Relatively low levels of FDI. - Next diagnostic step: distinguish low social returns (low total economic returns) versus low appropriability (low private returns despite potentially high social returns, e.g., due to taxes, corruption, market failures). *Source: IMF working paper content unit _wp07198 (excerpts provided).* ### 32. Low social returns—stemming from human capital problems—are one ### _wp07198 - 32. Low social returns—stemming from human capital problems—are one ### Constraints on growth: overview - Three candidate explanations for low social returns are considered: geography, infrastructure, and human capital. The first two can be readily ruled out for Croatia. - Tourism: tourist receipts account for over 20 percent of GDP. - Infrastructure: spending on highway construction (investment spending by the HAC and HC road funds) averaged nearly 2½ percent of GDP over 2002–06; infrastructure compares favorably by regional standards. - Human capital: the Institute for Public Finance (IJV, 2004) finds that “employees in the Republic of Croatia do not have the skills, knowledge, and abilities necessary to develop globally competitive products and to compete in the European Union.” ### Evidence that human capital is limiting growth - Activity rates are very low and have dropped for both men and women over the past five years. - Returns to education: Šošić (2004, in the IJV study) finds that the return on investment to education rose from 7.6 percent in 1996 to 10.5 percent in 2002, which is significantly above western and central European levels (around 6.5 percent). - Interpretation: High and rising returns to education are consistent with a limited supply of educated workers constraining economic growth. ### Appropriability and innovation considerations - Market failures (information externalities) are unlikely to be the main problem given reasonable levels of innovation. - Export diversification: Klinger and Lederman (2006) report that for 1997–2002 Croatia ranked 23rd in identified cases of export “discoveries” among 73 countries; Croatia registered 47 identified cases in the cited table. - Patents: Innovation measured by new patents is broadly in line with peer countries (Table 4), though behind regional leaders Hungary and Slovenia. - FDI as a source of new technology: World Economic Forum (2006) ranks Croatia weakly on FDI as a source of new technology, reflecting limited inflows of greenfield FDI. ### Public sector: macro vs micro risks - Macro risks: “Financial/monetary” risks are low; the CNB has maintained broad exchange rate stability and low inflation since the mid-1990s. Following fiscal consolidation since 2004, Croatia would meet—or at least is within striking distance of—the Maastricht deficit and debt criteria. Public debt is high by regional standards but below the euro area average. - Micro risks: The weak business environment suggests public sector “micro risks” are impeding growth significantly. ### Evidence on business environment weaknesses (micro risks) - Survey rankings: Croatia’s business environment is consistently ranked below the average of its peers in CEE countries and the euro area; mixed relative to SEE countries. - Doing Business 2006 rankings (selected): - Overall: 124 (2006 rank) vs 134 (2005 rank), Change in rank: 10 - Starting a business: 100 (2006) vs 112 (2005), Change: 12 - Dealing with licenses: 170 (2006) vs 171 (2005), Change: 1 - Employing workers: 130 (2006) vs 131 (2005), Change: 1 - Registering property: 109 (2006) vs 109 (2005), Change: 0 - Getting credit: 117 (2006) vs 117 (2005), Change: 0 - Protecting investors: 156 (2006) vs 156 (2005), Change: 0 - Paying taxes: 58 (2006) vs 72 (2005), Change: 14 - Trading across borders: 92 (2006) vs 140 (2005), Change: 48 - Enforcing contracts: 28 (2006) vs 28 (2005), Change: 0 - Closing a business: 80 (2006) vs 76 (2005), Change: -4 ### Specific micro-risk areas - Property rights and contract enforcement: - Doing Business: number of procedures to enforce contracts in line with OECD average, but enforcement remains slow. - European Commission (2006): “The judicial system has continued to suffer from slow and inefficient court proceedings, poor case management and low administrative and professional capacity.” - Administrative and regulatory burden: - Investors face uncertainties and delays obtaining permits, numerous and nontransparent fees, and complex local regulations conducive to corruption. - Employment protection legislation (EPL) is strict: Tonin (2005) finds Croatia has the second-strictest EPL in the sample of central and eastern European (non-OECD) countries and is also high by OECD standards; EPL is especially strict for temporary workers. - EPL effect: successful in protecting existing employees (insiders) but a severe disincentive to new job creation. - Corruption: - Transparency International’s CPI: Croatia suffers from “serious”, though not “severe”, levels of corruption. - World Economic Forum (2006) corroborates corruption concerns. - Tax burden: - Corporate income tax rate: 20 percent, broadly in line with the CEE average. - Social contribution rates: total 37 percent of gross earnings. - 2006 study by the Economics Institute of Zagreb: “forward-looking” effective average tax rates on investment suggest Croatia’s tax burden is favorable and needs better communication to potential foreign investors. - Global Competitiveness Report respondents cite the tax burden as the third most important problem for doing business (behind inefficient bureaucracy and corruption). ### Recent reforms to improve the business environment (central government measures) - hitro.hr launched in 2005: a “one-stop shop” to establish a business and platform for “e-government” services. - Trade and Investment Promotion Agency effectively established in late 2005 to assist foreign investors. - A working group (with USAID assistance) preparing a “regulatory guillotine” to propose elimination of obsolete/unnecessary regulations; report expected in July 2007. - Project launched in 2002 (with World Bank and EU assistance) to improve the land cadastre and registry system: pending land registration cases cut from 339,000 at end-2003 to 215,000 at end-2005; land registry data published on the internet in May 2005. - Government established “entrepreneurial zones” on land free of ownership uncertainty; consistent with EU rules, the zones do not provide any tax incentives. ### Diagnostic conclusions and policy implications - Binding constraints: - Primary binding constraint: public sector-related micro risks (property rights, inefficient bureaucracy, high regulatory burden, corruption) that worsen the business environment. - Secondary constraint: human capital problems (skills mismatch; limited supply of suitably educated workers). - Potential growth estimate: 4–4½ percent over the medium term is robust across methodologies (Hodrick-Prescott, production function, growth regression). - Sustaining higher growth: - Growth rates above 4–4½ percent cannot be sustained without further structural reforms to boost TFP and attract more greenfield FDI. - Reducing the role of the state through fiscal consolidation and privatization would help ensure macro stability, enhance market competition, and support private sector activity. - Structural reforms needed: facilitate start-up of new businesses, create efficient bureaucracy, increase labor market flexibility, and reform the judiciary. - Fiscal policy: significant expenditure reductions that could allow for lower fiscal deficit and tax cuts would yield full benefits only if the business environment is improved as well. *Source: _wp07198 (IMF working paper content provided in the supplied PDF excerpt).* ### 43. The possible human capital constraint on economic growth warrants a measured ### 43. The possible human capital constraint on economic growth warrants a measured policy response ### Key findings on human capital and growth - Growth will not necessarily be boosted simply by allocating more resources to education: Croatia already performs favorably on broader indicators of education and literacy. - The country faces a problem of insufficiently skilled employees that may constrain labor productivity and growth. - More difficult measures than increasing spending may be much more fruitful in addressing skills shortages. - Encouraging “lifelong learning” could boost labor productivity and growth. - Consolidating the numerous welfare benefits could help address disincentives to labor-market participation. ### Relevant quantitative context (selected indicators from Croatia, 2001–05) - Real GDP growth, 2002–05: 4.7 - Real GDP per capita growth, PPP adjusted (in percent), 2002–05: 6.5 - Total factor productivity growth (in percent), 2002–05: 1.6 - Real GDP per capita, PPP adjusted, in percent of euro area, 2005: 42.7 - Gross fixed capital formation (in percent of GDP), 2002–05: 27.5 - private: 20.7 - public: 6.8 - Gross national saving (in percent of GDP), 2002–05: 23.6 - Foreign direct investment, inflows (in percent of GDP), 2002–05: 4.8 - General government balance (in percent of GDP), 2005: -4.1 - General government primary balance (in percent of GDP), 2005: -1.8 - General government, total expenditure and net lending (in percent of GDP), 2005: 49.0 - consumption: 20.4 - General government, gross debt (in percent of GDP), 2005: 44.3 - CPI inflation (in percent), 2005: 3.3 - Illiteracy rate (in percent of population older than 15): 1.9 - Primary school enrollment ratio (in percent of relevant age group), 2003: 87.3 - Secondary school enrollment ratio (in percent of relevant age group), 2003: 85.0 - Public spending on education (in percent of GDP), 2002: 4.5 - Expenditure per student, primary (in percent of GDP per capita), 2002: 24.0 - Expenditure per student, secondary (in percent of GDP per capita), 2002: 23.5 - Labor force with primary education (in percent of total), 2001: 20.1 - Labor force with secondary education (in percent of total), 2001: 60.4 - Labor force with tertiary education (in percent of total), 2001: 17.2 - Labor skills (percent of managers surveyed ranking this as a major business constraint), 2002: 8.7 - Unemployment rate (in percent), 2005: 12.7 - Youth unemployment rate (in percent of relevant age group), 2002: 36.9 - Labor force participation rate (in percent), 2004: 65.5 - Labor market regulations (index, increasing from 1 to 10), 2004: 5.5 ### Policy recommendations and priorities - Prioritize measures that improve the skill composition of the labor force rather than solely increasing education spending. - Promote “lifelong learning” policies to upgrade skills of existing employees and raise labor productivity. - Consider consolidating and reforming welfare benefits to reduce disincentives to labor-market participation and encourage workforce entry. - Combine human capital policies with broader structural reforms to address complementary constraints (for example, labor market regulations and business environment). _Italic: Source — _wp07198 - 43. The possible human capital constraint on economic growth warrants a measured_ (IMF PDF content provided) _ --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07198.pdf_