Public Information Notice No. 00/4

Public Information Notice: IMF Concludes Article IV Consultation with Croatia

January 21, 2000

On January 7, 2000, the Executive Board concluded the Article IV consultation with Croatia.¹

Until recently, Croatia's economic performance was the envy of many countries in transition: a successful stabilization effort in late 1993 was followed by virtual price stability and real GDP growth of 6 percent a year during 1994-97. However, the mostly domestic demand driven expansion was accompanied by burgeoning imports, while exports stagnated as wage increases outpaced productivity gains. As a result, the external current account deficit widened to 11 ½ percent of GDP in 1997 and external debt increased by 9 percentage points to 32 percent of GDP. A tightening of monetary policy late in the year and again in early 1998 resulted in a 4 ½ percentage point improvement in the current account in 1998. A revenue windfall stemming from the introduction of the VAT in January 1998 also contributed to the external improvement.

While macroeconomic policy tightening helped reduce the current account deficit, it also contributed to the recession which began in the fourth quarter of 1998. The freezing of deposits in insolvent banks in the second half of 1998, the diversion of liquidity to purchase foreign currency for speculative purposes, and inadequate restructuring of public and privatized firms led to a rapid accumulation of arrears, which rose to 10 ½ percent of GDP at end-1998 and to 16 ½ percent of GDP in mid-1999. These structural problems reinforced the impact of the restrictive macroeconomic policy stance, causing real GDP to fall by 4 ¼ percent (year on year) in the last quarter of 1998 and by 1 percent in the first half of 1999. This, together with modest growth in exports, reduced the external current account deficit further in the first half of 1999, although external debt continued to rise, reaching 38 ½ percent of GDP by mid-1999.

Monetary tightening, the weak economy, and a drying-up of repatriated foreign savings exposed the underlying insolvency of a group of rapidly growing banks. The Croatian National Bank (CNB) intervened in 17 distressed banks-accounting for 17 percent of bank assets-during 1998 and the first half of 1999. Most of these banks are facing bankruptcy proceedings, while three banks are under CNB administration, and a solution avoiding bankruptcy is being sought for three politically sensitive banks. About 80 percent of deposits in the banks undergoing bankruptcy (about 5 ½ percent of broad money and 2 ¼ percent of GDP) are covered by deposit insurance, with the payouts to be funded by the budget.

A relaxation of fiscal policy and intensifying problems in the banking sector led to exchange market pressures in late 1998 and early 1999. Increased public spending for social services and benefits, reconstruction of war-damaged housing and infrastructure, an ambitious road-building program, large civil service wage increases, and new payment arrears more than offset the large VAT revenues and resulted in a deficit of 1 ½ percent of GDP on an accrual basis in 1998. The fiscal stance eased further in early 1999 as spending increased while revenues dropped against corresponding bases. The easing of fiscal policy and concerns about the soundness of the banking sector caused the kuna to depreciate by nearly 10 percent against the deutsche mark/euro between August 1998 and March 1999, despite heavy foreign exchange sales. Nonetheless, thanks to an increase in foreign currency liabilities to domestic banks, the CNB's net international reserve position was nearly unchanged in the year to March 1999.

Notwithstanding a modest improvement in competitiveness following the kuna depreciation and continued labor shedding, export performance remained poor. Depreciation coupled with structural reductions in employment more than offset a 10 percent increase in gross industrial wages, generating a 3 ½ percent depreciation in the unit labor cost based real exchange rate vis-a-vis Germany during 1998 and the first quarter of 1999. Nonetheless, exports failed to respond as Croatia is not a participant in preferential trade agreements and its product variety and quality have been slow to adapt to the demands of new foreign markets.

Concerns about the depletion of usable reserves, insufficient external financing, and depreciation of the currency led to a renewed tightening of macroeconomic policies in the second quarter of 1999. Following an increase in reserve requirements and official interest rates, and sharp restrictions on credit expansion-especially to the budget-the exchange rate stabilized. In addition, the budget was tightened in June to produce a consolidated central government deficit of 1 percent of GDP for 1999, following a deficit of over 5 percent of GDP on an annual basis in the first half of the year. The main features of the budget revision were a downward revision of tax revenues, a 10 percent reduction in discretionary current spending, a 25 percent cut in most capital spending, and larger receipts from privatization to finance deposit payouts. However, the revised budget retained a 17 ½ percent increase in civil service wages and allowed for the payout of only about a third of insured deposits in1999. Excluding one-off factors, the revised budget implied an underlying adjustment in expenditures of 2 percentage points of GDP in the second half of 1999.

The recession that began in late 1998 is likely to extend through at least the end of the year, and real GDP is expected to contract by 2 percent in 1999. The outlook for 2000 is, however, brighter and a recovery propelled by exports, private consumption and investment could see growth recover to 2 ½ -3 percent.

Executive Board Assessment

Executive Directors noted that following several years of favorable economic performance, the economy had recently fallen into recession. The new government faced daunting challenges-including an insufficiently flexible domestic economy and a still unsustainable external imbalance. However, Directors saw opportunities for a new start. There was some prospect for a resumption of positive economic growth, facilitated by the revival of external demand, the recent real effective depreciation of the currency, and a recovery of confidence in the wake of the parliamentary and presidential elections. But Directors stressed that to realize this growth and to make it durable, the new government would need to adopt policies that stabilized the external current account deficit at a more sustainable level.

On fiscal policy, Directors noted the need for a cut in expenditures sufficient to balance the budget and make room for a reduction of nonwage labor costs. The need for durable expenditure cuts was all the more urgent as privatization proceeds would dry up soon after the sale of a few large state enterprises and financial institutions. To this end, the authorities should undertake an early public expenditure review; hold the line on government wages, which had just been increased sharply in real terms; and guard against an erosion of VAT revenues.

Directors emphasized that the task of restoring fiscal balance could not be accomplished without redressing the finances of the pension and health care systems. Given the large increase in spending on social welfare in recent years and the need to reduce nonwage labor costs, they urged the authorities to implement a comprehensive pension reform and to adopt promptly a health care reform.

Directors called for greater fiscal transparency and accountability by improving the classification and presentation of fiscal data; establishing a single treasury account; and strengthening oversight by branch ministries of the extrabudgetary funds.

Directors noted that an adequate level of competitiveness was essential for strengthening the external current account and boosting growth and employment. While noting that the gradual depreciation of the past year appeared to have broadly improved competitiveness, Directors underscored the importance of wage restraint in sustaining the newly acquired level of competitiveness and in reactivating the economy and boosting employment.

As regards the exchange rate, Directors noted the continued preference for exchange rate stability. This had served Croatia well, and the authorities had skillfully managed a measured real effective depreciation that would facilitate an eventual economic recovery. They agreed that a sudden depreciation now, when economic agents were still adjusting to the gradual depreciation over the past 15 months, could jeopardize price stability and could undermine economic recovery by weakening unhedged balance sheets and raising the cost of servicing foreign-exchange denominated debt. But Directors stressed that tight fiscal policy, wage restraint, and greater economic efficiency through privatization and structural reform will be required to ensure that this strategy is viable. They recommended that, to the extent permitted by their exchange rate objective, the monetary authorities should strive to lower reserve requirements, and raise the remuneration on requirements for local currency deposits to ease their burden on the banking system and to facilitate the reversal of currency substitution.

Directors agreed that structural reform was another essential dimension in any successful strategy for renewed growth. They welcomed the recent acceleration of privatization efforts, and encouraged the authorities to press ahead with further sales of state enterprises and financial institutions.

Directors welcomed the steps taken to improve the soundness of the financial sector, and of the banking system in particular. They noted that strengthening confidence in the system will require that the payout of insured deposits in the failed banks be completed soon, and that quick solutions be found for a few troubled banks. Directors encouraged the CNB to further strengthen its supervisory capacity, enforce prudential regulations more strictly, and strengthen the overall regulatory system.

While Croatia's statistics are generally adequate for surveillance, Directors encouraged the authorities to redouble their efforts to improve economic data, in particular by providing fiscal arrears data, and improving timeliness and quality of data needed to assess banking system soundness.