Public Information Notice: IMF Concludes Article IV Consultation with the Republic of Croatia

March 23, 2001

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On March 19, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Croatia.1


Propelled by private consumption and exports, the economy has pulled out of the 1998/99 recession. Consumption was boosted in 2000 by large wage increases granted during 1999 and the lifting of political uncertainties, while exports benefited from the recovery in Europe, past real effective depreciation, and a strong tourist season. Notwithstanding fiscal retrenchment, weak private investment, and a drought stricken fall harvest, real GDP is expected to have grown by 3.5 percent in 2000.

Increases in excise taxes and administered prices added to oil price increases in pushing up headline inflation, which reached 7.4 percent at the end of 2000. By contrast, the core inflation rate rose only moderately from 4.2 percent to 4.6 percent, reflecting the absence of underlying inflationary pressures. Reinforced by efforts to reduce civil service pay and by income tax reductions, wage increases were more restrained in 2000.

Strong exports and large inflows of income transfers reduced the external current account deficit to an estimated 4.6 percent in 2000. Capital inflows from privatization, government borrowing and more favorable trade financing terms have strengthened international reserves and external vulnerability indicators have improved.

Economic policy implementation in 2000 focused on restoring control over the public finances. The new government gave immediate priority to paying fiscal arrears and adopting a tight budget for 2000, relying primarily on cuts in discretionary spending and on a partial rollback of previous salary increases. During the year the authorities adopted a number of revenue measures that substantially lowered the revenue ratio. Despite missing their budget target, the authorities managed to reduce the central government deficit from 7.4 percent of GDP in 1999 to an estimated 6½ percent in 2000, thus partly reversing the deterioration of the preceding three years.

In the absence of inflationary pressures, the Croatian National Bank (CNB) took advantage of the strong external position and rising confidence in the banking system to accumulate international reserves, ease foreign exchange surrender requirements, allow the currency to appreciate slightly against the euro during most of 2000, and reduce reserve requirements and policy interest rates. As a result of these measures and higher inflation, real interest rates on loans fell to historically low levels, but credit to the economy began to expand only later in the year, reflecting probably both still weak demand and banks' increased caution in lending. The stimulative effect of lower real interest rates was partly offset by real effective appreciation that reflected, successively, the strength of the kuna against the euro, higher inflation, and a weakening U.S. dollar. Monetary conditions are much easier in early 2001 than at any time during the second half of the 1990s.

Since the 1998/99 banking crisis, confidence in the banking system has been strengthening, as evidenced by the vigorous growth of deposit liabilities. Three rehabilitated banks (including the country's second largest) were sold to foreign banks in 2000, and several mostly smaller banks were acquired by both domestic and foreign buyers, thereby reducing the number of banks from 60 at the end of 1998 to 44 at the end of 2000. The monetary policy and supervisory frameworks were strengthened, with legislative changes to guarantee the independence of the CNB and increase its power of intervention in insolvency cases-as well as the privatization of three smaller banks-still pending.

The outlook for 2001 is encouraging. In the authorities' program, real GDP growth is expected to accelerate moderately to 4 percent. With exports and private consumption likely to experience a modest deceleration, this expectation hinges crucially on a revival of private investment after three years of contraction. The prospects for such a revival are good: apart from the favorable effects of political stability, enterprise profitability is being boosted by lower nonwage labor costs, wage restraint, tax reductions, and the availability of credit at low interest rates. This expectation could, however, prove optimistic if economic growth in Europe were to slow substantially or if oil prices failed to decline as envisaged.

Inflationary pressures are likely to subside. With the disappearance of base year effects and an easing of oil prices, as well as wage restraint and exchange rate stability under the program, retail price inflation is expected to decline to 4.5 percent by end-2001.

On recent trends and assuming further fiscal consolidation, the current account deficit is likely to contract further in 2001 to below 4 percent of GDP, as merchandise exports continue to grow with improving access to foreign markets and the normalization of trade relations with Yugoslavia and as the recovery in the tourist industry continues.

Executive Board Assessment

Executive Directors welcomed the progress achieved by the new government in restoring control over the public finances and its adoption of a comprehensive economic program for 2001-2003. Directors agreed that this program, with its focus on the fiscal deficit and tax reductions, wage discipline, and structural reforms in the context of a stable exchange rate, offers the best prospects for achieving sustainable economic growth and external viability, while increasing employment and the population's standard of living in the medium term. After an auspicious beginning, and with a recovering economy and a strengthened financial system, it is now important for the authorities to implement their program in a steadfast manner.

Directors agreed that a further reduction of the fiscal deficit and of the size of government is needed to improve economic efficiency and promote sustainable growth. The one-off nature of privatization receipts and the impending introduction of the second pension pillar add to the urgency of the adjustment effort, which should be completed over the next few years so as to avoid renewed increases in the public debt ratio.

In light of these requirements, Directors reviewed the 2001 budget as appropriate. Recognizing that the budget was burdened by the effects of recent tax relief measures and new court-ordered pension obligations, they attached particular importance to the strict observance of public spending limits. The intended reduction of the public sector wage bill and the implementation of the staff reduction plan are critical elements of this policy. Directors observed that the wage policy for the budgetary sector is ambitious, but needs to be seen against the backdrop of large wage increases in the past and a wage bill that is high by international standards. Directors welcomed the government's intention to implement contingency measures in the event of fiscal slippage, and to defer some discretionary expenditure until there is evidence that the envisaged external current account adjustment is on track. They also noted that the new treasury system should facilitate the observance of the spending limits and welcomed the increased transparency of the budget process. Directors emphasized that there is no room in the 2001 budget to reduce taxes further or to restore entitlements. In view of the magnitude of the expenditure adjustment to be achieved, they stressed the importance of mobilizing a sufficient social consensus in favor of the planned public sector reforms. Directors took note of the authorities' decision to rely on external borrowing to meet the public sector financing requirements. While Croatia's credit standing has improved strongly, Directors cautioned against any substantial increases in the country's level of external public debt.

Looking ahead, Directors supported the government's fiscal objectives for 2002-03, noting that priority attention would need to be given to further expenditure cuts. The government's wage bill will need to be kept under strict control, and Directors considered that substantial savings could be realized by reducing the large imbalances in the pension and health funds. They encouraged the authorities to consider reforms aimed at broadening the bases for social security contributions and co-payments for health services and at rationalizing benefits, including their harmonization across different types of beneficiaries.

In view of the considerable easing of monetary conditions, Directors encouraged the Croatian National Bank (CNB) to monitor liquidity conditions carefully and to ensure that interest rates remain sufficiently high to attract deposits. In view of the most recent reduction of the CNB's main policy rate, Directors considered that monetary policy had, for the present, gone as far as it prudently could to stimulate credit expansion.

Directors considered that the present level of the exchange rate is consistent with maintaining external competitiveness in the improved external environment, provided the authorities implement fully their overall economic program. They stressed, however, that the CNB should keep the exchange rate flexible and avoid resisting large or persistent exchange market pressures.

Directors noted that comprehensive and sustained structural reform is indispensable to put the economy on a higher growth path and achieve a lasting reduction in Croatia's high unemployment rate. They urged the authorities to proceed with the structural reform agenda in close cooperation with the World Bank, giving priority to pension and health sector reform, financial sector stability, labor market flexibility, and greater enterprise efficiency.

In this context they stressed the need to restructure and privatize the major state-owned enterprises after creating appropriate regulatory frameworks where needed. Apart from continued favorable conditions, the growth and employment prospects now depend on a revival of private investment. Directors stressed that for this to happen further steps need to be taken to cut red tape, reform the legal system, and ensure legal security for business, including clear property rights. They also noted the importance of economy-wide wage restraint for an improvement of the employment outlook.

Directors welcomed the recovery and revitalization of the banking system under a strengthened regulatory framework and improved supervision. With most banks now in private hands, Directors called on the authorities to privatize the remaining banks and complete legislation ensuring the independence of the CNB and further strengthening its role in preventing and solving banking problems. They welcomed the authorities' agreement to participate in the Financial Sector Assessment Program (FSAP), and looked forward to discussing the results of this exercise at the occasion of the next Article IV consultation.

Directors welcomed Croatia's accession to the World Trade Organization (WTO) and commended the authorities on the recent substantial reduction in tariff and nontariff barriers.

The authorities are encouraged to continue to improve their economic statistics, in particular regarding the timely compilation of data on general government operations and government arrears, leases, and guarantees.

Croatia: Selected Economic Indicators

            1995 1996 1997 1998 1999   2000   2001

Real economy (percentage change)                      
Real GDP           6.8 6.0 6.6 2.5 -0.4   3.5 1/ 4.0
Unemployment rate (average; percent of labor force) 2/ n.a 10.0 9.9 11.4 13.6   15.1 3/ 14.5
Nominal net wages (percentage change; period average) 14.4 17.7 14.8 15.4 11.2   9.0 4/ ...
Retail prices (e.o.p.)         3.7 3.4 3.8 5.4 4.4   7.4   4.5
Gross domestic saving (percent of GDP)   9.9 16.1 18.2 17.2 18.7   20.2 1/ 22.0
Gross domestic investment (percent of GDP)   17.6 21.9 29.8 24.3 26.3   24.8 1/ 25.8
Public finance (percent of GDP)                      
Consolidated central government (cash basis) 5/   -0.9 -0.4 -1.3 0.6 -2.0   -5.1 1/ -0.8
Consolidated central government (accrual basis)   ... ... -2.0 -3.0 -7.4   -6.5 1/ -5.3
Money and credit (e.o.p.; percentage change)                    
Broad money           40.4 49.1 37.6 13.0 -1.1   26.5 1/ 15.3
Credit to consolidated central government   -3.0 -3.4 -49.9 -2.7 41.1   19.2 1/ 0.0
Other credit 6/           18.9 3.1 44.1 22.4 -6.5   4.4 1/ 15.9
Interest rates (e.o.p.; percent)                        
Average deposit rate         6.1 4.2 4.4 4.1 4.3   3.6   ...
Average credit rate         22.3 18.5 14.1 16.1 13.5   10.5   ...
Balance of payments (percent of GDP)                      
Trade balance           -17.3 -18.2 -25.8 -19.2 -16.4   -17.9 1/ -17.3
Current account balance       -7.7 -5.5 -11.6 -7.1 -7.6   -4.6 1/ -3.9
Total external debt (e.o.p.) 7/       20.8 23.2 31.9 40.3 44.5   53.2 1/ 50.4
Gross official reserves (USD million; e.o.p.)   1,895 2,314 2,539 2,816 3,025   3,423   3,663
Reserve cover (months of imports of goods and services) 2.4 2.8 2.7 3.2 3.7   4.2   4.3
Short-term debt in percent of gross usable official reserves 5/ 31.6 40.7 45.6 75.1 77.3   96.3 1/ 75.7
Exchange rate                            
Exchange rate regime         Other managed floating      
Croatian kuna per US$ (January 31, 2001)   8.37687
Nominal effective rate (1995=100; p.a.)     100.0 100.3 101.0 100.4 94.7   94.4 8/ ...
Real effective rate (1995=100; p.a.)     100.0 99.3 99.6 101.3 97.1   98.8 8/ ...

Sources: Croatian authorities; Information Notice System; and IMF staff estimates.

1/ Estimate.
2/ Labor Force Survey (based on ILO standards).
3/ January-June.
4/ November.
5/ National presentation, with privatization receipts above the line.
6/ After inclusion of arrears repayment, credit expansion would be 15.3 percent in 2000 and 18.5 percent in 2001.
7/ Does not include debt that was excluded from the London Club agreement.
8/ October.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the March 19, 2001 Executive Board discussion based on the staff report.


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