Republic of Croatia: Staff Concluding Statement of the 2019 Article IV Mission
IMF News, December 16, 2019
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- Published: December 16, 2019
Summary overview
- Croatia has experienced strengthening over the last five years: growth is strong, inflation is subdued, and unemployment has been significantly reduced.
- Public debt is steadily declining and external reserves are healthy.
- Continued prudent policies and supportive global conditions are likely to sustain the positive picture in the near term.
- Long-term challenges: deepening integration with Europe (including future euro adoption) during rapid technological change; need for prudent investment and reforms with broad public support.
What is missing / inclusive growth challenges
- Employment and social inclusion:
- Share of the workforce between the ages of 20 and 64 that is employed is only slightly above 60 percent.
- Share of the population at risk of poverty and social exclusion is estimated at 25 percent.
- Demographic and labor market risks:
- Youth concern about long-term prospects has spurred emigration and hollowing out of internal regions.
- Short-term symptom: labor shortages in construction and tourism.
- Longer-term risks: "brain drain" and pressures on pension and healthcare systems.
- Income gap:
- Income per person of Croatia stands at 63 percent of the EU average.
- The statement warns that maintaining living standards without productivity growth would require ever increasing amounts of debt.
- Three steps to durably raising living standards:
- Maintaining macroeconomic and financial stability.
- Making the state a source of greater dynamism through reforms.
- Investing resources wisely to raise productivity.
Maintaining macroeconomic and financial stability — fiscal and monetary guidance
- Near-term policy stance:
- If global conditions worsen, allow existing tax and transfer automatic stabilizers to operate first.
- Only consider further tax cuts or higher spending if adverse conditions persist for a long period.
- Medium-term fiscal guidance:
- Taxation, spending, and government income policies should aim for budgets in structural balance.
- With growth at or near potential, avoid excessive short-term stimulus.
- Focus on growth via reforms and medium-term investments.
- Specific fiscal recommendations:
- Support for withholding the VAT rate reduction from 25 to 24 percent.
- Recommend holding back on any other tax reductions at this stage.
- Strongly urge restraint on further wage demands until a thoroughly analytically researched new public sector wage grid and coefficients are developed.
- New wage system should reward talent and productivity and be accompanied by optimization of staffing levels.
- Monetary and financial sector observations:
- Monetary policy remains appropriately accommodative given the exchange rate anchor that has served Croatia well for the last 25 years.
- Bank lending to the private sector—primarily to households—is strong; house prices are picking up in the capital and coastal areas.
- Banking system is profitable, liquid, and well-capitalized overall.
- Financial sector risks and recommended actions:
- Low interest rate environment and lingering uncertainties related to legacy Swiss Franc housing loans could pose new challenges.
- Reforms to debt restructuring, insolvency, and court procedure predictability and efficiency are very important.
- The credit register has stopped fully operating; underlying causes should be addressed quickly to prevent systemic risk.
- CNB recommendations for greater caution with longer-term uncollateralized consumer lending are producing effects; supervise migration to other household lending forms.
Implementing reforms to make the state a source of greater dynamism
- Growth ambition and investment needs:
- To bridge 15 percentage points of the current average per person income gap with the EU by 2030, the economy would need to grow at 1.5 percentage points more rapidly than the EU average over this period.
- Achieving higher relative growth requires higher private investment and higher public sector investment in both quantity and quality.
- Fiscal composition and reallocation:
- Over the last decade public spending tilted toward non-investment goods and services, subsidies, compensation of employees, and other social benefits, and away from public investment.
- Recommended: reallocate some share of current spending to capital spending without raising taxes or cutting overall government spending.
- Estimate: if around 4 percent of overall government revenues were gradually and efficiently reallocated to smart investments, the Croatian economic growth rate can be raised sufficiently to bridge a significant portion of the gap with the EU over the next decade.
- Key structural reforms recommended:
- Public employment and wages:
- Implement a meritocratic system for public sector wages; align public employment levels with the economy’s needs.
- Use active employment policies to facilitate transfers of public sector workers with suitable skills to the private sector.
- State-owned enterprises:
- Continue modernization of state-owned enterprise management and performance.
- Note: this year they will meet or exceed the initial target of 0.4 percent of GDP contribution to the budget; further increases should be targeted and persistently achieved.
- Social benefits:
- Optimize social benefits through better targeting to the most vulnerable and in need.
- Improve IT systems and coordination across levels of government.
- Continue social dialogue to mitigate effects of the recent roll-back of pension reforms.
- Align retirement incentives with migration realities and longer life expectancy.
- Local government:
- Improve territorial organization of local governments to enhance their capacity to invest and deliver uniform high-quality public services.
- Public communication:
- Broad public understanding and support are essential to enable savings in current spending redeployed to capital spending.
Investing wisely — physical and digital infrastructure, and skills
- Physical infrastructure priorities:
- Roads network is good; port investments are underway.
- To make ports fully productive, investment in railways—particularly for freight purposes—is needed.
- High priority investments also include solid waste and waste-water treatment.
- Public investment assessment and management capacities need to improve at all levels of government.
- IMF offers technical assistance if requested.
- Digitalization and technological infrastructure:
- Recommend a single independent entity with a long-term perspective to lead digitalization strategy and responsibility.
- Croatia lags behind advanced European peers and many New Member States in leading edge fast and ultra-fast digital technology, despite good connectivity in fixed broadband and mobile technologies.
- Households’ take-up of mainstream technologies is relatively slow; businesses’ integration of these technologies is also lagging.
- Progress in digital public services for individuals exists; more progress needed for digital services for businesses.
- The “START” initiative allowing simple electronic procedures to start a business is a welcome development.
- Skills and education:
- Higher education:
- Croatia does relatively well in the share of university graduates with engineering and technology skills, but their ability to find competitive employment domestically is limited.
- Opportunities: ICT and business services exports, and “near-shoring” in manufacturing enabled by better technology and more capital-intensive factories.
- Croatia needs to produce an even greater talent pool of university graduates in these fields to position as a hub.
- Primary and secondary education:
- Despite one of the lowest pupil-to-teacher ratios in Europe, Croatia is stagnating in natural science, mathematics, and problem-solving skills by most established measures.
- The issue appears to be whether current expenditures deliver needed results, not expenditure levels or teacher numbers.
- Vocational and technical training through apprenticeship programs for pre-high school graduates are recommended to enhance secondary education efficiency.
Conclusion and next steps
- Croatia is deepening European integration while technology evolves rapidly; this presents opportunities and challenges requiring long-term vision.
- The ERM-II process currently underway sets the stage, at the appropriate time, for euro adoption.
- The long-term future depends on domestic action: making the country more dynamic today for a better tomorrow.
- The mission thanks the authorities and all interlocutors for constructive dialogue and hospitality.
Republic of Croatia: Staff Concluding Statement of the 2019 Article IV Mission — December 16, 2019
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