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Republic of Croatia: Concluding Statement of the 2015 Article IV Mission
May 6, 2015
A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.
The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.
Croatia’s economy is projected to grow for the first time in seven years, as a more benign external environment supports exports and consumption, even though private investment continues to contract as corporations struggle with high debt levels. To foster durable growth and generate employment, vigorous reform efforts remain critical. These include strengthening debt workout frameworks, improving the governance of state-owned enterprises, and reducing red tape, especially at the levels of local governments and state agencies. High fiscal deficits and growing public debt render fiscal consolidation imperative, phased in gradually to limit the burden on the still feeble economy. Fiscal reporting requires strengthening.
Recent Developments, Outlook and Risks
1. There are positive signs for Croatia’s economy. Private consumption appears to have bottomed out, as evidenced by robust retail sales. Employment has stabilized. Corporate profits are recovering, including for state-owned enterprises. Most encouraging, both exports and foreign direct investment are showing signs of improvement (albeit from a low base), suggesting that the economy’s shift from inward orientation towards the tradable sector is finally making progress. Improved economic performance has been helped by a favorable external environment: lower energy prices that support consumption, stronger euro area growth that helps exports, and ample domestic and external liquidity that contain debt servicing costs. As a result of these factors, IMF staff projects real growth of about ½ of a percent in 2015—which would be the first positive growth rate in seven years—followed by a gradual recovery to growth rates of 1½–2 percent in subsequent years.
2. Still, the economy is not out of the woods, and several structural factors weigh on the recovery going forward. Corporate investment continues to contract as many companies struggle with high debt levels. State-owned enterprises (SOEs) continue to tie up a disproportionate part of economic resources. Together with a weak business environment and wages that remain relatively high compared to peers (i.e., other new EU member states), this increases the costs of operation for private corporations, hampering their efforts to strengthen competitiveness and re-orient toward markets with growth potential. Policy uncertainty—which is especially high in face of upcoming parliamentary elections—weighs on sentiment.
3. Risks to the outlook are tilted to the downside. The tailwinds from a favorable external environment may not last, with higher commodity prices, a stronger euro (and therefore kuna), and increased financial strains affecting funding conditions: all distinct possibilities. Corporations’ efforts to reduce debt may last longer than envisaged, hampering a self-sustained recovery in growth and employment. An uneven fiscal consolidation process (see below) may constrain growth. Finally, domestic political risks feature large ahead of parliamentary elections, and harbor the potential for popular but destabilizing policies.
Reviving Growth
4. The length and depth of Croatia’s recession has been both unusual and troubling. The pre-2008 boom left Croatia with appreciated wage and cost levels and impaired private sector balance sheets, similar to other countries in the region. However, different from them, limited export orientation left corporations without alternative sources of income as domestic demand contracted. Rigid labor markets dominated by state-owned enterprises slowed workforce restructuring and wage adjustment. An inefficient judicial system stood in the way of debt workouts. High wages and red tape, especially at the local government level, discouraged foreign direct investment.
5. Some important structural reforms have been taken in recent years. The revised labor law passed in 2014 reduced costs of workforce restructuring and increased flexibility of working hours. The investment promotion act of 2013 that aims at facilitating green field investments is showing first results. A pre-bankruptcy settlement procedure (PBSP) introduced in 2012 initially helped restructure some corporate debts. Some central government social benefits were streamlined. The share of SOEs in employment and corporate revenues has shrunk, mostly through downsizing in the context of tighter government oversight of SOE operations and SOE restructuring.
6. However, many structural obstacles remain to be addressed. Given the upcoming elections, in many areas decisive progress in the coming months is unlikely; but the reform agenda should be advanced forcefully thereafter.
Debt restructuring framework. The PBSP was halted in 2014 after problems arose relating to minority creditor rights. The revised procedure currently in front of the parliament aims at increasing legal certainty and should be passed swiftly, as should the envisaged consumer bankruptcy act. Judicial reform to enhance the capacity of commercial courts remains critical.
State-owned enterprises. Notwithstanding some improvement in the performance of SOEs, several problem cases persist, including the state railway and highway companies, as well as Petrokemija. In many cases—especially corporations operating in areas other than public infrastructure, and including currently profitable SOEs—sale is a better option than restructuring, as it would allow attracting professional expertise and thus overcome constraints from the public sector’s limited administrative capacity. Meanwhile, chronic governance issues need to be addressed. A positive step is the envisaged professionalization of SOE management and supervisory boards, including through public tenders for executive positions, and by holding management accountable to clear performance criteria.
Governance and business climate. Red tape, especially at the local government level, would best be addressed by comprehensive reform that clearly defines municipalities’ responsibilities, including by regulating access to central government funding according to municipalities’ capacity to provide public services. As for the central government, better coordination of regulatory activities by different line ministries and agencies is called for. The planned rationalization of para-fiscal charges and the envisaged reduction in state agencies are commendable steps. Another helpful measure would be to merge the land registry and the property cadastre.
Social benefits. Streamlining of benefits should encompass the entire central government and extend also to the myriad of transfers granted at the local level that often overlap with central government benefits, creating employment and poverty traps.
Pensions. A further increase in the penalty for early retirement—beyond that already enacted—is called for, as are reductions in privileged pensions, with a view to increase chronically low labor market participation.
Restoring Sustainability of the Public Finances
7. The analysis of fiscal policy is complicated by methodological changes and shifts in the coverage of the public sector, reflecting Croatia’s adoption of the European Union statistical accounting standards. While these changes should eventually greatly improve the quality of fiscal statistics—including by reflecting fiscal risks more accurately than the cash-based central government statistics used thus far—they trigger large revisions to fiscal aggregates in the short term. The 2014 general government deficit is now reported at a sizeable 5.7 percent of GDP, significantly higher than originally forecast. The widening reflects inter alia the inclusion of additional agencies in the deficit computation, and the calling of a state guarantee by Croatian Railroads. In terms of policies, expenditure-side consolidation efforts were neutralized by weak revenue performance in the face of GDP contraction and deflation, especially in the first half of 2014. As a result of both the deficit and methodological changes, public debt stands now at 85 percent of GDP and is on a rapidly increasing path.
8. The challenge for fiscal policy remains to strike a balance between sending a signal of strong and credible consolidation on the one hand—even more important now in the face of the upward revisions of government deficits and debt—and the need to not overburden the still weak economy on the other. Staff estimates that the fiscal stance reflected in Croatia’s 2015 convergence program with the EU contains net consolidation measures of 0.5-1 percent of GDP (a precise assessment is not possible, as several measures are not yet fully specified), yielding a headline deficit of 5-5½ percent of GDP. In terms of the quantity of fiscal adjustment, this appears broadly appropriate.
9. The composition and quality of consolidation measures is questionable, however. The 2015 budget contains an income tax cut of about 0.6 percent of GDP (through the realignment of tax brackets). Part of the cut is offset by a couple of high-quality but low-yielding revenue measures, notably higher excises for gasoline and tobacco, and a new tax on interest earnings. But the larger portion is compensated by ad-hoc and incompletely specified spending cuts in line ministries and—especially—SOEs, concentrated in material expenditures and public investment. Further, the convergence program contains optimistic forecasts for dividends collected from SOEs, and tax revenue projections also appear subject to downside risk, especially in view of deflationary pressures.
10. In IMF staff’s view, consolidation in 2015 would have been better carried out through (i) foregoing the income tax cut—whose effectiveness is doubtful, as it benefits mostly medium and higher earners—and instead (ii) well-defined revenue measures with limited spillovers to private demand, such as reducing exemptions from personal income tax (notably child tax allowances for higher earners), and limiting a tax break for reinvested corporate earnings. Better absorption of EU structural and cohesion funds would also help mitigating the impact of consolidation.
11. For 2016 and beyond, a priority is to restructure expenditures, so as to render public spending more growth and employment friendly. In particular, subsidies and transfers in Croatia are higher than in comparable countries, and are often poorly targeted. Conversely, public investment is low. In this context, the government has recently prepared a valuable public expenditure review, with a view to identifying options for fiscal consolidation going forward. This document should be published. Another priority is to complete preparations for a modern property tax; unfortunately, these efforts appear to have stalled.
12. Since the beginning of this year, the public health insurance fund operates outside the central government. IMF staff sees fiscal risks from loosening treasury control over spending. At the same time, the health insurance fund has engaged in an ambitious reform to strengthen performance incentives within the hospital system and increase pressures on hospitals to stay within their budgets. The test for success of these efforts will be whether the envisaged reduction in health sector arrears materializes. The government should stand ready to act if results disappoint.
Maintaining Monetary and Financial Stability
13. The kuna depreciated slightly against the euro in 2014 and early 2015 before recovering some ground in recent months. Overall, the central bank continues to tie the currency closely to the euro. While this prevents the exchange rate from acting as shock absorber, the policy is without viable alternative, given widespread distrust in a domestic monetary anchor—as evidenced by high deposit euroization—and the large share of foreign currency-denominated loans whose kuna-value would increase in case of devaluation. Foreign currency reserves remain modest compared to standard IMF adequacy metrics, but related risks are mitigated by the absence of foreign investors in kuna securities markets—reducing the risk of destabilizing sell-offs—and a tight regulatory regime that obliges banks to maintain sizeable foreign currency liquidity buffers.
14. The banking system has remained stable, and is, on average, liquid and well-capitalized. Continued supervisory vigilance is needed to preserve this record. Non-performing loans (NPLs) are high at almost 17 percent. Given banks’ large capital buffers, the stock of NPLs presents no systemic risk to financial stability. However, clearing out NPLs at a faster pace appears desirable, not least to allow borrowers a fresh start. A task force with representatives from tax authorities, the accounting and legal professions, banks, and regulators should seek to identify and remove obstacles to NPL write-offs and sales.
15. The surprise Swiss Franc (CHF) appreciation in early 2015 has affected a sizeable portion of borrowers indebted in CHF. Given the distress borrowers already suffered from CHF appreciation prior to 2012 (although the impact has been offset partly by lower CHF interest rates), the recourse to a quick, temporary relief measure in form of a one-year freeze of the applicable kuna/CHF exchange rate has been understandable. The unsettled situation produces policy uncertainty, however; hence negotiations between borrowers and creditors on a permanent solution should proceed swiftly. The negotiations should focus on needy borrowers that lack capacity to pay; according to central bank estimates about one-quarter of CHF borrowers owing about 5 percent of CHF debt. By contrast, across-the-board bailouts—that would also benefit large investors with speculative carry-trade positions—should be avoided for several reasons: (i) any such solution would result in a de facto conversion of CHF loans into kuna, putting pressure on already modest FX reserves and thus endangering financial stability, and (ii) the economy’s perception could suffer if an impression were to take hold that politicization is a means of avoiding contractual obligations.
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We thank the authorities for their hospitality and for constructive discussions.
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