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Croatia: Staff Concluding Statement of the 2021 Article IV Mission
June 23, 2021
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IMF Communications Department
MEDIA RELATIONS
PRESS OFFICER: Raphael Anspach
Phone: +1 202 623-7100Email: MEDIA@IMF.org
June 23, 2021
PRESS OFFICER: Raphael Anspach
Phone: +1 202 623-7100Email: MEDIA@IMF.org
Washington, DC: Summary: Between the pandemic and two large earthquakes, Croatia has been severely tested, and the country’s resilience has come through. The economic contraction in 2020—painful as it has been—was not as severe as those experienced by many other economies with a strong tourism component. This is mainly due to the swift measures enacted by the authorities. Still, the pandemic is not yet vanquished. A higher share of the population needs to be vaccinated. Support measures must remain in place until the health of the population and the economy have been fully restored. As conditions improve, support measures need to rotate toward preparing the workforce for the post-pandemic world, and facilitating balance sheet repair of viable businesses. Thereafter, the challenge of once again reducing deficits and the public debt whilst shifting growth into a new high gear must be taken on. The generous funding from the EU represents a historic opportunity, to help meet these challenges successfully—an opportunity that must be fully utilized, in a timely fashion.
The skies are brightening again…
Following a painful contraction of 8 percent in 2020, the economy looks set for growth between 5 and 6 percent in 2021 driven by a rebound in the services sector and investment—provided the pandemic does not provide further unwelcome surprises. Since the first quarter, the recovery has picked up noticeably with areas like construction and manufacturing already reaching activity levels higher than in 2019. Overall, the number of registered unemployed persons has fallen by nearly 13 percent since a year ago. However, tourism and directly related sectors are yet to fully recover. This process is likely to take another year or two. With sufficient luck regarding tourism outcomes, and a successful vaccination drive within the next months, growth could even exceed 6 percent this year. Assuming the pandemic fades by the end of this year, growth could remain high over the next few years, if the country makes full and timely use of the potentially sizable forthcoming inflow of EU funds.
What are the immediate budget priorities?
The economic contraction last year would have been much more severe, were it not for the array of measures enacted by the authorities. These range from subsidy and job retention schemes, and tax relief and deferrals, to the opt-in limited time debt service moratorium, and guarantees and grants given to businesses, among other measures. It is hard to precisely quantify how much deeper the economic contraction, and the rise in inequality might have been in the absence of such measures. Yet, it is telling that the contraction in Croatia was lower than in many other countries across the world that have similarly high reliance on tourism, also due to structure of tourism supply and favorable geographic position.
Just as these support measures were essential during the worst of the crisis, they must now be better targeted to lagging sectors of the economy—and they must remain in place till the economy has more fully recovered. It is paramount that a vaccination drive be as successful and widespread as possible, that extra healthcare costs are fully met and arrears in the healthcare system are reduced to the maximum possible extent. Complementing the use of funds such as the European Social Fund, fiscal resources saved this year due to improving conditions can also be usefully redeployed to train more workers in sectors like greening and digitalization—where the productive and well-paid jobs of the future reside. In sum, in the view of IMF staff, the most important fiscal goal in 2021 is to focus on spending available resources wisely to restore the economy to health. If this is successfully accomplished this year, it will more firmly ground the efforts to reduce the deficit and debt over the next few years.
Regarding revenues, the authorities need to conserve all available resources to meet any unexpected expenditures into 2022, and well beyond. This is one clear lesson from this completely unforeseen shock the world has suffered. We hold that this is not the right time for any further tax cuts or weakening of the tax base. Current conditions are still far too fragile for the country to afford them. Frequent tax changes also create uncertainty, and risk complicating the tax system. Even after the pandemic subsides, Croatia needs to preserve its ability to respond to future shocks.
Back to the future: will we be ready?
There are numerous uncertainties about how a post-pandemic world will and should look. Nevertheless, two areas with few doubts are, that it will be more digitalized in the most basic aspects of our lives, and that it should be greener. In these two areas, Croatia has great strides to take, from which there will be a sizable return on investment, for decades to come.
After our last Article IV Consultation, our most important recommendation was to raise public investment, for the sake of future growth. Now, that conviction has only deepened, as it is important to acknowledge a singular aspect in which Croatia is actually better off than it was before the pandemic—the generous allocation of EU Funds, including from the Recovery and Resilience Fund (RRF) . The RRF resources amount to 10.6 percent of GDP in grants to be utilized by 2026. [1] These funds reflect a truly unique opportunity along the path of economic development, which many countries in the world are not fortunate enough to have. It is important for all stakeholders in Croatia to fully understand the significance of this opportunity. These funds are available, but they need to be absorbed efficiently, and in a timely manner. They must also be accompanied by needed reforms, discussed further below.
Previously, it may have been said that recommending higher public investment is all and good, but how can the resources for this investment be found without cutting other areas of government expenditure, and without increasing debt? That line of reason cannot hold now. Thanks to the influx of these EU funds beginning towards the end of this year, Croatia can significantly upgrade its public capital stock, decarbonize its economy, catch up with digitalization, and improve its maritime and rail transport systems. If the projected investments go according to plan, we currently assess that the funds from the RRF alone could add as much as 2.9 percentage points to real GDP over the next twenty years. [2] When the effects of the planned reforms, as well as the other EU structural funds are put together, Croatia now has its best chance since independence to significantly narrow the current 35% gap in per capita income with respect to the EU average. Furthermore, the prospect of living in a vibrant society with prosperity rapidly converging to EU levels could cause the young to fundamentally re-evaluate their future, thereby further stemming the tide of outward migration. That, in turn, would have the positive effect of reducing risks to the sustainability of the healthcare and pensions systems. It is very much possible now, and unlike ever before, to start a virtuous cycle—and to definitively escape past vicious circles.
IMF staff has and will continue to offer its input to help the country make the best of this opportunity. Significant progress can be made by strengthening public investment management practices so that available resources are used efficiently. This requires ensuring that the planning, selecting, budgeting and implementation of investment projects is at international best practice across the entire public sector. The authorities have requested a Public Investment Management Assessment (PIMA) from the IMF, to take place in August 2021. This assessment will help prepare an action plan to help make sure investment spending is effective, is sensitive to climate change related considerations and supports sustainable long-term growth.
The authorities’ National Recovery and Resilience Plan (NRRP) has laid out major complementary reform commitments across five components: green and digital economy, public administration and judiciary, education, science and research, labor market and social protection, and healthcare. These are essential for the flexibility Croatia needs to operate its economy smoothly, once inside the eurozone. We are encouraged that the plan is “front-loaded”, with a significant share of the reforms slated for completion over the next three years.
Within the reform areas where the strength of public finances is the focus, IMF staff re-emphasizes the importance of support, from all stakeholders, for the following:
In addition to these areas, constantly improving the competitiveness of the Croatian economy through active dialogue with the private sector, remains essential. In this regard, the authorities’ proposed improvements for both the tourism and non-tourism sectors alike are steps in the right direction. Current surveys suggest that recent efforts are already starting to deliver results—international investors now convey a greater willingness to increase their dealings with Croatia, particularly if the reform momentum keeps steady.
Monetary and financial sectors: continued vigilance
Monetary policy remains highly expansionary, within the exchange rate anchor in place since 1993. This stance is appropriate given the need to nurse the economy fully back to health. There are more than ample funds in the banking system to meet the demand for credit in an economy recovering from such a severe shock. The recent pick-up in inflation is more likely than not to be transitory in nature, relating to energy prices and the nascent economic recovery. Should inflationary pressures prove more persistent than in the euro area the CNB may consider reducing excess liquidity in the banking system, while maintaining exchange rate stability.
The banking system has remained liquid and is on average well capitalized. The restoration of the credit register is welcome, as this should help banks with their risk management. Bank lending to companies, which needed working capital, was initially strong at the onset of the pandemic, but has recently tapered off. Bank lending for housing remains firm. Uncollateralized retail cash loans have fallen—due to the pandemic and the CNB’s measures—which is a healthy development. Although the ratio of non-performing loans (NPLs) to total loans has remained stable, the so-called stage II loans, a forward-looking indicator of future asset quality problems, has risen—particularly for non-financial corporations. This development warrants continued close monitoring.
The pandemic has not affected the upward trend in house prices in Zagreb and coastal areas. To the extent that housing purchases are not driven by excessive household borrowing, they do not constitute an immediate financial stability risk. However, this also requires continued monitoring by the CNB. If circumstances require it, the CNB might wish to consider putting in place more formal macro-prudential measures (than the current implicit debt-service-to-income ratio included in the Foreclosure Act).
For the forthcoming increase in public investment to have maximum effect on the economy’s growth rate, it must be complemented by increases in private investment, as well. Reforms to the framework of debt restructuring, insolvency, and efforts to further improve predictability and efficiency in legal procedures remain central to unlocking more resources from investors, as it allows them to invest with greater confidence.
Conclusion
Despite the considerable setback dealt by the pandemic, Croatia has a rare opportunity, over the next five years, to restore its people and economy to health. It can ramp up the public investments necessary for appreciably higher growth rates, with the help of EU funds. Such opportunities should not be taken for granted. The onus of efforts is not exclusively on the authorities. All stakeholders in society must offer them the support for vital reforms, while doing their parts to re-energize private investment, and innovation. Adopting the euro will help remove some existing economic frictions by removing exchange rate risk. Yet, reaping the full benefits of the currency union requires strong focus and preparation. A brighter future is very much within reach. The time to act is now.
[1] Taken together with the regular structural EU funds, the country could experience total inflows of 35.7 percent of GDP over the next six years.
[2] This estimate is relative to a policy neutral real GDP baseline. The actual increment to the policy-neutral GDP level will depend on the extent to which the government replaces the depreciating capital stock that is added, and how it finances this replacement.
