Mission Concluding Statement 

Zagreb, Croatia: The Croatian economy has continued to grow rapidly, still among the highest in the euro area, and achieved notable progress in living standards, assisted in part by the robust absorption of the Recovery and Resilience Fund. However, imbalances are emerging and need to be curtailed. The fiscal stimulus during strong economic growth has led to rising fiscal deficits and exacerbated domestic demand pressure, contributing to higher inflation and current account deficit. Credit growth has been rapid and housing prices have increased strongly. Croatia continues to contend with subdued productivity, labor shortages and skill mismatches, and green and digital transitions. In the current global environment characterized by elevated uncertainty and structural shifts, it is crucial for Croatia to address the emerging imbalances early on and safeguard macroeconomic and financial stability, build resilience and buffers, and enhance productivity. We see a stronger and front-loaded fiscal consolidation as key to achieving these objectives. Further vigilance and close monitoring are warranted to preserve financial stability. Now is also the time to deepen reforms to sustain Croatia’s convergence to advanced Europe and put Croatia in a stronger position to respond to future shocks and challenges.

Outlook and Risks

The strong post-pandemic growth is expected to moderate with gradual disinflation. Amid elevated global uncertainty, we project real GDP growth to decelerate from almost 4 percent in 2024 to a still solid pace of 3.1 percent in 2025 and 2.7 percent in 2026. Strong domestic demand—supported by improving household real incomes, lower interest rates, and EU-funded investment—would more than offset potential adverse effects from elevated global uncertainty and weak growth of trading partners. Over the medium term, growth would approach its potential of 2½ percent, as productivity-enhancing investment under the National Recovery and Resilience Plan balances the drag from demographic headwinds. Inflation is projected to move closer to the ECB’s target in end 2026-early 2027, as growth slows, wage pressures moderate, the fiscal deficit stabilizes, and the euro appreciation so far and the Croatian National Bank’s (CNB) borrower-based macroprudential measures help disinflation. The current account deficit will continue to widen in the short run before improving somewhat over the medium term as domestic demand growth eases.

Risks to the growth outlook are broadly balanced while risks to inflation are tilted to the upside. Downside risks are mostly external. Growth may slow if external demand, particularly in the tourism sector, were to weaken, including because of worsening geopolitical or trade tensions, or weaker growth of major trading partners. Global shocks could also result in higher inflation, notably through energy and food prices. Domestically, there is a risk of protracted overheating, as maintaining an accommodative fiscal stance and higher-than-expected wage and credit growth could further fuel domestic demand, stall disinflation, and erode competitiveness. On the upside, faster implementation of essential structural reforms could ease supply side constraints, raising actual and potential growth.

Addressing Emerging Imbalances and Building Fiscal Buffers

Fiscal stimulus amid strong growth has amplified inflationary pressures and reduced Croatia’s competitiveness. The general government deficit has steadily increased since 2023 and is close to 3 percent of GDP this year, primarily due to higher wage bills and social benefits. Our analysis suggests that the fiscal stimulus, particularly the one resulting from public wage reform, has played a notable role in inflation since 2024. Moreover, the rapid growth of permanent spending on wages and social benefits also makes the budget more rigid, threatening public investment in the event of adverse shocks. Taking into account the government’s 2026 budget plan and existing policies, we project the deficit to remain at about 2.9 percent of GDP in 2026. Given the expected higher financing by EU grants which is deficit neutral, the budget plan implies little withdrawal of fiscal stimulus next year. Beyond 2026 we expect the fiscal deficit to remain marginally below 3 percent of GDP and estimate a modest withdrawal of fiscal stimulus. The public debt-to-GDP ratio is projected to increase slightly and approach 60 percent of GDP by 2030. We assess Croatia’s sovereign stress risk to be moderate.

We call for stronger and front-loaded reduction in the fiscal deficit, aiming to reach a structural primary balance by 2030. With the monetary policy set at the euro area level, greater and expedited consolidation that safeguards public investment is key for dampening demand pressures and reducing inflation and imbalances. It is also essential for strengthening Croatia’s competitiveness, generating resources for investment as the importance of the EU funding recedes, and building buffers against future shocks and large spending needs related to aging, defense, and green and digital transitions.

We recommend reducing the general government deficit to about 2½ percent of GDP in 2026. This can be achieved through restraint in public salary growth and social expenditure increases, along with improving VAT compliance. It is also important to end the remaining cost of living support measures and enforce and strengthen fiscal discipline at local government units to prevent deterioration in their fiscal position.

Over the medium term, consolidation should focus on enhancing spending efficiency as well as broadening the tax base and improving the tax system.

• Notwithstanding the authorities’ recent efforts, tax reforms are warranted to broaden the tax base and reduce distortions. Although Croatia’s tax revenue is close to the EU average, it is below pre-pandemic levels and there is considerable room to improve the tax system. Reviewing and rationalizing VAT exemptions and reduced rates and moving to value-based taxation on property and short-term rental income are important for strengthening tax collection and fairness. Croatia can consider introducing a carbon tax in parallel to the Emission Trading System (ETS) and removing explicit and implicit subsidies on fossil fuels.
• Croatia has significant scope to improve public spending efficiency. Public wage bills, already among the highest in the euro area, would rise further to about 13½ percent of GDP in 2025. We support strengthening actual or functional mergers of local government units. The authorities’ plan to review and rationalize public employment is also welcome. Based on our analysis, we suggest that the focus be on the healthcare and education sectors. Public spending on education and healthcare each exceeds the EU average by about ½ percent of GDP. Potential efficiency gains are substantial, and reforms can reduce fiscal costs and enhance health and education outcomes. Furthermore, better targeting social benefits would help limit spending growth while still supporting the most vulnerable.

Pension reforms are essential to raising adequacy, improving intergenerational equity, and ensuring long-term sustainability. The new Pension Insurance Law aims to improve pension adequacy that has been gradually eroding. As the system is already facing large deficits, measures to increase pension adequacy should be accompanied by policies to ensure the long-term financial sustainability of the system. Priorities include narrowing the numerous early retirement options, raising the retirement age and linking it to life-expectancy, and increasing the minimum contribution years.

The authorities should continue improving corporate governance of state-owned enterprises (SOEs) and public investment management. The adoption of a new legal framework on SOEs governance is welcome. By-laws and regulations for the implementation of the law need to be adopted soon and regular assessments and disclosure of fiscal risks stemming from SOEs need to be introduced. There remains scope to enhance public investment management, through a more centralized framework for appraisal, processing, and monitoring of public investment projects.

Bolstering Resilience of the Financial System

Heightened risks call for close monitoring and continued vigilance to safeguard financial stability. Despite declining profits, the banking system remains highly profitable, well capitalized, and highly liquid. While still moderate, cyclical systemic risks have risen with the synchronized rapid growth of bank credit and house prices as well as lenient lending criteria for new loans. Banks also face structural vulnerabilities stemming from digitalization, cybersecurity, climate, and the relatively elevated bank-sovereign nexus. Ongoing vigilance remains important given the buildup of vulnerabilities and risks, particularly in the housing sector. Moreover, corporate vulnerabilities should continue to be closely monitored, including by developing corporate stress tests and pursuing ongoing efforts to understand dynamics of intercompany loans.    

In response to the buildup of risks, the CNB appropriately tightened macroprudential policies. We welcome the introduction of explicit borrower-based measures (BBMs) aimed at reducing excessive household borrowing and helping ease inflationary pressures. Given the calibration of the BBMs, they will be likely more binding for cash loans than for housing loans. Going forward, as macro-financial conditions evolve, the authorities should continue to monitor their effectiveness (e.g., controlling for potential leakages) and consider recalibrating them if warranted, including by reducing the exemptions and the loan-to-value ratio for buy-to-let and investment housing loans in case cyclical risks persist. Coordination with housing policy measures is desirable. Specifically, measures to support demand should be carefully calibrated to avoid undermining the effects of BBMs while actions to further boost housing supply, including making better use of the large existing vacant stock, are highly recommended. We also support the recently announced increase of the counter-cyclical capital buffer (CCyB) to 2 percent on January 1, 2027, which will strengthen the banking system’s resilience and expand releasable buffers in the event of shocks.

Investing in Human Capital and Skills

Croatia should take advantage of its current economic upswing to deepen structural reforms. Recent growth has been supported by capital and labor accumulation, but productivity gains were relatively subdued. Investing in human capital and skills through healthcare and education reforms is essential to boosting productivity and potential growth.

Reform in the healthcare sector should aim at both reducing costs and improving outcomes. Croatia dedicates a larger share of its resources to healthcare than its peers, but health outcomes are lower Efficiency-enhancing reforms should reduce geographical inequality in access to healthcare services. Increasing prevention has the potential to significantly improve the population well-being and health outcomes. Furthermore, the central role of hospitals in the healthcare system should be reviewed, notably in the provision of outpatient care, with a view to cutting costs and freeing resources to prepare for the reorganization necessary for adapting to the needs of an aging population. Finally, improved use and distribution of pharmaceuticals could reduce costs for public finances and the population.

Education reform should focus on reducing skill mismatches, complemented by measures to increase participation in adult learning. This would require (i) a reorganization of the educational system to increase mandatory teaching hours; (ii) a revision of the curricula to better align education with labor market needs; and (iii) promoting tertiary education that is increasingly needed to acquire essential skills for an information-based economy and to adapt to rapid technological changes.

Immigration is helping Croatia tackle labor shortages and an aging population, but better integration is needed to realize its full potential. To maximize the impact of immigration on growth and welfare, policies need to further support labor market integration of the increasingly diverse workforce, better match and use immigrant skills, and strengthen recognition of foreign qualifications. The provision of public services, including at local levels, should keep up with demographic changes, and improving rental housing affordability is a priority.

The IMF team thanks the Croatian authorities and other counterparts for the constructive dialogue and productive collaboration. We are especially grateful to the Croatian National Bank and Ministry of Finance for their hospitality and excellent support.