IMF Executive Board Concludes the 2012 Article IV Consultation with the Republic of CroatiaPublic Information Notice (PIN) No. 12/123
November 13, 2012
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. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2012 Article IV Consultation with the Republic of Croatia is also available.
On November 7, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Croatia.1
Sustained recovery from the economic crisis in 2009 remains elusive. Growth stagnated in 2011 after two years of contraction. With unfavorable external conditions and subdued domestic demand, GDP is expected to contract further by 1½ percent in 2012, only modestly picking up by ¾ percent in 2013. Further on, barriers to investment and employment growth, if not forcefully addressed, will keep potential growth modest.
Despite a significant narrowing of the current account deficit, external vulnerabilities remain high, with gross external debt above 100 percent and an external financing requirement of about 30 percent of GDP. Competitiveness is hampered by substantial non-price weaknesses, which have severely limited export growth performance.
To address these weaknesses and restart growth, the authorities adopted a comprehensive structural reform program in August 2012. The program aims to improve the business climate and competition and foster labor force participation by reducing administrative barriers to investment, speeding up restructuring and privatization of state-owned enterprises, and reforming pensions and health care systems. While some measures have already been taken, many important reforms remain to be developed in terms of specific policies and desired effects.
To restore fiscal sustainability, the authorities have launched a significant consolidation in 2012, aimed at reducing the deficit from 5.2 percent of GDP in 2011 to 4 percent of GDP in 2012 under staff’s macroeconomic projections. The adjustment has focused on better targeting of subsidies, restraints on expenditures of goods and services, and improved tax collection. Reforms in public sector workers’ remuneration and further rationalization of health expenditures have also been initiated, with results expected from 2013 on.
Within their framework centered on a broadly stable exchange rate, the Croatian National Bank has allowed in recent years increased two-way exchange rate flexibility, which has facilitated macroeconomic adjustment and limited speculation. Despite official credit support schemes, credit growth slowed down markedly in 2012 reflecting weak demand. The largely foreign-owned banking system remains well capitalized, although growing non-performing loans have started eroding profitability.
Executive Board Assessment
Executive Directors noted that Croatia is experiencing a prolonged recession reflecting subdued domestic demand, lackluster competitiveness, and a difficult external environment. Short-term growth prospects remain weak and downside risks prevail, while structural impediments hamper medium-term growth. Directors underscored the importance of advancing with policies and structural reforms to boost growth and reduce vulnerabilities.
Directors welcomed the authorities’ commitment to fiscal consolidation and the expenditure retrenchment that has taken place in 2012. While they recognized that fiscal consolidation is particularly challenging at the current juncture, they underscored its necessity to restore debt sustainability, satisfy the requirements of the Fiscal Responsibility Law, and retain market access. Directors therefore saw a need to continue a gradual but steady expenditure-based consolidation in 2013 and well into the medium term, while protecting capital spending. Directors also encouraged the authorities to persevere with their efforts to rebalance the tax structure away from labor in a revenue-neutral way.
Directors welcomed the recent adoption of the government’s structural reform program, which makes a good start on the road to restore competitiveness and spur growth. Strengthening EU funds absorption capacity would allow Croatia to take full advantage of EU accession by supporting growth-enhancing investments. Directors encouraged the authorities to develop specific policies and prioritize measures, focused on raising labor force participation, enhancing labor market flexibility, reducing barriers to market entry, and fostering competition.
Directors welcomed the increased exchange rate flexibility of recent years, as it has improved the economy’s resilience to shocks and aided macroeconomic adjustment. They generally agreed, however, that the broadly stable exchange rate framework has served Croatia well and that excessive exchange movements would be harmful given the high degree of euroization and the sizeable external debt. In order to build further an important buffer against external shocks, Directors recommended that the central bank continue to gradually accumulate international reserves.
Directors noted that the financial sector appears well-capitalized and resilient to shocks, but faces risks related to potential further deterioration of asset quality, indirect credit risk stemming from vulnerable borrowers, and sizeable dependence on parent banks for funding. They stressed the importance of maintaining high statutory capital buffers, ensuring adequate provisioning for non-performing loans, further strengthening financial supervision and regulation and cross-border supervisory cooperation, and closely monitoring liquidity and credit developments.