The authorities continue to appreciate the close cooperation with the Fund. They valued the frank discussions with staff on the 2011 Article IV Consultation. The authorities broadly share the staffs views in the report, although they would like to nuance some of the findings. In line with their long-standing practice, the authorities consent to publication of the paper.
Economic Developments and Outlook
Since the 2008-09 crisis, the Croatian economy has been undergoing a painful but necessary internal adjustment. GDP growth contracted in 2009 and 2010 as a result of a slump in domestic demand. In the face of lower capital inflows, private sector balance sheets have started to deleverage. Amid the growing negative output gap and rise in unemployment, average nominal monthly wages declined and inflation came practically to a halt last year. Due to a contraction in imports and increase in exports, the current account deficit reduced sharply from almost 9 percent in 2008 to slightly more than 1 percent of GDP in 2010.
Given the ongoing internal devaluation, the authorities broadly share staffs assessment of the outlook. As regards the balance of risks to the outlook, the authorities agree that these are tilted to the downside in the short run. Developments in the periphery of Europe could affect Croatia through higher funding costs, but the impact has so far been relatively limited. Staff argues that in light of high financing needs, a shift in investor sentiment could trigger lower rollovers of external debt and BOP pressures. However, the authorities consider the likelihood of such a scenario very small, given the intercompany nature of the debt inflows. These inflows have proven to be very stable. Even at the peak of the global crisis, rollover rates exceeded 100 percent. Based on the inflows so far, external rollover needs will almost certainly be met in 2011.
The authorities have been working arduously towards EU accession, involving a wide range of far-reaching reforms. These efforts have been rewarded, as the Commission recently proposed to the EU Council of Ministers to close the last four chapters in the accession negotiations with Croatia. This will pave the way for Croatia to join the EU as of 1 July 2013. While EU accession is expected to increase growth, partly through higher capital investment, the authorities are fully aware that EU accession in itself will not lead to miracles. They share staffs view that through enhancing competitiveness and securing macroeconomic policy space Croatia could obtain much larger benefits of EU accession. Steadfast implementation of the Economic Recovery Program (ERP) and fiscal consolidation will therefore be required going forward.
Monetary and Exchange Rate policies
The authorities remain strongly committed to the broadly stable exchange rate regime. This policy has served the country well, by providing an anchor for inflation expectations and financial stability in the context of high financial euroization. Staff argues that the exchange rate regime has also contributed to overleveraging in foreign currency. According to the authorities, exactly the opposite is true. In Croatia, foreign currency credit is mostly driven by foreign currency deposits. Currency substitution was as high as 90 percent in the eighties and early nineties; reflecting a protracted period of unstable exchange rate developments and high inflation. Since the establishment of the actual exchange rate regime end-1993, liability and thus asset euroization in banks’ balance sheets have actually decreased. This process was only partly reversed since the crisis.
In view of the sizable foreign currency exposure of both the private and public sectors, the authorities recognize that even moderate exchange rate depreciation would cause strong negative balance sheet effects and credit losses. The broadly stable exchange rate regime is also key to retain the country’s investment grade rating, as was recently stated by Moody’s. In this regard, they agree with staff that exchange rate policy is constrained. At the same time, the benefits in terms of improving competitiveness through a more flexible exchange rate should not be exaggerated for a relatively small and open economy as Croatia. Even with nominal exchange rate depreciation, competitiveness in the broader sense would be helped only marginally, if the required real adjustments in fiscal policy and particularly labor and product markets would lag behind. In the view of the authorities, the benefits of the current regime therefore clearly outweigh the costs. The appropriateness of the regime was also recognized by the Board last year.
Given the broadly stable exchange rate policy and the existing external vulnerabilities, the authorities underscore the importance of having adequate foreign currency buffers. While reserves are relatively low compared to many other emerging markets in relation to maturing short-term liabilities, reserves are adequate in relation to imports and money supply. Assessing reserve adequacy goes further than merely looking at a few metrics, or a weighted metric, and requires taking into account country-specific circumstances, including the nature of liabilities. Croatia’s short-term debt consists largely of intercompany bank debt and FDI-related short-term liabilities that have proven to be less volatile than regular external bank debt or portfolio investments.
That being said, the authorities see merit in gradually increasing reserves, as they have been doing both before the crisis and again since 2010. However, the authorities see no merit in the staff’s suggested intervention technique. In the authorities’ view, such an asymmetric pre-announced intervention technique could lead markets to suspect that the authorities are altering the exchange rate regime through the backdoor. Therefore the authorities fear it could backfire on the goal of building up reserves.
Financial Sector policy
The banking system has weathered the downturn well, owing to conservative regulatory and prudential policies. Despite the rise in nonperforming loans, the banking system remains profitable and resilient, as illustrated by the report’s financial soundness indicators. Banking profitability is likely to remain subdued amid weak growth prospects. However, stress tests indicate that profits of most banks should be more than sufficient to fully absorb provisioning costs arising from an increase in NPLs ratio to roughly 18 percent, which is highly unlikely to materialize. Even in the event of a more severe worsening of asset quality, the system-wide capital adequacy ratio, currently almost 19 percent, would remain above the prudential minimum. The authorities are of the view that the experience of the crisis has demonstrated that the dependence of foreign parent banks turned out to be a factor mitigating liquidity risks.
The authorities agree to the need of fiscal consolidation to facilitate further internal adjustment, reduce debt, secure adequate policy space to address future economic shocks and absorb a rise in ageing-related spending. They are fully aware that this consolidation should be led by expenditure cuts in view of the high social security and tax rates. The authorities also aim to step up efforts in tax collection.
Despite having taken measures of almost 2 percent of GDP over 2009–10, the fiscal deficit has widened to 5 percent of GDP due to a slump in tax revenues. For this year, the authorities are strongly committed to contain the deficit. Public wages and pensions will again be frozen and subsidies reduced. In the event revenues fall short of what is expected, the authorities are committed to take compensatory measures. Their ambition is to reduce the fiscal deficit to around 2 percent of GDP by the end of 2013.
Guided by the recently established Fiscal Responsibility Law, the authorities will seek further consolidation, particularly through savings in the areas of public administration and social security. Rationalization of the public administration remains a priority for the government. Headcount reduction is progressing, although slower than expected, and steps have been taken that make the public work force more flexible. A new law is also being prepared to make the public sector wage system more merit-based. With respect to social security, the authorities have adopted several measures to curtail hospital and pharmaceutical spending by introducing more co-payments. Pension laws were also amended to equalize the retirement age between genders and a mix of penalties and incentives have been introduced to discourage early retirement. The fiscal impact of these steps is expected to increase over the medium to long run.
Wage and other structural policies
Croatia needs to boost competitiveness. While the real exchange rate is broadly in line with fundamentals according to CGER, the country has lagged many of its regional peers in gaining market share in the world’s good markets. Some progress was made in stimulating labor market participation and flexibility. Benefits after 3 months of unemployment were reduced, and the law on civil service employment was modified to allow for easier dismissal of unsatisfactory workers. The authorities agree that wage setting needs to be made more competitive. Equally important is to improve the business environment by reducing the administrative and regulatory barriers to entry and exit of firms. In this context, non-tax fees were cut by 25 percent. Yet there is more room for improvement. In September 2010 they adopted an action plan for eliminating investment barriers, covering business registration, issuance of permits and taxation. Amendments have also been made to the bankruptcy act, allowing for more speedy procedures. The authorities agree to the need to reduce the state involvement in the economy. Clear progress is being made to restructure and privatize the country’s shipyards.
All in all, the authorities recognize that, going forward, implementation of the reforms agreed in the context of EU accession and the ERP as well as further structural reforms are key to increase competitiveness and potential growth in a sustainable manner.